WEEK 1: Introduction To Law

and Economics
LAW’S ORDER: WHAT ECONOMICS HAS TO DO
WITH LAW AND WHY IT MATTERS
DAVID D. FRIEDMAN

1. What Does Economics Have to Do with Law?

- The most fundamental subject of economics are the implications of rational choice, which is
an essential tool for figuring out the effects of legal rules.

- Knowing what effects rules will have is central both to under- standing the rules we have and
to deciding what rules we should have.

FUNDAMENTAL ASSUMPTION OF THE ECONOMIC APPROACH TO LAW: People are rational

- Eg: A robber will rationally consider whether he should rob your house while armed. If it is
clear that it will reduce the risk of being caught without increasing the punishment, he is
quite likely to pull the trigger.

has
Standard of proof: how strong does the evidence against you have to be for you to loose a civil
case and pay damages or to be convicted?
um

- Even the strongest evidence establishes only probability

- A confession is not absolute proof - plea bargaining is legal
- Even a DNA match may be a mistake, or a coincidence
- Raising the standard of proof reduces the chance of convicting an innocent defendant but
increases the chance of acquitting a guilty one.

- Law in the United States and similar systems requires a high standard of proof (“beyond a US -
criminal-high Sp
reasonable doubt”) in a criminal case but only a low standard (“preponderance of the D
-

Civil = low Sp

evidence”) in a civil case.

- Why is that? In civil cases, unlike criminal cases, one man’s loss is
another’s gain; a money transfer. If I get hanged for a murder I didn’t
commit, you gain nothing.

HIGH STANDARD OF PROOF: Beyond reasonable doubt

LOW STANDARD OF PROOF: Preponderance of the evidence

 structure of Incentives :

- Legal rules are to be judged by the structure of incentives they establish and the
consequences of people altering their behavior in response to those incentives.

- Eg. If I murder my uncle, and they let me walk free, it establishes a legal rule that lowers the
risk of punishment for murder.

How She Growed: The Three Enterprises of Law and Economics

THREE ENTERPRISES OF THE ECONOMIC ANALYSIS OF THE LAW:

1. Predicting what effect particular legal rules will have Empirich

2. Explaining why particular legal rules exist Descriptive

3. Deciding what legal rules should exist Normative

Common Law -
Economically Efficient
JUDGE RICHARD POSNER’S THESIS: The common law, tends to be economically efficient

- Why might one expect legal rules to be like that?

Argument 1:

- The two central issues with which we might expect judges to be concerned are efficiency
(the effect of legal rules on the size of the pie) and distribution (their effect on who gets how
much of it).

- Most distributional effects of changes in the law are illusory; when we compel a change in
one term of a contract in favor of one party, other terms, such as the price, shift in the
opposite direction, wiping out the distributional effect.

- If using the law to redistribute is difficult, it seems plausible that judges might leave
redistribution to legislatures and concern themselves with efficiency instead.

Argument 2:

- Inefficient rules generate litigation, and litigation, eventually, generates changes in the rules.
If some rule of the common law prevents people from doing things that are in their mutual
interest, those affected will try either to change the law or work around it.

Argument 3 (Empirical):

- The common law legal rules we observe are, in most although not all cases, the rules we
would get if we were trying to design an economically efficient legal system.

COMMON LAW: The part of the law that comes not from legislatures but from the precedents
created by judges in deciding cases.
ECONOMIC EFFICIENCY: Economic efficiency can most usefully be thought of as the
economist’s attempt to put some clear meaning into the metaphor “size of the pie.” What
makes doing so difficult is that the relevant pie is not a single object that we can weigh or
measure but a bundle of many different sorts of goods and services, costs and benefits,
divided among hundreds of millions of people.

2. Efficiency and All That

Legal rules affect a lot of people in different ways. How can we decide, which laws ought to
exist? One answer is, that we should have laws that best serve our interest. However, this
poses a question of how to measure this interest across all people?

I. A VERY LARGE PIE WITH ALL OF US IN IT

Alfred Marshall’s Solution

1. The argument starts by the consideration of some legal change.

2. The result of the change is to make some people better off, and some people worse off.

3. In principle one could measure the magnitude of the effects by asking each person affected
how much he would, if necessary, pay to get the benefit (if the change made him better off)
or prevent the loss (if it made him worse off).

