Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2017 Lecture 2

Logistics • TA sections begin this Friday • “Fake homework” for Wednesday on website • First real homework also up, due next Thursday (Feb 2) • If you want to read ahead: • Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication” • For a counterpoint to Posner: Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization” • Both have links on syllabus, and both are on Learn@UW

Last week, we… • defined law and economics • saw some brief history of the common law • and the civil law • and discussed ownership of dead whales

Today: efficiency • quick review of rational choice • what is efficiency? • is efficiency a good goal for the law?

Rationality, optimization,revealed preference

Most microeconomics is based on the premise of rational choice • People have preferences… • They understand their options, and how much they like each one • …and they optimize • They choose the option they like the best • This is what economists mean when we talk about rationality or rational behavior • Behavior that is consistent with someone having well-defined, consistent preferences • And this is what we’ll be assuming throughout the semester 5

This leads to the idea of revealed preference • If I see you choosing something… • …I infer you like it more than your other alternatives • We assume people succeeded in doing what they like, rather than screwing up and doing the wrong thing • And this allows us to learn peoples’ preferences from their choices (to some degree) 6

All this is useful if we want to judge what are “good” outcomes • If we assume that people have coherent preferences… • …and that we might be able to learn those preferences… • …then we can try to use those preferences to judge when one societal outcome is “better” than another 7

One way to do this: Pareto criterion • a Pareto improvement is any change to the economy which leaves… • everyone at least as well off, and • someone strictly better off • example • you prefer $3,500 to your car • I prefer your car to $3,500 • I buy it for $3,500 – Pareto improvement • an outcome is Pareto superior to another, or Pareto dominates it, if the second is a Pareto improvement over the first Vilfredo Pareto(1848-1923) 8

Pareto superiority is not that useful a measure for evaluating a legal system • Pareto improvements are “win-win” • But most new laws create some winners and some losers • so the Pareto criterion usually can’t tell us whether one policy is “better” than another • even the car example might not be a true Pareto-improvement • So we need another way to compare outcomes 9

Kaldor-Hicksand Efficiency 10

We generally assume preferences are complete • Given any two options, I can figure out which one I like more (or else I truly don’t care) • Given two options – say, $4,000, or a 2002 Grand Am… • Maybe I prefer the money • Maybe I prefer the car • Maybe I’m exactly indifferent between the two • But one of these must be the case 11

We also assume more money is better… • If you don’t like it, you can always burn it… • …but we generally assume everyone prefers more money to less money “Everybody needs money. That’swhy they call it money.” -Danny DeVito, in Heist 12

And finally, we assume preferences are continuous • If I prefer your car to $3,000… • …but I prefer $5,000 to your car… • …there’s some amount in between that makes me indifferent • We can say that’s my value for the car • If I’m exactly indifferent between $4,000 and your car… • …we can say I value your car at $4,000 13

Next, we define Kaldor-Hicks improvement • Informally: a K-H improvement is any change to the economy which increases the total value achieved by everyone in society… • …where the “value” someone gets from something is measured by their willingness to pay for it

Next, we define Kaldor-Hicks improvement • Suppose there are three people in society, each has $100 • If we find a policy change that leaves them with ($105, $105, $95), that’s a Kaldor-Hicks improvement • Going back to the car example • Your car is worth $3,000 to you and $4,000 to me • Government seizes your car and gives it to me • I’m better off, you’re worse off • But since I value the car more than you… • …this is a Kaldor-Hicks improvement

Another way to think about Kaldor-Hicks improvements • Unlike a Pareto improvement, a Kaldor-Hicks improvementcan create some winners and some losers… • …as long as the winners gain more than the losers lose • If I get your car for free… • I end up better off by $4,000 (my value for the car) • You end up $3,000 worse off (your value for the car) • $4,000 > $3,000, so this is a K-H improvement • We can think of it as a net creation of value • We created $4,000 of value (me getting the car) • And destroyed $3,000 of value (you losing it) 16

Formal definition of a Kaldor-Hicks improvement • a change to the economy is a Kaldor-Hicks improvement if it could be turned into a Pareto improvement with monetary transfers • K-H improvements also called potential Pareto improvements • I get your car for free • If we combined this change with me giving you $3,500… • …then it would be a Pareto improvement • So even without the transfer, it’s a K-H improvement 17

