George Mason Law and Economics Center PPE Program, June 2007 Second Three Hours: 19 June 2007 Eric Rasmusen, erasmu

1. George Mason Law and Economics Center PPE Program, June 2007 Second Three Hours: 19 June 2007 Eric Rasmusen, erasmuse@indiana.edu For institute materials: http://rasmusen.org/special/ppe-institute

2. The value of the economic approach “One of the attractions of the economic analysis of law is that it provides a way of answering questions about what the law out to be, what rights we ought to have. It starts with what looks like a very weak premise--- that one should design legal rules to maximize the size of the pie. It assumes nothing at all about the sorts of things we expect legal and ethical rules to be based on: desert, rights, justice, fairness.” (David Friedman, http://www.daviddfriedman.com/Academic/Course_Pages/L_and_E_LS_98/Why_Is_Law/Why_Is_Law_Chapter_15/Why_Is_Law_Chapter_15.html)

3. From one ethical principle, we get Theft and murder should be punished, but only if there is mens rea. More harmful offenses should be punished more heavily. Contracts should be enforced, and with expectation damages. Criminal penalties should require higher standards of proof than civil penalties. Procedures should try hard not to punish the innocent. Torts should be punished by fines, not prison, but only if there is negligence. Negligence should be defined as omitting precautions whose cost is greater than their benefit.

4. Hour 1: Big Ideas • Modelling • Market Failure- Market Power, Asymmetric Information, Externalities • Government Failure— Governments as collections of individuals • Marginalism • Opportunity Cost • Incentives (no detail on this)

5. MAKING MODELS: Good theory of any kind uses: Occam’s razor, which cuts out superfluous explanations, and the ceteris paribus assumption, which restricts attention to one issue at a time. Hourglass Approach: First, a broad and important problem is introduced. Second, it is reduced to a very special but tractable model that hopes to capture its essence. Third, in the most perilous part of the process, the results are expanded to apply to the original problem. Mahabharata Story of the Arrow Law, modern philosophy: hypotheticals. “Don’t fight the hypothetical”

6. MAKING MODELS 1. Logical Positivism, Popper, M. Friedman: A theory should have testable implications and be falsifiable. Assumptions can be totally unrealistic. 2. Paradigm Shifts, Kuhn. Theories last till something else fits better. It takes a theory to beat a theory. 3. Theorems are Processes, Lakatos. People don’t state a hypothesis and then test it or prove it: they figure out the hypothesis along the way as they test and prove. Economists implicitly accepts Lakatos, though M. Friedman’s theory is what they’ll tell you (because they don’t know the other two)

7. Making Models: Lachman I A map is an abstraction of the world, and its use requires a theory by which one can link the abstraction with the world. Before this linkage is established, however, one needs to know the questions the map should answer. Humbug. A map is a map is a map, you say? Then, by all means, help yourself to a soundscape map of Boston: “A composite view of the variety of city sounds s perceived along a sequence of streets . . . [in which symbols represent qualities of sounds . . ., for example, soft, intense, roaring, muted, sharp, echoing, expansive.” Or if that's not quite what you had in mind, how about an Eskimo Coastline Relief Carving (yes, you read that correctly), convenient for carrying on and around your ship? Or a color-coded map showing “The Percent of [the U.S] Population Unchurched . . . 1971?” And so on. http://homepage.mac.com/brettbecker/soundscape/pugetsoundscape.html

8. Making Models: Lachman II “Somehow, these maps offer little help in getting from Madison to Chicago. Instead I want a road map, and a certain kind at that: I need to be given the details of the street plan for the cities at each end, but not such details for everywhere in between. I need to know about the roads, and seasonal temperature and precipitation indicators would be nice. What about cloud movements, wind direction and color-keyed info on vegetation? National and local parks, population centers, and Howard Johnson restaurants? The map darkens progressively with colors and symbols, and darkens still some more until . . . until I notice that even as I gave free rein to my desire to know more, I consigned myself to a map from which I could only know less.”

9. Making Models: Lachman III “Now, within this budget, as in any other, there are allocative choices to be made. If I spend most of the available complexity showing parks and schools, there will not be much left for depicting the alternative street routes that can take me to my destination. So among the details of which the world is so rich, one must discern those details most important for the purpose at hand, and in the austerity that is the elegance of abstraction, select only the highest in priority from among these… The best abstraction, or even the better one, cannot be determined without reference to the abstraction's purpose. In order to judge the better map from the worse, a critic must know these goals --must even, for purposes of judging, accept them -- and carry on the criticism from there.”