4. If the sum was positive, if total gains were larger than total losses, we would describe the
change as an economic improvement; if it was negative, an economic worsening.

Things to notice:

- One is that we are accepting each person’s own judgment of the value to him of things that
affect him (since they are asked how much they’d pay)

- We are comparing effects on different people using dollars as our common unit—not dollars
actually paid out or received, but dollars as a common measure of value, a way of putting all
costs and benefits on the same scale.

II. HOW TO ADD PEOPLE UP

- The idea of asking people the value question is imaginary because we can’t expect them to
tell us the truth

- We get the relevant information not by asking questions but by observing behavior - revealed
preferences

REVEALED PREFERENCE: Preferences are revealed by choices

III. IS EFFICIENCY ALWAYS A GOOD THING?

Virtues of Marshall’s Approach to Defining Economic Efficiency:

1. It sometimes makes it possible to answer questions of the form “When and why is strict
liability in tort law efficient?” or “What is the efficient amount of punishment for a particular
crime?”

2. Although “efficient” is not quite identical to “desirable” or “should,” it is close enough so

that the answer to the question “What is efficient?” is at least relevant, although not
necessarily identical, to the answer to the question “What should we do?”

Limitations of Marshall’s Approach to Defining Economic Efficiency:

1. It assumes that all that matters is consequences. It thus assumes away the possibility of
judging legal rules by nonconsequential criteria such as justice.

2. It assumes that when evaluating the consequence of a legal rule for a single person, the
appropriate values are that person’s values as expressed in his actions, that there is no
relevant difference between the value of insulin and of heroin.

3. It assumes that, in combining values across people, the appropriate measuring rod is
willingness to pay, that a gain that one person is willing to pay ten dollars to get just
balances a loss that another is willing to pay ten dollars to avoid. But most of us believe
that, measured by some more fundamental standard such as happiness, a dollar is worth
more to some people than to others—more to poor than to rich, more to materialist than to
ascetic.

Why efficiency and not distribution?

- Laws favouring one group over another almost never work. The other laws will eventually
balance it out. For example, a law that favours poor tenants over landlords might bight
tenants in the ass, as at one point landlords will stop leasing apartments to poor people at all
because it is not in their benefit.

- The legislature and the IRS should take care of distribution through the means of taxation
IV. ALTERNATIVES TO MARSHALL, OR RUGS TO SWEEP THE DUST UNDER

Definition of Economic Improvement According to Vilfredo Pareto

- He avoided the problem of trading off gains to some against losses to others by defining an
improvement as a change that benefits someone and injures nobody.

- In a complicated society it is very unlikely indeed that a change in legal rules will produce
only benefits and no costs.

MARSHALL: net gains

PARETO: some gain, no loss

THE SIMPLE CASE FOR LAISSEZ-FAIRE

- Simple solution to the problem of creating efficient legal rules—private property plus
freedom of exchange.

- Any new good belongs to whoever produced it. So if the cost of producing a good, the
summed cost of all the necessary inputs, is less than its value to whoever values it most, it
will pay someone to buy the inputs, produce the good, and sell it to the highest bidder.

- Not only do all goods end up in their highest valued uses, but all goods are produced if and
only if their value to whoever values them most is greater than their cost to whoever can
produce them most easily.

WHAT IS WRONG WITH THE SIMPLE CASE OF LAISSEZ-FAIRE

Assumption 1: All transactions are voluntary

- A voluntary exchange must benefit the parties who make it, otherwise they wouldn’t.
- While it may make a third party worse off, that loss must be less than the gain to the
transacting parties, since otherwise Anne would have offered a higher price and gotten the
apple.

Assumption 2: Transactions are costless

- They are not if during a bidding you misestimate somebody else’s value of a product.

3. What’s Wrong with the World, Part I

Questions:

1. Under what circumstances does individual rationality fail to lead to group rationality—to the
best possible outcome for the group, with “best” defined in terms of economic efficiency?

2. How can legal rules be designed to minimize such problems?

PECUNIARY or TRANSFER EXTERNALITIES: Effects on other people that result in a net

transfer between them but not a net cost to them.