Another example • You and I are neighbors, you want to throw a party • The party would make me $100 worse off… • …and make you $50 better off… • …and make each of your 30 guests $5 better off • Is the party a Pareto improvement? • No – can’t be, because it makes me worse off • Is the party a Kaldor-Hicks improvement? • Yes – it increases total value: $50 + $150 – $100 = $100 > 0 • (Or: you could throw the party, plus you give me $40 and each of your guests gives me $3 – that would be a Pareto improvement, so just having the party is a K-H improvement) 18

Efficiency • we will call a change to the economy efficient if it is a Kaldor-Hicks improvement • we’ll say law A is more efficient than law B if moving from B to A is a Kaldor-Hicks improvement • and we’ll say a situation is efficient if there are no available Kaldor-Hicks improvements • an efficient situation is when there’s no way to make some people better off, without making some others worse off by more • we’re already getting maximal value out of all available resources

Pareto vs Kaldor-Hicks improvements Pareto improvement Kaldor-Hicks improvement • “good for everyone” • makes some people strictly better off, doesn’t make anybody worse off • “good for society as a whole” • may make some people worse off, but increases total surplus/value not that interesting, because they wouldn’t be controversial we’ll often be looking for these

All semester, when we say “efficient”, this is what we’ll mean • Outcome A is more efficientthan outcome B if it’s a Kaldor-Hicks improvement • If there’s more total surplus realized under outcome A • Or if outcome A, plus some monetary transfers, would Pareto-dominate outcome B • Outcome A is efficient if there’s no way to change it that creates a Kaldor-Hicks improvement • No way to increase total value being achieved

We said it’s efficient for you to have the party • Makes you $50 better off • Makes 30 guests $5 better off • Makes me $100 worse off • $50 + $150 – $100 = 100  party “creates $100 of value” • So it’s efficient for you to have the party • True whether you compensate me or not • Even if “my slice of the pie” is smaller, overall pie is bigger… • …which is all that efficiency measures

What we’ve really done here • In a sense, what we’ve done here is created a way to add up different peoples’ utility functions… • …by equating utility with willingness to pay • We said the party made me $100 worse off • We equated my disutility from you making noise with the amount of money that would replace the inconvenience – if you threw the party and gave me $100, I’d be just as well off as before • Once we’ve done that, what’s efficient is whatever configuration of the economy “creates the most value”

One more example: is it efficient for me to drive to work instead of taking the bus? • Bus to campus from where I live is free • Driving is more convenient, but costs me $1 (gas) • Driving also imposes costs on other people: there’s more traffic, less parking, more pollution • Suppose when I drive to work, it makes 1,000 other people worse off by $0.01 each • By driving to work, I create $11 of total costs • It’s efficient for me to drive to work if the benefit I get is more than $11 • If the benefit is less than $11, it’s inefficient for me to drive

Some other, similar measures • our definition of efficiency: actions are taken when total benefits outweigh total costs • “goal” is to achieve all Kaldor-Hicks improvements • Ellickson: efficiency is “minimizing the objective sum of (1) transaction costs, and (2) deadweight losses arising from failures to exploit potential gains from trade” • Posner: “wealth maximization” • Polinsky: “Efficiency corresponds to ‘the size of the pie’, while equity has to do with how it is sliced”

What forces lead to inefficiency

To see whether something’s efficient… • Compare gains to everyone in society (total social benefit)… • …to costs to everyone (total social cost) • Example we already saw (me driving to work): • Total social cost = $1 (gas) + 1,000 X $0.01 = $11 • Total social benefit = whatever benefit I gain by driving to work • So we just said: it’s efficientfor me to drive to campus whenever the value I get from driving is more than $11

How do we expect people to actually behave? • When people decide how to act… • …they consider the cost and benefit to themselves, not to everyone • private benefit and private cost • Driving only costs me $1 • so I’ll drive whenever benefit to me is more than $1 • On days when value I get from driving is more than $1 but less than $11, I’ll choose to drive to work even though that’s inefficient

So externalities cause inefficiency • I’ll do something whenever private benefit > private cost • Efficiency depends on whether social benefit > social cost • If I was the only one affected by my choices, then social benefit = private benefit and social cost = private cost • when I’m deciding which movie to watch on Netflix, nobody else is affected by my choice, so my choice will be efficient • But when my choices affect other peoples’ payoffs… • social benefit ¹ private benefit, or social cost ¹ private cost • so actions I choose to take may not be efficient