10. Making Models: Lachman IV Differing senses of “like” are what distinguish one discipline from another, one form of answer from another. To my amazement in the first few days of law school, I learned that water can be like cows. When is water like cows? Answer: When it's escaping from land. A lawyer might be equally surprised to find that hay-bailing wire can be like San Francisco housing. When is this so? When both are in short supply due to price controls. Judith Lachman, ``Knowing and Showing Economics and Law, '' (A review of An Introduction to Law and Economics, A. Mitchell Polinsky (1983)) Yale Law Journal, 93: 1587, 1598-1605(July 1984).

11. Models: ALFRED MARSHALL (1) Use mathematics as a short-hand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. [BAD] (6) If you can't succeed in 4, burn 3. This last I did often.

12. Market Failure: When Do Markets not Maximize Surplus? A. Poorly defined or defended property rights B. Poor enforcement of contracts 1. Market power (monopoly) 2. Externalities (spillovers) 3. Asymmetric Information

13. Sen 1970 The Impossibility of a Paretian Liberal (Externalities) Prude and Lewd. (1) Prude reads the dirty book and Lewd does not. (2) Lewd reads the dirty book and Prude does not. Both prefer (2). That requires regulation, forced behavior. Mental externalities: If other people would pay $200 to me to paint my walls white instead of pink, and I would accept as little as $30, then surplus maximization requires that the walls be white. The idea is generalized in: Kaplow, Louis & Steven Shavell (2002a) Fairness versus Welfare (Cambridge, Mass: Harvard University Press, 2002). (2002b) “Human Nature and the Best Consequentialist Moral System,” Harvard Center for Law, Economics, and Business Discussion Paper No. 349. (2001a) “Moral Rules and the Moral Sentiments: Toward a Theory of an Optimal Moral System,” Harvard Law and Economics Discussion Paper No. 342,http://ssrn.com/abstract=293906 (November 2001).. (2001b) “Any Non-Welfarist Method of Policy Assessment Violates the Pareto Principle,”Journal of Political Economy, 109: 281-286 (April 2001).

14. Vice as Pollution (externalities) “ … the analogy between health and disease and virtue and vice. They differ in several essential respects, but they resemble each other in several leading points. Vice is as infectious as disease, and happily virtue is infectious, though health is not. Both vice and virtue are transmissible, and, to a considerable extent, hereditary. Virtue and vice resemble health and disease in being dependent upon broad general causes which, though always present, and capable of being greatly modified by human efforts, do not always force themselves on our attention.

15. Government Failure Two problems of governments: 1. They make dumb mistakes 2. They purposely choose not to do what a social planner would have them do. Reason: Governments are collections of people, each with their own objectives, which may or may not include the Public Good, and rarely include ONLY the Public Good.

16. Problems for the Social Planner (government failure) Is there market failure? If so, do we have to worry about government failure if we try to impose regulation? Easterly review of Sachs book on development aid: http://www.washingtonpost.com/wp-dyn/articles/A25562-2005Mar10.html, http://www.time.com/time/magazine/article/0,9171,1034738-11,00.html

17. Marginalism Let’s have a vote. Which is more important: Trees, or lumberjack jobs? Childseat safety, or convenience? A small budget deficit, or a strong army? Guns, or butter? These questions may be fun, but they’re stupid.

18. Marginalism Figure 8

19. Details here (Marginalism)

20. The Paradox of Value (marginalism) Water and Diamonds. Which is more valuable?

21. Opportunity Cost What would be the cost for you to get a J.D. in law?

22. The Parable of the Talents (KJV) (opportunity cost) Matthew 25: 14 For the kingdom of heaven is as a man travelling into a far country, who called his own servants, and delivered unto them his goods. 15 And unto one he gave five talents, to another two, and to another one; to every man according to his several ability; and straightway took his journey. 16 Then he that had received the five talents went and traded with the same, and made them other five talents. 17 And likewise he that had received two, he also gained other two. 18 But he that had received one went and digged in the earth, and hid his lord's money. 19 After a long time the lord of those servants cometh, and reckoneth with them. 20 And so he that had received five talents came and brought other five talents, saying, Lord, thou deliveredst unto me five talents: behold, I have gained beside them five talents more. 21 His lord said unto him, Well done, thou good and faithful servant: thou hast been faithful over a few things, I will make thee ruler over many things: enter thou into the joy of thy lord. 22 He also that had received two talents came and said, Lord, thou deliveredst unto me two talents: behold, I have gained two other talents beside them. 23 His lord said unto him, Well done, good and faithful servant; thou hast been faithful over a few things, I will make thee ruler over many things: enter thou into the joy of thy lord. 24 Then he which had received the one talent came and said, Lord, I knew thee that thou art an hard man, reaping where thou hast not sown, and gathering where thou hast not strawed: 25 And I was afraid, and went and hid thy talent in the earth: lo, there thou hast that is thine. 26 His lord answered and said unto him, Thou wicked and slothful servant, thou knewest that I reap where I sowed not, and gather where I have not strawed: 27 Thou oughtest therefore to have put my money to the exchangers, and then at my coming I should have received mine own with usury. 28 Take therefore the talent from him, and give it unto him which hath ten talents. 29 For unto every one that hath shall be given, and he shall have abundance: but from him that hath not shall be taken away even that which he hath. 30 And cast ye the unprofitable servant into outer darkness: there shall be weeping and gnashing of teeth.