Eg. Suppose I decide to put my house up for sale. One result is that my neighbor ends up
selling his house for five thousand dollars less than he otherwise would have because he had
to cut his price in order to keep his customer from buying my house instead. My neighbor is
worse off by five thousand dollars as a result of my action, but the person who bought his
house at the lower price is five thousand dollars better off, so the net effect on other people is
zero.

PIGOUVIAN TAXES (EFFLUENT FEES IN THE CONTEXT OF POLLUTION): A tax on a market

transaction that creates a negative externality, or an additional cost, borne by individuals not
directly involved in the transaction. The purpose of it is to redistribute the cost back to the
producer or user of the negative externality.
ADVANTAGES OF PIGOUVIAN TAXES:

1. The regulator does not have to know anything about the costs of pollution control; he can
safely leave that to the firm. If the firm can reduce its emissions at a cost of less than
twenty cents per pound, it is in its interest to do so.

2. This approach generates not only the right amount of pollution control but the right amount
of product as well. When the firm produces steel, its costs now include both the cost of
controlling pollution and the cost of any pollution it fails to control. So the price steel is sold
at now represents the true cost of producing it

LIMITATIONS OF PIGOUVIAN TAXES:

1. They do not solve the problem of making it in the political interest of the regulators to do
the right thing. They might deliberately set the fee too low in exchange for political
contributions or future jobs for the regulatory officials, or deliberately set the fee too high to
punish firms for making contributions to the wrong candidate.

SUMMARY OF THE LOGIC BEHING PIGOUVIAN TAXES:

1. Someone takes an action that imposes costs on others.

2. It is in his interest to take the action as long it produces a net benefit for him, even if
including the effects on the rest of us converts that to a loss.

3. We solve the problem with legal rules that force the actor to bear the external cost himself,
to internalize the externality.

4. His net cost now equals net cost to everyone, so he takes the action if and only if it
produces a net benefit.

5. Individual rationality has been harnessed to produce group rationality.

RENT SEEKING: HOW NOT TO GIVE THINGS AWAY

PECUNIARY EXTERNALITY: An externality that imposes no net cost, since the effects on other
people cancel out

RENT SEEKING: Occurs when there is an opportunity for people to spend resources
transferring wealth from others to themselves. As long as the gain is more than the cost, it is
worth making the transfer—from the standpoint of the recipient. As more people compete to
be recipients, the gain falls.

GETTING IT WRONG: FRAUD ON THE MARKET SUITS

FRAUD ON THE MARKET:

The CEO of a company gives an optimistic speech. Six months later the newest product turns
out to be a flop, and the company’s stock falls. An enterprising lawyer files a class action suit
on behalf of everyone who bought stock in the company between the speech and the stock
drop. His argument is that the speech, by omitting relevant facts that might have led to a more
pessimistic conclusion, fraudulently induced people to buy the stock for more than it was
worth and that the company should therefore make up their losses.
Problems with the theory underlying such suits:

- CEOs are no more omniscient than anyone else, making it a considerable stretch to treat an
optimistic statement that turns out to be wrong as actionable fraud.

- Customers are free to decide for themselves whose predictions to believe.

- An investor who takes optimistic speeches and press releases for gospel might be wiser to
keep his money under his mattress instead.

- How to calculate damage of such a suit? Even if we concede that the speech was
deliberately fraudulent, liability ought to depend on net damage done

- Insofar as the CEO’s optimism merely resulted in different people holding the stock when it
fell, the externality is purely pecuniary and should give rise to no liability at all.

- We get a net externality only if I bought the stock from the CEO, making the effect of his
speech a transfer from him to me and converting the situation from pecuniary externality to
rent seeking.

4. What’s Wrong with the World, Part 2

- 1960: Ronald Coase changed the Pigou’s established analysis on externalities

- The three problems with Pigou’s analysis:
1. The existence of externalities does not necessarily lead to an inefficient result Not an issue

2. Pigouvian taxes do not in general lead to the efficient result. An issue

3. The problem is not really externalities at all. It is transaction costs. Something else

NOTHING WORKS

Coase’s first point is that since external costs are jointly produced by polluter and victim, a
legal rule that assigns blame to one of the parties gives the right result only if that party
happens to be the one who can avoid the problem at the lower cost.