A classic example of this: the Tragedy of the Commons • Hardin (1968), “The Tragedy of the Commons” • Picture a small fishing village on a lake • The more fish I catch, the fewerfish are left in the lake… • …and the harder it is for everyone else in the village to catch fish • So my fishing imposes a cost (externality) on everyone else • So everyone ends up fishing more than the efficient amount

Tragedy of the Commons – example • 10 fishermen • Cost of fishing is 12 fish per hour • Notation • h = how many hours I fish • H = combined hours everyone in the village fishes • Fishermen catch 100 – H fish per hour • What is the efficient level of fishing? How much utility would that give to each fisherman? 4.4 hours per day per fisherman; 193.6 fish/day • Left to their own devices, how much will each person choose to fish? How much utility will each person get? Total fish caught “Maximum Sustainable Yield” H (100 – H) Efficient Level of Fishing 0 2.5 5 7.5 10 Hours fishing, per day, per fisherman

Tragedy of the Commons – example • 10 fishermen • Cost of fishing is 12 fish per hour • Notation • h = how many hours I fish • H = combined hours everyone in the village fishes • Fishermen catch 100 – H fish per hour • What is the efficient level of fishing? How much utility would that give to each fisherman? 4.4 hours per day per fisherman; 193.6 fish/day • Left to their own devices, how much will each person choose to fish? How much utility will each person get? 8 hours per day per fisherman; 64 fish/day Total fish caught “Maximum Sustainable Yield” H (100 – H) “Equilibrium” Level of Fishing Efficient Level of Fishing 0 2.5 5 7.5 10 Hours fishing, per day, per fisherman

What’s going on here? • Fishing imposes a negative externality on other fishermen • Each one ignores this externality when deciding how much to fish… • …so they all end up fishing more than the efficient amount • Same thing happens with other communal resources • Cattle grazing, whaling, overhunting, oyster beds • Aristotle: “That which is common to the greatest number has the least care bestowed upon it” • Elinor Ostrom, who shared the 2009 Nobel Prize in Economics, studies how different societies solve this problem • Positive externalities work the opposite way • Activities which create positive externalities are naturally done less than the efficient amount

So externalities can lead to inefficiency • Without some sort of regulation/intervention… • Activities which impose a negative externality will tend to happen more than the efficient amount… • …and activities which impose a positive externality will tend to happen less than the efficient amount • One recurring theme we’ll see in this class: if we want the law to lead to efficient outcomes, we can try to design the law to eliminate externalities! • “Internalization”

Other forces which lead to inefficiency

Another thing that leads to inefficiency:barriers to trade • Cuban cigars • Suppose I’d pay $15 each for Cohibas • They cost $2 each to make, and another$3 each to transport from Havana to Madison • Clearly, it’s efficient for me to smoke Cohibas • But trade embargo on Cuba makes it illegal for me to buy them • Anything that prevents me from buying something I want can be a source of inefficiency • One approach to property law: make it as easy as possible for people to trade among themselves • (This may seem like an obvious point; but then, there are lots of things we’re not allowed to sell…)

Another thing that leads to inefficiency: taxes • I value my free time at $40/hour • Working in a factory, I can build things worth $50/hour • Clearly, it’s efficient for me to work • Each hour I work creates $10 of new value • Doesn’t matter who gets it – it’s efficient for me to work • But suppose there’s a 25% income tax • Factory owner can’t pay me more than $50/hour • But $50/hour pre-tax is only $37.50 after-tax… • …and I’d rather stay home than earn $37.50 an hour • So I don’t get hired – which is inefficient

Another example of taxes leading to inefficiency • This is a new BMW that’s been cut in half • Taxes distort behavior away from efficiency

(or private information) Another thing that leads to inefficiency: monopoly • Example • Demand for some good given by P = 100 – Q • Monopolist can produce good for $40/unit • Monopoly price is 70, demand is 30 • Deadweight loss is inefficiency • Customers willing to pay more than marginal cost but unable to trade CS P = 100 – Q P* = 70 Profit DWL MC = 40 Q* = 30