23. (opportunity cost) You and your wife bought two tickets to the opera for $100. When you arrive, you find you left the tickets at home. The box office, though, says you can buy two new tickets just as good at the reduced price of $80. • Should you buy them?

24. (opportunity cost) Daniel Kahneman asked 200 people to imagine they were going to a movie. Upon arrival, half discover they've lost their tickets, while the other half discover they've lost $10 in cash. A new ticket costs $10. Only 12 percent of the participants who lost tickets said they'd buy replacements, compared with 54 percent of the cash losers. The tickets were regarded as an entertainment expense; but the cash had yet to be entered in any spreadsheet. (Michael Munger’s discussion is here) You can fool all of the people some of time…

25. Schumpeter: “The Process of Creative Destruction” (opportunity cost( When the government subsidizes companies like Lockheed or Chrysler or bans outsourcing of phone answering, “preserving jobs”, what is the cost? --The software industry doesn’t get the capital and labor it otherwise would. But nobody notices the “lost new jobs”– just the “preserved old jobs”. Roughly speaking: for one industry to grow, another industry must shrink.

26. Mankiw's 10 Principles (big ideas generally) 1. People Face Tradeoffs. To get one thing, you have to give up something else. Making decisions requires trading off one goal against another. 2. The Cost of Something Is What You Give Up to Get It. Decision-makers have to consider both the obvious and implicit costs of their actions. (opportunity cost) 3. Rational People Think at the Margin. (Marginalism; Think about small changes) A rational decision-maker takes action if and only if the marginal benefit of the action exceeds the marginal cost. 4. People Respond to Incentives.Behavior changes when costs or benefits change.

27. Mankiw's 10 Principles(big ideas generally) 5. Trade Can Make Everyone Better Off.Trade Raises Surplus Trade allows each person to specialize in the activities he or she does best. By trading with others, people can buy a greater variety of goods or services. 6. Markets Are Usually a Good Way to Organize Economic Activity. Start by Assuming that Markets Work Households and firms that interact in market economies act as if they are guided by an "invisible hand" that leads the market to allocate resources efficiently. The opposite of this is economic activity that is organized by a central planner within the government. 7. Governments Can Sometimes Improve Market Outcomes. Governments Can Help in Certain Situations: Market Power, Asymmetric Info, SpilloversWhen a market fails to allocate resources efficiently, the government can change the outcome through public policy. Examples are regulations against monopolies and pollution.

28. Mankiw's 10 Principles(big ideas generally) • 8. A Country's Standard of Living Depends on Its Ability to Produce Goods and Services.DROP THIS ONE. • Countries whose workers produce a large quantity of goods and services per unit of time enjoy a high standard of living. Similarly, as a nation's productivity grows, so does its average income. • 9. Prices Rise When the Government Prints Too Much Money.When a government creates large quantities of the nation's money, the value of the money falls. As a result, prices increase, requiring more of the same money to buy goods and services. • 10. Society Faces a Short-Run Tradeoff Between Inflation and Unemployment. DROP THIS ONE. • Reducing inflation often causes a temporary rise in unemployment. This tradeoff is crucial for understanding the short-run effects of changes in taxes,government spending and monetary policy. • (http://www.swlearning.com/economics/mankiw/principles2e/principles.html)

29. Mankiw's 10 Principles: Rasmusen substitutes(big ideas generally) • 8’. Government Decisions Are Made by People with Personal Motivations, not by Gods (government failure) • Governments act to advance people’s personal goals, not social ideals. As a result, governments often make wrong decisions, on purpose or through incompetence. • 10’. Consumption Is the Goal, not Production. • A country or person which produces more without consuming more is no better off, and is worse off if it has to work harder. • Yoram Bauman,"Mankiw’s Ten Principles of Economics, Translated for the Uninitiated" • For a different sort of list of big ideas: George Stigler, ``The Conference Handbook,'' Journal of Political Economy, 85: 441-443 (April 1977)

30. HOUR 2: Indifference Curves

31. HOUR 2: Indiffrence Curves Figure 9

32. HOUR 2: Indifference Curves Figure 10

33. maps detail readabilityself-other speed safety ALchian dagger too.

