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Prof. Dr. Friedrich Schneider Institut für Volkswirtschaftslehre http://www.econ.jku.at/schneider. Recht und Ökonomie ( Law and Economics ). LVA-Nr.: 239.203 W S 2012/13 (2) The Coase Theorem and Behavioral Economics. 1. Assumptions and premises. People respond to incentives.

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Prof. Dr. Friedrich Schneider

Institut für Volkswirtschaftslehre

http://www.econ.jku.at/schneider

Recht und Ökonomie (Law and Economics)

LVA-Nr.: 239.203

WS 2012/13

(2) The Coase Theorem and Behavioral Economics

Law and Economics

1 assumptions and premises
1. Assumptions and premises
  • People respond to incentives.
  • Law is a method of ordering society to further social goals.
    • Law creates incentives for people to behave in certain ways.
    • Law can help people by facilitating their achievement of their legitimate goals.
  • Economics provides both theoretical and empirical techniques for examining law’s likely and actual effects in the world.

Law and Economics

1 assumptions and premises cont
1. Assumptions and premises (cont.)
  • So, to discourage a particular activity, law should increase the “price” for engaging in that activity.
    • E.g., by increasing the sanction for engaging in undesirable behavior.
    • Or by increasing monitoring and enforcement of the undesirable activity.
    • If legal sanctions increase or become more likely, people will “consume” less of the sanction-triggering activity.

Law and Economics

2 coase theorem
2. Coase Theorem

Ronald A. Coase, “The Problem of Social Cost,” 3 J.L. & Econ. 1 (1960).

If transaction costs are zero, bargaining will lead to an efficient allocation of resources, regardless of the law.

Law is only necessary to induce efficient behavior when transaction costs are positive.

An implication: assign legal entitlements to the party who would have ended up with the entitlement (that is, to the person who values it the most).

Law and Economics

3 the economics of contract law
3. The Economics of Contract Law
  • Law should seek to reduce the costs of concluding and enforcing consensual agreements.
  • Law does so by providing a set of default and mandatory rules that contracting parties can use as a template for concluding an agreement.
    • Default rules.
    • Mandatory rules.

Law and Economics

3 the economics of contract law cont
3. The Economics of Contract Law (cont.)
  • Why do private parties need help in forming, relying upon, and completing consensual agreements?
    • Time-intensive transactions (i.e., those that take time to complete).
    • Coordination, commitment, and cooperation.
    • Risk allocation.
    • Information exchange.

Law and Economics

4 the economics of tort law
4. The Economics of Tort Law
  • Minimize the social costs of accidents.
    • Precaution costs.
    • Accident losses.
    • Administrative costs.
  • Continue to assume that potential victims and injurers are rational decision-makers.

Law and Economics

4 the economics of tort law cont
4. The Economics of Tort Law (cont.)
  • Tort law holds out the prospect of liability for accident losses so as to:
    • create incentives for parties to choose levels of precaution and activities in which to participate in order to minimize their liability, and
    • thereby to minimize the social costs of accidents.

Law and Economics

5 precaution costs
5. Precaution costs
  • How does a rational potential injurer decide how much precaution to purchase?
    • Assume provisionally that the injurer will be liable for the victim’s losses if there is an accident.
      • But recognize that most parties are acting “behind a veil of ignorance” - they do not know if they will be a victim or an injurer.
    • A rational potential injurer takes all cost-justified precaution - i.e., precaution for which the cost of the last unit of precaution taken is just equal to the benefit provided by that precaution.

Law and Economics

5 precaution costs cont
5. Precaution costs (cont.)

The expected benefit of a unit of precaution equals the probability of an accident’s occurring times the anticipated accident losses.

Suppose that one more unit of care will reduce the probability of an accident’s occurring by 0.005 and that if an accident occurs, given that amount of precaution, the losses are likely to be 100,000$.

The expected benefit of that unit of precaution is (0.005) x 100,000$ = 500$.

So, if that unit of precaution costs less than 500$, society would like a potential injurer to purchase the precaution because the cost is less than the expected benefit.

Law and Economics

6 additional topics in the economics of tort liability
6. Additional topics in the economics of tort liability
  • Different tort liability standards.
  • The relationship between administrative agency safety regulation and tort liability.
    • Should regulatory compliance be a defense in a private tort action?
  • “Who are these rational people you’re talking about?”
    • If injurers and victims are not fully rational, then a situation that might seem to be one of bilateral precaution may be, instead, one of unilateral precaution.

Law and Economics

7 crime and punishment
7. Crime and Punishment
  • Becker’s rational-choice theory of the decision to commit a crime:
    • Criminal compares the expected costs (EC) and expected benefits (EB) of a crime.
    • Expected costs (EC) include the probability of detection, arrest, and conviction times the value of the sanction imposed.
    • Expected benefits (EB) include the monetary value of the crime plus any non-monetary satisfaction the criminal receives.