But, saying these things lead to inefficiency doesn’t automatically mean they’re bad • For example • we just said taxes lead to inefficiency… • …but without taxes, there’s be far too few public goods, which is also inefficient • we just said monopoly leads to inefficiency… • …but we’ll study patents, which are legal monopolies used to encourage innovation • But also, we’ve defined “efficient”, but we haven’t claimed that “efficient = good” • Which brings us to…

Is efficiency a good goal for the law? Jump

Important distinction: positive versus normative economics • positivestatements are statements of fact • can be descriptive: “2014 U.S. GDP was $17 trillion” • can be theoretical predictions: “if prices rise, demand will fall” • “economics of what is” • normative statements contain value judgments • for example, “less inequality is better” • or, “government should encourage innovation” • “economics of what ought to be”

Most of this class will be positive analysis • Predicting behavior, and outcomes, that follow from a law or legal system is positiveeconomics • “Law X will lead to fewer car accidents than law Y” • “Law X will lead to more efficient outcomes than law Y” • But in the background, we’d like some sense of what is the normative goal of the legal system • “Law X is better than law Y” • One candidate for that normative goal is efficiency

Friedman gives a few arguments for studying efficiency “The central question [in this book]… is a simple one: what set of rules and institutions maximize the size of the pie? What legal rules are economically efficient? There are at least three reasons why that is the question we ask. The first is that while economic efficiency… is not the only thing that matters to human beings, it is something that matters quite a lot to most human beings. The second reason is that there is evidence that considerable parts of the legal system we live in can be explained as tools to generate efficient outcomes… It is a lot easier to make sense out of a tool if you know what it is designed to do. A final reason is that figuring out what rules lead to… efficient outcomes is one of the things economists know how to do – and when you have a hammer, everything looks like a nail.” - Friedman, Law’s Order, p. 312

Indeed, focusing on efficiency will make things much easier for us in some ways • All we care about is “final outcomes” – who ended up with what – not why • We can ignore the direct effect of monetary transfers • Suppose the law says if I hit you with my car, I owe you $3,119 • Me paying you that money has no impact on efficiency • So we can ignore the transfer itself, and think only about its effects on our incentives 45

Another argument why policy evaluation should at least start with efficiency… Let’s first dispense with the straw man. I’ve never heard of an economist who believes that every efficient policy is good, and I’ve heard of very few who believe that every inefficient policy is bad. It’s true that most economists do seem to believe that any good policy analysis should start by considering efficiency. That doesn’t mean it should end there. I think economists are right to emphasize efficiency, and I think so for (at least) two reasons. First, emphasizing efficiency forces us to concentrate on the most important problems. Second, emphasizing efficiency forces us to be honest about our goals. – Steven Landsburg http://www.thebigquestions.com/2010/08/30/efficiency-experts 46

“Emphasizing efficiency forces us to be honest about our goals” Politician: Here’s my program to make the health care system work better by subsidizing health care for the poor. Economist: Your program costs a billion dollars and delivers half a billion dollars worth of benefits. That’s inefficient. Politician: So what? Economist: Well, the “so what” is that maybe you could take that billion dollars and deliver a full billion dollars worth of benefits instead if you spent it a little differently. Why not just hand the cash out to poor people? Politician: Because I don’t want to help all poor people. I only want to help sick poor people – and this is the only way I can think of to do that. Economist: Ah. So your goal here is not to make the health care system work better at all. Instead it’s to transfer resources to sick poor people. Politician: I guess so. Economist: That’s fine. Now we can have a healthy debate about whether that’s what we want to do. 47

But… • This answers the question, “Why should we study efficiency?” • Not the question, “Should the law be designed with the goal of achieving efficiency?” • We’ll tackle this latter question on Wednesday Jump

Up next • Where we’re headed next:Richard Posner, “The Ethical and Political Basis of Efficiency Norm in Common Law Adjudication” • For a counterpoint to Posner:Peter Hammond, “Review: The Economics of Justice and the Criterion of Wealth Maximization” • After that, we’ll get to:Ronald Coase, “The Problem of Social Cost” • Wednesday, I’ll be showing an example of how “narrow taxes distort more than broad-based taxes”The example is online as a “fake homework” • See you Wednesday! 49

Econ 522 Economics of Law