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Law and Economics Notes
Law And Economics (George Mason University)
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Incentives, Rationality, & Intro to Economic

Analysis of the Law
Tuesday, August 15, 2017
7:18 PM
Study economics to study the effect of the http://www.unm.edu/~parkman/M1.pdf
law.
Intro to Law & Economics
Send message on TWEN with background in
economics, title, and any date expected to What is Economic Analysis of Law?
miss.  A law is an obligation backed by a state sanction
 Economics provides scientific theory to predict
Do all the readings! the effects of legal sanctions on behavior.
 Predictions always guide the law, so behavioral
Misperception that economics is the study of science resembles the mortar between the
money. It is that, but more an approach to cathedral's stones, which are ubiquitous and
think about human behavior. support every stone.
 In order to know the effects of laws on achieving
Economic approach is not constrained by important social goals, judge sand lawmakers must
substance. have a method of evaluating laws' effects on
important social values. Economics predicts the
Commonalities among economists: effects on efficiency.
 Identify institutions that affect  Legal constraints are necessary to assure that
incentives. transactions are voluntary.
 Investigate how people react to these  A good legal system keeps the profitability of
incentives. business and the welfare of people aligned, so that
people who pursue profits also benefit the public.
Common assumptions:
Rationality: Some Examples:
 Formally: preferences are transitive  When a decrease in probability of punishment
and complete offsets an increase in the magnitude of punishment,
 In practice: Given available then the expected cost of crime remains roughly
information, people make the choice the same for criminals. But the costs of crime to the
that maximizes their objective function. criminal justice system may change. The probability
Given what you know, you make choices of being caught and convicted depends in large part
for what you want. on the resources devoted to apprehending and
prosecuting white-collar criminals. Incarcerating a
Behavioral economics: assumptions on criminal is inefficient unless the ability to pay fines
rationality relaxed. Focus on systematic ways has been completed exhausted.
that people behave irrationality.  Court apportions the loss between two parties
 Economists assume preferences stable simultaneously when the contract is silent on non-
 Economists concerned with how to performance in the event of a war. This
maximize utilities accomplishes resolving a dispute between the
 Rational vs. irrational: if you can step litigants, and guides future parties who are in
out of current immediate desires and similar circumstances about how courts might
look at meta-picture, would you still do resolve their dispute.
it?  From the standpoint of economic efficiency, the

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 Addiction to coffee rational because court should assign the loss from non-delivery so as
working to finish paper. to make future contractual behavior more efficient.
 People hate to lose things: If I give you  Assuming that the oil company that breaches
a mug, how much would somebody non-performance during war is better able to bear
have to pay to give up the mug? the risk of war, economic efficiency requires the
court to hold the oil company liable for breach of
contract and, therefore, make it responsible for
paying the European manufacturer's lost profits
due to a non-performance.
The Primacy of Efficiency over Distribution in Analyzing

Private Law:
 The decision about how much of the stakes each
party gets in a legal dispute creates incentives for
future behavior, not just by the particular parties to
the dispute.
 Reasons reshuffling private legal rights influences
cost of redistribution: Income tax precisely targets
inequality, whereas redistribution by private legal
rights relies on crude averages, distributive effects
of reshuffling private rights are hard to predict., the
transaction costs of redistribution through private
legal rights are typically high, and redistribution by
private law distorts the economy more than
progressive taxation does.
Why Should Lawyers Study Economics?

 View laws as incentives for changing behavior
(implicit prices) and as instruments for policy
objectives (efficiency and distribution).
Mathematical Tools
 A value of x determines an exact value of y,
whereas a value of y does not determine an exact
value of x. Y is the dependent variable, because it
depends on the value of x. And x is called the
independent variable, because y depends upon x.
 All we have from each consumer is the order of
preference, not the strength of preferences. There
is no metric by which to measure the strength of
preferences.
 Suppose a decision-mak`er proposes to increase
slightly above his initial level whatever it is he is
doing. There will be a cost associated with this
small increase called the marginal cost. But there
will also be a benefit of having or doing more of
whatever it is that he is attempting to maximize.

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There benefit of this small increase is called the

marginal benefit. The decision maker will perceive
himself as doing better at this new level, by
comparison to his initial level, so long as the
marginal benefit of the small increase is greater
than the marginal cost of the change.
Economic Approach to Human Behavior

 Becker argues that all human behavior can be
viewed as involving participants who maximize their
utility from a stable set of preferences and
accumulate an optimal amount of information and
other inputs in a variety of markets.
 Humans are assumed to be utility maximizers as if
they maximize their intrinsic utility or wealth
function.
 Markets are in place to coordinate humans
'actions (market equilibrium)
 It is assumed that humans' preferences are stable
over time and similar among people (stable
preferences). These preferences include
fundamental aspects that people have to deal with
in life, not goods and services.
Price Theory - Demand

Monday, August 21, 2017
7:03 PM
Demand
Tuesday, August 22, 2017
3:40 PM
Consumer Choice & Demand
Utility: economist's way of talking about how much you like/value something.
If people are rational, their references can be represented by utility functions.
A utility function is often written as u(X) where X is the input, and utility is the output.