Law and Economics

7 crime and punishment cont
7. Crime and Punishment (cont.)
  • A rational potential criminal commits the crime if EB > EC and refrains if EB < EC.
  • Society can reduce crime by raising the expected costs of crime.
    • Raise the probability of detection, arrest and conviction, or
    • increase the criminal sanction, or
    • do both.

Law and Economics

8 recent u s statistics on crime
8. Recent U.S. Statistics on Crime
  • Since mid- and late 1980s a decline in non-violent crime. There is now less auto theft in the U.S. than in much of Western Europe.
    • Property crimes down 30 percent in the 1990s.
  • Since 1991 a precipitous decline in violent crime, with homicide at the lowest level since the 1930s.
    • Homicide rates down 40 percent in the 1990s.

Law and Economics

9 why the decline in crime
9. Why the Decline in Crime?
  • “Deterrence works”.
    • Increasing incarceration rates.
    • More police and improved policing strategies.
  • Decline in crack cocaine.
  • A robust economy.
  • Increased victim precaution.
    • Alarms and security procedures.
    • Faster and more effective trauma treatment.
  • The legalization of abortion?

Law and Economics

10 donohue levitt the impact of legalized abortion on crime
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime”
  • Donohue and Levitt attribute half of the decline in crime since 1991 to the legalization of abortion in 1973.
    • Roe vs. Wade led to a significant increase in the number of abortions. (1.6 million per year by 1980; 1 abortion per 2 live births.) Therefore, relatively fewer 18 year-olds in the population beginning in 1991.
    • All the other factors together account for the other half of the decline.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • What’s the evidence for legalized abortion’s effect on crime?
    • Broad consistency with the prevailing pattern - namely, most crime is committed by 18-24 year-old males; because of legalized abortion, there are fewer 18 year-olds exactly 18 years after Roe, and that’s when the downturn in crime began.
    • Five states legalized abortion in 1970 (before Roe v. Wade), and they experienced a decline in crime before the rest of the country did.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont1
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • Higher rates of abortion in a state in the late 1970s and early 1980s are strongly linked to lower crime (in that state) for the period from 1985 to 1997.
  • There is no relationship between abortion rates in the mid-1970s and crime changes between 1972 and 1985.
  • Almost all of the decline in crime in the 1990s can be attributed to reduction in crime among the cohorts born after abortion legislation; there is little change in crime among older cohorts (over the last 30 years).

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont2
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • The other hypotheses are unlikely to explain the drop in crime in the 1990s:
    • The greater use of imprisonment, more police, and changes in police strategies have been going on for a long time. It’s unlikely that they could cause a sudden and sharp drop in crime just in the 1990s. And the drop occurred in places, such as Los Angeles, where there was no particular improvement in the police force.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont3
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • Similarly for the decline in the crack cocaine trade. That was largely a phenomenon of major urban areas. But the crime drop occurred not just in major urban areas but everywhere.
  • The robust economy has been with us since the early 1980s, not just in the 1990s. And, moreover, there is a relatively weak correlation between macroeconomic activity and crime levels. Indeed, there is some evidence that much crime is anti-cyclical, increasing when the economy is doing well and declining when it is doing poorly.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont4
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • Donohue and Levitt identify two components that make up the total effect that legalized abortion had on crime:
    • The “cohort size” effect:

When the cohort reaches the late teens - the prime years for committing crimes, there are fewer of them and, therefore, less crime.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont5
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • The “cohort quality” effect:

Children born after abortion legalization may on average have lower subsequent rates of criminality.

    • Women who have abortions are those most at risk to give birth to children who would engage in criminal activity. Teenagers, unmarried women, and the economically disadvantaged.
    • Women may use abortion to optimize the timing of childbearing. Through abortion women may delay childbearing till later if their current conditions are suboptimal. Children tend to be born into better environments.

Law and Economics

10 donohue levitt the impact of legalized abortion on crime cont6
10. Donohue & Levitt: “The Impact of Legalized Abortion on Crime” (cont.)
  • Of the half of the drop in crime in the 1990s that Donohue & Levitt attribute to the legalization of abortion:
    • about half of that total effect is attributable to the “cohort size” effect, and
    • about half to the “cohort quality” effect.

Law and Economics

11 new developments in law and economics
11. New developments in law and economics

New developments:

Empirical research.

Behavioral law and economics.

The impact of law and economics on the legal academy.

Law and Economics

12 law and empirical economics ellickson and social norms
12. Law and empirical economics: Ellickson and Social Norms
  • Natural experiment: damage done to property by unsupervised cattle in Shasta County, California.
    • In part of the county the owners of cattle were responsible for damage done by their unsupervised cattle.
    • In the other half of the county, owners were not responsible.

Law and Economics

12 law and empirical economics ellickson and social norms cont
12. Law and empirical economics: Ellickson and Social Norms (cont.)
  • Should there be a difference between the two halves of the county in terms of the number of cattle and other indicators of efficiency?
    • Not necessarily, if the Coase Theorem is true.
  • There was no difference in behavior between the two halves, even though the liability rules were different. Why?