- An external cost is not simply a cost produced by one person and borne by another. In
almost all cases, the existence and size of external costs depend on decisions by both
parties

EG. The pollution from your steel mill would not be damaging my lungs if I didn’t decide to
settle nearby.

- Let’s say the mill does 200k worth of damage a year. It can be eliminated at a cost of a 100k
through the imposition of a Pigouvian tax. However, if we shift the land affected by the
pollution to a new use (tree-planting), then the cost is only 50k. The result without Pigouvian
 taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with
Pigouvian taxes is inefficient.

EVERYTHING WORKS

- As long as the parties can readily make and enforce contracts in their mutual interest, neither
direct regulation nor a Pigouvian tax is necessary in order to get the efficient outcome. All
you need is a clear definition of who has a right to do what, and the market will take care of
the problem.

- What if, instead, the legal rule had been that the people downwind had a right not to have
their air polluted? The final result would have been the same. The mill could eliminate the
pollution at a cost of $100,000 a year. But it is cheaper to pay the landowners some amount,
say $75,000 a year, for permission to pollute. The landowners will be better off, since what
they are getting is more than the cost to them of changing the use of the land. The steel mill
will be better off, since what it is paying is less than the cost of eliminating the pollution. So it
pays both parties to make such an agreement.

COASE THEOREM: If transaction costs are zero, if, in other words, any agreement that is in the
mutual benefit of the parties concerned gets made, then any initial definition of property rights
leads to an efficient outcome.

IT ALL DEPENDS (ON TRANSACTION COSTS)

Let us return again to the steel mill. Suppose it has the right to pollute but that doing so is
inefficient; pollution control is cheaper than either putting up with the pollution or changing the
use of the land downwind. Further suppose that there are a hundred landowners downwind.

With only one landowner there would be no problem; he would offer to pay the mill for the cost
of the pollution control equipment.

Each landowner has an incentive to refuse to pay, figuring that his payment is unlikely to make
the difference between success and failure in the attempt to raise enough money to persuade
the steel mill to eliminate its pollution.

Seen from this perspective, the problem is not externalities but trans- action costs. With
externalities but no transaction costs there would be no problem, since the parties would
always bargain to the efficient solution.

COASE PLUS PIGOU IS TOO MUCH OF A GOOD THING

This time we have only one factory and one landowner, so bargaining between them is simple.

Pollution does $60,000 worth of damage, pollution control costs $80,000, switching the land
use from resorts to timber costs $100,000.

The EPA imposes a pigouvian tax of 60k

We have forgotten the landowner. The fine goes to the EPA, not to him, so if the factory pays
and pollutes, he suffers $60,000 of uncompensated damage. He can eliminate that damage by
offering to pay part of the cost of pollution control, say $30,000. Now, when the factory
controls its pollution, it saves a $60,000 fine and receives a $30,000 side payment from the
landowner, for a total of $90,000, which is more than the $80,000 cost of pollution control.

We are adding together Pigou’s incentive (a fine for polluting) and Coase’s incentive (a side
payment from the victim for not polluting), giving the factory twice the proper incentive to
control its pollution. If the cost of control is less than twice the benefit, the factory buys it even
if it shouldn’t.

COASE, MEADE, AND BEES

James Meade offered externalities associated with honeybees as an example of the sort of
problem for which the market offered no practical solution:

Bees graze on the flowers of various crops, so a farmer who grows crops that produce nectar
benefits the beekeepers in the area. The farmer receives none of the benefit himself, so has an
inefficiently low incentive to grow such crops.

Since bees cannot be convinced to respect property rights or keep con- tracts, there would
seem to be no practical way to apply Coase’s ap- proach to the problem. We must either
subsidize farmers who grow nec- tar-rich crops (a negative Pigouvian tax) or accept
inefficiency in the joint production of crops and honey.

HOWEVER, A COASIAN SOLUTION HAS BEEN PRACTICED FOR AGES:

When the crops were producing nectar and did not need pollination, beekeepers paid farmers
for permission to put their hives in the farmers’ fields. When the crops were producing little
nectar but needed pollination (which in- creases yields), farmers paid beekeepers. Bees may
not respect property rights, but they are, like people, lazy and prefer to forage as close to the
hive as possible.

