Law and Economics Outline

Law and Economics

Barry

Fall 2011

The Nature of Economic Reasoning: p. 3

· Law and Economics: many of the doctrines and institutions of the legal system are best understood and explained as efforts to promote the efficient allocation of resources.

· Until the 1960s, economic analysis of the law was virtually synonymous with antitrust economics; the application of economics to the legal system has since emerged in countless fields (e.g., torts, contracts, restitution, property, IP, criminal law, family law and even constitutional law, etc); p. 29.

· Note: Guido Calabresi’s first article on torts and Ronald Coase’s article on social cost were the first modern attempts to apply economic analysis systematically to areas of law.

· Traditionally, economics was thought to be defined by its subject (the economy) not its method; the legal system, though understood to affect the economy, was not thought of as an economic system itself.

· A deeper, wider, more sustained engagement of economics with law had to await recognition that economics is both a theory as well as an area of study – specifically the theory of rational choice; one that can be applied to any social activity, thus including law, even when law regulates nonmarket activities, such as crime, adjudication, or marriage.

· Fundamental Concepts: Economics is the science of rational choice in a world in which resources are limited in relation to human desires.

· Rational maximization must not be confused with conscious calculation; economics is not a theory about consciousness.

· Behavior is rational when it conforms to the model of rational choice; information costs are often prohibitive (because they are so costly) especially when the information one seeks concerns the future.

· There will always be situations where rational choice is precluded by uncertainty, defined as non-calculable risk; uncertainty impedes the use of cost-benefit analysis because the costs, benefits (or both), are generally probabilistic, rather than certain, making precise estimation impossible.

· When people act in the face of uncertainty, they are not concocting a groundless probability, they are acting despite the uncertainty and weighing plausible consequences of foreseeable risks.

· People respond to incentives, thus producing the four fundamental principles of economics: (1) the Law of Demand; (2) opportunity costs; (3) tendency to gravitate toward most valuable/efficient usage; and (4) equilibrium.

· An economic theory of law will not capture the full complexity and confusion of the phenomena it attempts to explain, but its lack of realism is far from invalidating.

· Economic theory can explain a large number of market and nonmarket phenomena; judged simply by its explanatory power, economic theory is a significant success – suggesting that the assumption that people are rational maximizers of their satisfaction is not so unrealistic as it may seem.

· Another, and perhaps stronger test of economic theory is its predictive power; e.g., after the aftermath of communism, it was affirmed that price regulation lead to queuing, black markets, and shortages; competition and free trade, on the other hand, promoted productivity; and property rights encourage investment, etc.

Scarcity:

· What does it mean for resources to be scarce? à Where a good/service is limited (e.g., oil, steel, time, etc.).

· There are ways to get more out of your resources but at the end of the day, resources are limited.

· Economics is not about money; it is about the allocation of scarce resources.

Utility:

· How much does an individual ‘like’ a particular state of the world?

· Comparing and contrasting my preferences.

· The function of utility – takes into account anything we deem relevant about the state of the world and spits out a number for each person’s happiness; the importance of the utility function is the ranking.

· The social welfare/utility function: look at the whole world, country, or town and observe what the each unit values – what each country values as compared to others.

Rationale Decision Making:

· This assumes that people know what makes them happy and that they will act in ways (in response to incentives) that will give them what they want.

· Q: but do people know what makes them happy?

· On some level, people know what they want (e.g., favorite foods, favorite outfits, what cars we like, etc.)

· Turns out that lottery winners are less happy after they win then before they win because they bank on winning the lottery to make them happy.

· Q: even if people know what makes them happy, do they always act in their own self-interest?

· Again, sometimes people fail to do what will make them happy in the short-scheme, but generally will seek a life they are relatively happy with.

· Q: What do we mean by rational?

· The basic assumption that human behavior is rational seems contradicted by the experiences and observations of everyday life.

· Rationality (in an economic sense) is objective; rational decision-making is often intuitive rather than conscious & intentional.

· Ex: people who are really good at pool aren’t sitting down and calculating the physics of each shot, however, their actions take those calculations into account generally.

The Law of Demand:

· Poses an inverse relation between the price charged and the quantity demanded.

o However, this analysis assumes that the only change occurring in the system is the change in relative price or quantity; also assumes away the possible impact on income.

· Where a consumer’s income is reduced, he will be forced to buy more of some goods (inferior goods) instead of other goods (normal goods).

· Where a consumer’s income is increased, he will be able to buy more of some goods (superior goods) instead of other goods (normal goods).

Opportunity Cost: a cost incurred only when someone is denied use of a resource.

· Ex: the principle cost of higher education is not tuition; it is the forgone earnings that the student would have if he were working rather than attending school.

· Ex: where a woman decides to remain in the home to care for her children and manage the household, the earnings she forgoes by doing so is an opportunity cost.

o Rationale: housework, is an economic activity, even if the house worker is a spouse who does not receive pecuniary compensation.

· Though money is important, economics is primarily concerned with how resources are allocated; the economist actually distinguishes between transactions that affect the use of resources and purely pecuniary transactions (e.g., just a transfer of payment).

o Ex: the transfer by taxation of $1,000 from me to a poor person is costless in itself, regardless of its effects on his/my incentive or any differences in the value of a dollar to us; it does not diminish the stock of resources thus it is a private cost, not a social one.

§ Social Cost: diminish the wealth of society.

§ Private Cost: rearranges prior-existing wealth.

· An out-of-pocket cost is observed; an opportunity cost is an estimate of what will happen if an individual or a firm does or fails to do something; where there is uncertainty, a person may prefer the bird in the hand to the (possible) two birds in the bush.

The Demand Curve: relation of quantity to price

· Note: Must assume that nothing else changes about the world, only price and quantity are variable, everything else is constant.

· Generally, as price goes down, people are more likely to desire the product more (thus, higher quantity is demanded); where price increase, people will often buy substitutes and thus, less quantity is demanded.

· However, sometimes will buy more of something where the price is higher (e.g., just to prove they can afford the brand).

· Rarely, this same effect can happen in the super-poor market (e.g., rice and wheat – peasants had to make sure they got enough calories/day to survive, and when the price of the grain goes up, they must forego meats and purchase more of the grain).

· Additionally, network goods (e.g., telephone and internet access) – only worth anything to anyone when most people are using the same network.

· Further, where the price of a good continues to rise, more people will want to enter the market and become suppliers to benefit from those profits.

· With competition, the last item you produce tends to be ‘at cost,’ as you are going to be unwilling to produce an item that costs more than you will recover upon its sale.

· Consumer Surplus: the happiness that consumers have when they spend less then they would’ve if asked by the demand curve.

· Supplier Surplus: the happiness that suppliers have when they profit more than they would’ve settled for, if forced by the demand curve.

· Pareto Efficiency: where we can’t make anybody better off without making someone else, worse off – anything we do at this point that makes someone happier would make someone less happy.

· There can be no losers in Pareto Efficiency; usually pretty uncontroversial because no one is losing.

o Counter Ex: where an artist has sentimental value for his painting and a purchaser seeks it only for aesthetic purposes and they come to a Pareto Efficient selling-price, though economically this is a Pareto Improvement, this is a cost of the state of our society, and unless you are going to argue for a redistribution of wealth, prohibiting the t