34. HOUR 2: Indifference Curves Figure 11

35. Hour 3: Crime

36. Six Approaches to Punishment 1. Economic, Surplus-Maximizing 2. Kantian, Authority protecting Dignity 3. Divine Law, revelation, tradition 4. Natural Law, what anyone can deduce from studying the world 5. Formalist, consistency, precedent 6. Power, Marxian, Thrasymichus: benefit your own group

37. The Criminal’s Demand Curve for Beef $14 Price per pound Demand by the criminal Supply by the store $4 pounds of beef per year 200 0 Figure 12

38. The Criminal’s Demand Curve for Larceny 14 days in jail Price per larceny Demand by the criminal Supply by victims 4 days in jail larcenies per year 200 0 Figure 13

39. What’s Wrong with Theft? If Smith values his car at $20,000, and Jones values it at $5,000, Smith should keep the car. How do we know the current owner (Smith) values the car most? We don’t. But if we prohibit stealing, and Jones actually values the car the most, we’ve done no harm. Jones can pay money for the car. If we allow stealing, what do people do that reduces total surplus?

40. The Implication: Prohibit as crimes activities which reduce surplus. Owners value their goods more than thieves do. Victims value their lives more than murderers do. Other drivers lose more from drunk driving than the drunk drivers gain in convenience. Sellers gain less from a cartel than consumers lose. Child-abusers benefit less from the abuse than the children lose.

41. Three Questions 1. Why make the penalty proportional to the crime, if we want to deter all crime? Why not make life imprisonment the penalty for both burglary and murder? 2. Why punish recidivists more? Fairness is one answer, but that begs the question. Why do we think some things are fair and not others? 3. Why are some evil deeds not punished as crimes? Most wives would prefer to have their husband hit them physically than with news of an adulterous affair, yet adultery is not (in most states) a crime. Why?

42. Why not make life imprisonment the penalty for both burglary and murder? 1. Marginal deterrence– otherwise a criminal has “nothing to lose” by doing even worse 2. Some crimes actually increase surplus 3. Punishment is costly (we don’t need fairness as an answer)

43. Efficient Crime: The Cabin A hunter, lost in the woods and starving, stumbles across a locked cabin containing food. He breaks in and feeds himself. His gain is more than the owner's loss, so his crime is efficient. Solution 1: It’s not a crime (defense of necessity) Solution 2: Prosecutorial discretion (policeman escorting a mother about to give birth to the hospital at 70 mph)

44. “Zero Tolerance” f you attend school in the Los Angeles Unified School District, don't carry a toy key fob like this one in your pocket. A 7-year-old boy was suspended in school for carrying one of these because it violates the district's "zero tolerance" policy on "weapon possession".

45. Judicial Discretion “If there be a controversy between men, and they come unto judgment, and [the judges] judge them; then they shall justify the righteous, and condemn the wicked; and it shall be, if the wicked man be worthy to be beaten, that the judge shall cause him to lie down, and to be beaten before his face, according to his wickedness, by number. Forty stripes he may give him, he shall not exceed;…” (Deuteronomy 25)

46. Optimal Costly Penalties If all burglaries would be deterred by having a 30-year sentence, then that would be a good idea--- a costless punishment. If some people will still offend, then it becomes a costly punishment. Thus, we need to balance extra deterrence against extra cost. More harmful crimes should have higher penalties, to deter more.

47. Fines: Low-Cost Penalties Suppose we have a 20% probability of a ten thousand dollar punishment for some crime. Why not switch to a 10% probability of a twenty thousand dollar punishment? We will only have to catch and try half as many criminals so we can save money by firing some police, judges and prosecutors. How about a 5% chance of a $40,000 penalty? How about a 1% chance of a $200,000 penalty?

48. Expected Penalties “If a man shall steal an ox, or a sheep, and kill it, or sell it; he shall pay five oxen for an ox, and four sheep for a sheep. If the thief be found breaking in, and be smitten so that he dieth, there shall be no bloodguiltiness for him. If the sun be risen upon him, there shall be bloodguiltiness for him; he shall make restitution: if he have nothing, then he shall be sold for his theft.” (Exodus 22)

49. 2. Why Aren’t Lying and Adultery Crimes? “Before an act can be treated as a crime, it ought to be capable of distinct definition and of specific proof, and it ought also to be of such a nature that it is worth while to prevent it at the risk of inflicting great damage, direct and indirect, upon those who commit it. These conditions are seldom, if ever, fulfilled by mere vices. It would obviously be impossible to indict a man for ingratitude or perfidy. Such charges are too vague for specific discussion and distinct proof on the one side, and disproof on the other. Moreover, the expense of the investigations necessary for the legal punishment of such conduct would be enormous. It would be necessary to go into an infinite number of delicate and subtle inquiries which would tear off all privacy from the lives of a large number of persons.” (Stephen)

50. 3. Why penalize recidivism? Recidivists have shown that the experience of a 1-year penalty will not deter them. Rather than giving them a series of 30 1-year terms, we could give them a single 30-year term. Another consideration: After three trials, we are more sure that they are truly guilty.