—> The observation that an economist as distinguished as Meade assumed an externality

problem was insoluble save by government intervention in a context where Coase’s market
solution was actually standard practice suggests that the range of problems to which the
Coasian solution is relevant may be much greater than many would at first guess.

BRIGHT LINE RULES: General rules that yield easily predictable results

STANDARDS: Rules that require a case-by-case decision by courts

COASE, PROPERTY, AND THE ECONOMIC ANALYSIS OF LAW

Which of the rights associated with land are included in the bundle we call “ownership?

The Coasian answer is that the law should define property in a way that minimizes costs
associated with the sorts of incompatible uses we have been discussing: airports and
residential housing, steel mills and resorts.
1. Try to define rights in such a way that, if right A is of most value to someone who also holds
right B, they come in the same bundle. Eg. The right to decide who flies a mile above a
piece of land is of no special value to the owner of the land, hence there is no good reason
to include it in that bundle.

—> So one of the considerations in the initial definition of property rights is doing it in such a
way as to minimize the transaction costs associated with fixing, via private contracts, any
mistakes in the original assignment.

ECONOMIC ANALYSIS OF LAW

POSNER

CHAPTER 1: THE NATURE OF ECONOMIC REASONING

1.1 Fundamental Concepts

ECONOMICS: The science of rational choice in a world in which resources are limited in
relation to human wants.

THE TASK OF ECONOMICS: To explore the implications of assuming that man is a rational
maximizer of his ends in life, his satisfactions — what we shall call his “self-interest.”

- The concept of man as a rational maximizer of his self-interest implies that people respond
to incentives

THE 3 FUNDAMNENTAL PRINCIPLES OF ECONOMICS:

1. The Law of Demand: The inverse relation between price charged and quantity demanded

Practical Example:

- If the price of steak rises by 10¢ a pound, and if other prices remain unchanged, a steak will
now cost the consumer more, relatively, than it did before.

- Being rational and self-interested he will react by investigating the possibility of substituting
goods that he preferred less when steak was at its old price but that are more attractive now
because they are cheaper relative to steak.

- Many consumers will continue to buy as much steak as before; for them, other goods are
not good substitutes even at somewhat lower relative prices.

- But some purchasers will reduce their purchases of steak and substitute other meats (or
other foods, or different products altogether), with the result that the total quantity
demanded by purchasers, and hence the amount produced, will decline.
—> Simplified: The more expensive shit gets, the more demand decreases

2. Cost as Alternative Price

Profit Maximisation: Sellers seek to maximise the difference between their costs and their sales
revenue

ALTERNATIVE PRICE: The lowest price that a rational self-interested seller would charge; the
price that the resources consumed in making (and selling) the seller’s product would command
in their next best use

-> A corollary of the notion of cost as alternative price is that a cost is incurred only when
someone is denied the use of a resource.

OPPORTUNITY COST: The benefit forgone by employing a resource in a way that denies its
use to someone else.

SOCIAL COST: Diminishes the wealth of society

PRIVATE COST: Rearranges the wealth

COASE THEOREM: If transactions are costless, the initial assignment of a property right will
not determine the ultimate use of the property.

Example: Suppose that a farmer has a right not to have his crop destroyed by sparks from
railroad locomotives; that the value of the crops to him is $100, based on the difference
between revenue of $330 and labor and capital costs of $230, but the cost to the railroad of
installing spark arresters is $110; and that transac tions between railroads and farmers are
costless. The real cost of the crops to the farmer is not $230; it is between $330 and $340, for
it includes the price that the farmer could get by agreeing with the railroad not to use his
property in a fire-sensitive way. Since the true cost of exercising his right to grow crops
exceeds his revenues, he will sell that right, and the use of his land will be the same as if the
railroad had had the right to emit sparks freely. In this example the initial assign ment of the
property right really does not dictate the use of the affected property.

MARGINAL COST: The change in total costs brought about by a one-unit change in output; in
other words, it is the cost of the last unit of output — the cost that would be avoided by
producing one unit less.

ECONOMIC RENT: A positive difference between total revenues and total opportunity costs.