Law and Economics

12 law and empirical economics ellickson and social norms cont1
12. Law and empirical economics: Ellickson and Social Norms (cont.)

Not because neighbors were bargaining to the most efficient result, regardless of the law.

Rather, because neighbors were not paying attention to the law.

They sought to conform their behavior to the prevailing social norms, not to the law.

Law and Economics

13 behavioral law and economics
13. Behavioral law and economics

Recall the close connection between rational choice theory (RCT) and traditional law and economics.

Social and cognitive psychologists have found some systematic deviations from the predictions of RCT.

Taking these deviations into account in analyzing law leads to changes in the economic analysis of that flowed from RCT.

Law and Economics

13 behavioral law and economics cont
13. Behavioral law and economics (cont.)
  • Consider four examples:
    • Endowment effect / status quo bias.
    • The ultimatum bargaining game experiments (results, implications).
    • Loss aversion.
    • Difficulties with probabilistic reasoning.

Law and Economics

13 1 endowment effect status quo bias
13.1. Endowment effect / status quo bias
  • People seem to place a very high value on the things they have and the way things are.
  • Systematic difference between:
  • the willingness-to-pay (WTP): price to acquire something one doesn’t have, and
  • the willingness-to-accept (WTA): price to give up that same thing if one already possesses it.

Law and Economics

13 1 endowment effect status quo bias cont
13.1. Endowment effect / status quo bias (cont.)
  • WTA ≈ 2 WTP.
  • Not experience-related.
  • Applies to pens, coffee mugs, and other trivially valuable items.
  • Implication:
    • Far more difficult to change the way things are than one might anticipate.
    • Change may not just be a matter of transaction costs.

Law and Economics

13 2 the ultimatum bargaining game
13.2. The ultimatum bargaining game
  • Two parties are to split 20$.
    • This is a pure cooperative surplus.
    • The players are not allowed to talk or meet.
  • Player 1 makes an offer for division of the 20$.
  • Player 2 can accept the offer, in which case they each get the proposed division, or reject the offer, in which case neither player receives anything.

Law and Economics

13 2 1 the ultimatum bargaining game results of the game
13.2.1. The ultimatum bargaining game: results of the game

Result of the ultimatum bargaining game:

The game has been played in over 100 countries with thousands of players of all ages and socio-economic circumstances.

The modal result is a 50-50 split.

Law and Economics

13 2 1 the ultimatum bargaining game results of the game cont
13.2.1. The ultimatum bargaining game: results of the game (cont.)
  • An unexpected finding (although not necessarily inconsistent with rational choice theory) is that if Player 1 proposes a split that gives him or her more than 70 percent of the surplus, Player 2 almost always rejects the offer.
    • People have a strong sense of what is fair.
    • Interestingly, if Player 1 is selected on some seemingly meritorious criterion, Player 2 will tolerate Player 1’s receiving more of the surplus than if Player 1 is selected randomly.

Law and Economics

13 2 2 implications
13.2.2. Implications
  • Perhaps we need not worry overly about how parties divide up cooperative surpluses. They seem to do it equitably.
  • But we need, perhaps, to pay attention to the fact that overreaching can cause otherwise mutually beneficial transactions to fail.
    • The Normative Hobbes Theorem.

Law and Economics

13 3 loss aversion
13.3. Loss aversion
  • The standard social science theory of decision-making under uncertainty is that of subjective expected utility (SEU):
    • Individuals are thought to maximize expected utility rather than expected value.
    • The difference arises from attitudes toward risk: risk-neutrality, risk-preferring, and risk-aversion.

Law and Economics

13 3 loss aversion cont
13.3. Loss aversion (cont.)
  • Kahneman and Tversky found that most people are risk-averse with respect to gains but risk-seeking with respect to losses.
    • Option A: 50$ with certainty.
    • Option B: 100$ with probability 0.5 or 0$ with probability 0.5:
      • Same expected value.
      • Most people prefer Option A.

Law and Economics

13 3 loss aversion cont1
13.3. Loss aversion (cont.)
  • Option C: -50$ with certainty.
  • Option D: -100$ with probability 0.5 or 0$ with probability 0.5:
    • Same expected value.
    • Most people prefer Option D.
  • Implication: In civil actions, defendants may be less likely to settle than plaintiffs.
    • The standard law-and-economics theory of litigation versus settlement is that trial almost always results from mistaken and inconsistent estimates of the likelihood of prevailing at trial.

Law and Economics

13 4 difficulties with probabilistic reasoning
13.4. Difficulties with probabilistic reasoning
  • Many legal situations imply that decision-makers make probabilistic calculations.
    • Rational criminals are thought to compare expected costs and expected benefits of crime.
    • Tortfeasors and victims are imagined to compare precaution costs with expected liability.

Law and Economics