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Functions are very general, which maps relationship between set of inputs to a particular output.
Diminishing marginal utility: for one unit of gain in wealth, utility has a sharp rise. When you already
have a lot of wealth, adding the same unit gives it a smaller rise.
Bundles that contain objects of components that we like, and assign utilities to them
3 slices of pizza and 2 beers: bundle A
2 slices of pizza and 3 beers: bundle B
Utilities represent preferences and rankings. Utilities are defined as ordinal concepts, which provides
information only on ordering and nothing else. We use ordinal utility functions to study consumer
behavior and choices.
If bundle x and bundle y are such a u(x) = u(y), then x is indifferent.
If bundle x and bundle y are such that u(x) > u(y), then x is preference.
Indifference curve: everything above and the right, is preferred. Everything below and to the left is not
preferred.
The value of an apple or an orange depends on how many you have.
Marginal rate of substitution: The slope of the indifference curve tells you how many apples you'd be
willing to give up in order to get more oranges. At a specific place and point, for a marginally benefit,
what are the marginal costs?
The slope of the budget line is the price of x divided by the price of y. You can afford anything beneath
the budget line. The budget line is the maximum amount of money and prices. As we go right, we want
more, as we go left, we want less.
Demand is the relationship between price and the quantity of a good or service that consumers are
willing to purchase, over a certain time interval, holding all else constant (e.g. income, prices of
substitutes and complements).
Individual demand for widgets: the number of widgets an individual want at a given price.
Market demand for widgets: the total number of widgets that everyone in a market wants at a given
price.
Markets: group of people who may buy or sell itel (could be all people in the country, or a town, or all
people who are interest in widgets)
Consumer surplus: difference between the price paid for a good and the maximum price that someone
would be willing to pay for that good (individual level).
Consumer surplus for the market is the sum of individual consumer surplus. Left of the demand curve
and above the price.

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The law of demand: as prices rise, quantity demanded falls, holding all else constant.
 Budget constraints
 Substitution: you can get more value spending your money on other things
Example: opioid crisis

 In 2010, OxyContin got reformulated to make it harder to crush or dissolve the drug
 Unintended consequences with policy
Price elasticity of demand:

 Percent change in quantity demanded as a result of a percent change in the price.
 Percent change in quantity: (Q2-Q1)/Q1
 Percentage change in price: (P2-P1)/P1
 If elasticity is greater than one, we say it is elastic
 If elasticity is less than one we say it is inelastic.
 Percent change gets at relative price. Percent changes depend on where you started.
 More elastic when thinking about substitutes and long run consequences
Shifts in demand curve: Any change that raises the quantity that buyers wish to purchase at any given
price shifts the demand curve to the right. Any change that lowers the quantity that buyers wish to
purchase at any given price shifts the demand curve to the left.
The quantity demanded of a good is negatively related to its price, the percentage change in quantity
will always have the opposite sign as the percentage change in price. A larger price elasticity implies a
greater responsiveness of quantity demanded to changes in price.
Even though the slope of a linear demand curve is constant, the elasticity is not. The slope is the ratio of
change in the two variables, whereas the elasticity is the ratio of percentage changes in the two
variables.
Cross price elasticity of demand: Whether the cross-price elasticity is a positive or negative number
depends on whether the two goods are substitutes or compliments. An increase in the price of hot dogs
induces people to grill hamburgers instead. Because the price of hot dogs and the quantity of
hamburgers move in the same direction, the cross-price elasticity is positive.

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Supply
Sunday, August 27, 2017
1:29 PM
Profit-Maximizing Firm:
 Firms maximize profits subject to the constraints imposed on them by consumer demand
and the technology of production.
 A firm will maximize profit if it produces that amount of output whose marginal costs
equals its marginal revenue.
 When marginal revenue exceeds marginal cost, the firm should expand production, and
that when marginal cost exceeds marginal revenue, it should reduce production.
 When profits being earned in a particular industry exceed the average profit rate for
comparable investments, firms will enter the industry, assuming there are no barriers to
entry. As entry occurs, the total industry output increases, and the price of the industry
output does down, causing each firm's revenue to decrease. The increased competition for
the factors of production causes input prices to rise, pushing up each firm's costs. The
combination of these two forces causes each firm's profits to decline. Entry ceases when
profits fall to the average rate.
 The average return on capital is treated as part of the costs that are subtracted from
revenues to get economic profits. When the rate of return on invested capital in this
industry equals the average for the economy as a whole, it is said that economic profits are
zero. Economic profits are zero in an industry that is in long-term equilibrium. Because this
condition can occur only at the minimum point of the firm's average cost curve, where the
average costs of production as are low as they can possibly be, inputs will be most
efficiently used in long-term equilibrium.
Applications of Supply, Demand, and Elasticity