—> The very high incomes earned by a few singers, athletes, and lawyers contain economic
rents that are due to the inherent scarcity of the re sources that they control — a fine singing
voice, athletic skill and determination, the analytical and forensic skills of the successful lawyer

3. Resources tend to gravitate toward their most valuable uses if voluntary exchange is
permitted.

Eg: Why does farmer A offer to buy farmer B’s farm at a price higher than B’s minimum price
for the property? It is because the property is worth more to A than to B, meaning that A can
use it to produce a more valuable output as measured by the prices consumers are willing to
pay.

—> When resources are being used where their value is highest, we may say that they are
being employed efficiently.

- There is a methodological assumption that there are no unexploited profit opportunities. If

the profit opportunity does not attract resources, economists assume that there are barriers
to the free flow of trade, and not that people are dumb.

- The barrier could be: high information costs, externalilties, inherent scarcities
HORIZONTAL DEMAND CURVE

The significance of a horizontal demand curve is that if the seller raises, however slightly, his
price above the market price, his sales will go to zero; this is because, by raising his price and
thereby opening a gap between price and marginal cost, he will create a profit opportunity that
another seller will immediately snatch away from him.
1.2. Value, Utility, Efficiency

VALUE: The economic value of something is how much someone is willing to pay for it or, if he
has it already, how much money he demands to part with it.

UTILITY:

1. Used to mean the value of an expected cost or benefit as distinct from a certain one.
Suppose you were asked whether you would prefer to be given $1 million, or a 10 percent
chance of getting $10 million. Probably you would prefer the former, even though the
expected value of the two choices is the same: $1 million ( = .10 X $10 million).

DIMINISHING MARGINAL UTILITY OF MONEY: Means that the more money you have, the less
additional happiness you would get from another dollar.

Concepts of efficiency:

PARETO-SUPERIOR TRANSACTION: A transaction that makes at least one person in the world
better off and no one worse off.

KALDOR-HICKS CONCEPT (POTENTIAL PARETO-SUPERIORITY): The winners could

compensate the losers, but need not (not always, anyway).

Whether and in what circumstances an involuntary exchange may be said to increase

efficiency?

- Most crimes and accidents are involuntary transactions, and so is a legal judgement to pay
damages or a fine. How is one to know when such transactions increase, and when they
reduce, efficiency?

CHAPTER 2: THE ECONOMIC APPROACH TO LAW

2.1 It’s History

The ‘New’ Law and Economics:

- The law and economics that is new within the last 25 years — is the application of the
theories and empirical methods of economics to the legal system across the board

- The new law and economics may be dated somewhat arbitrarily from the beginning of the
1960s

- The first modern attempts to apply economic analysis systematically to areas of law that do
not avowedly regulate economic relationships

- A list of the founders of the “new” law and economics:

1. Guido Calabresi

2. Ronald Coase

3. Pigou
4. Gary Becker

2.2. Normative and Positive Economic Analysis of Law

- Economic theory of law has normative and positive aspects

Normative: To clarify value conflicts and to point the way toward reaching given social ends by
the most efficient path

THE EFFICIENCY THEORY OF THE COMMON LAW: The theory is that the common law is best
(not perfectly) explained as a system for maximizing the wealth of society. Statutory or
constitutional as distinct from common law fields are less likely to promote efficiency,

2.3. Criticisms of the Economic Approach

1. The normative underpinnings of the economic approach are so repulsive that it is

inconceivable that the legal system would (let alone should) embrace them.

- Law embodies and enforces fundamental social norms, and it would be surprising to find
that those norms were inconsistent with the society’s ethical system.

2. The positive use of the approach doesn’t explain every important rule, doctrine, institution,
and outcome of the legal system.

3. Positive economic analysis of law ought to give an economic reason why judges might be
led to use efficiency to guide decision

4. It manifests a conservative political bias.

- We shall see that its practitioners have found, for example, that capital punishment has a
deterrent effect, legislation designed to protect consumers frequently ends up hurting them,
no fault automobile insurance is probably inefficient, and securities regula tion may be a
waste of time. Findings such as these indeed provide ammunition to the supporters of
capital punishment and the opponents of the other policies mentioned. Yet economic
research that provides support for liberal positions is rarely said to exhibit political bias.

5. The economic approach to law is also criticized for ignoring “justice.”