 Changes in Equilibrium:
o Examine whether the supply or demand curve shifts
o Consider which direction the curve shifts
o Use supply and demand diagram to see how the market equilibrium changes.
Costs of Production
 The most important relationship is between the quantity produced and total costs.
 Marginal costs rise with the quantity of output produced.
 Average fixed cost always declines as output rises because the fixed cost is spread over a
larger number of units. Average variable cost typically rises as output increases because of
diminishing marginal product (U Shaped).
o Efficient scale: the quantity of output that minimizes average total cost.
 Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.
o The marginal-cost curve crosses the average-total-cost curve at its minimum.
 At low level of output, marginal cost is below average total cost, so
average total cost is falling. But after the two curves cross, marginal cost rises
above average total cost.

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 Average total cost must start to rise at this level of output. This point of
intersection is the minimum of average total cost.
Costs in Short Run and Long Run

 When long-run average total cost declines as output increases, there is said to be
economies of scale.
o Often arise because higher production levels allow specialization among workers,
which permits each worker to become better at a specific task
 When long-run average total cost rises as output increases, there is said to be
diseconomies of sale.
o Often arise because of coordination problems that an inherent in any organization
 When long-run average total cost does not vary with level of output, there are said to be
constant returns to scale.
Class Notes:
Supply curve: as you produce more of a good, it gets less efficient.
The opportunity cost is the value of the best thing that you are sacrificing to use for function.
Marginal product: how much extra product can be produced with a small increase in inputs.
When marginal product is increasing, then efficiency is increasing.
Average product: the average amount of product that can be produced with a given amount of
input (average production divided by total workers).
If average produce is negative, the average product is going to decrease.
Marginal vs. average (grades) - A 4.0 means solid A's. When you get an A-, the marginal change
is 4.0 to 3.7.
Diminishing marginal product: property whereby the marginal product of an input declines as the
quantity of the input increases. The slope of the production function measures the marginal
product of an input, such as a worker. When the marginal product declines, the production
function becomes flatter. It is a reasonable assumption in a short run scenario.
Cost is the value of the next best forgone alternative when choosing to engage in some particular
activity.
Fixed costs: sunk or salvageable; do not change with output
Variable costs: costs that do change with output (hiring more workers).
Marginal cost: the cost of producing an additional unit of output. The cost of the NEXT unit of
output.

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Total Cost(2) - Total Cost (1) / Q(2) - Q(1) = marginal cost
Marginal revenue: the amount of extra revenue a firm receives for a small increase of output. It's
the same as cost!
Always produce where marginal revenue = marginal cost.
Marginal Revenue > Marginal Cost, get more $ from increasing production than it costs to
increase production.
If Marginal Cost > Marginal Revenue, decreasing product by 1 unit would decrease costs more
than you would decrease money.
The marginal cost curve is the supply curve.
Look at costs as in reference of what those costs could be used for.
Intersect price with marginal cost, you are concerned with the quantity line.
Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a
change in the price of that good.
"I"nelastic - Straight vertical line like "I"

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Equilibrium
Monday, August 28, 2017
10:51 PM
Although it is possible for one person to have an absolute advantage in both goods, it is
impossible for one person to have a comparative advantage in both goods. Comparative
advantage is the opportunity cost of two producers.
The principle of comparative advantage states that each good should be produced by the country
that has the smaller opportunity cost of producing that good.
A shift in the supply curve is the change in supply, and a shift in the demand curve is the change
in demand. A movement along a fixed supply curve is a change in the quantity supplied, and a
movement along a fixed demand curve is called a change in the quantity demanded.
Consumer surplus market = total of all consumer surpluses
Dead weight loss: the loss of social welfare that comes about from price ceiling.
For a price floor that is above equilibrium price, the surplus transfers from consumer to producer.
For a price floor that is below equilibrium price, the surplus transfers from the producer to the
consumer.
Minimum wage: people sell more labor when prices are high.
Outline
Monday, September 4, 2017
1:04 PM
Production Possibilities Frontier
 A production possibilities frontier is a graph that shows the combinations of
output the economy can possibly produce given the available factors of production and
the available production technology. It is drawn assuming the economy produces only
two goods.

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o If the economy is operating on the production possibilities frontier, it is

operating efficiently because it is producing a mix of output that is the maximum
possible from the resources available.
o Points inside the curve are inefficient. Points outside the curve are
currently unattainable.
o If the economy is operating on the production possibilities frontier, we can
see the trade-offs society faces. To produce more of one good, it must produce
less of the other. The amount of one good is given up when producing more of
another good is the opportunity cost of the additional production.
o The production possibilities frontier is bowed outward because the
opportunity cost of producing more of a good increases as we near maximum
production of that good. This is because we use resources better suited toward
production of the other good in order to continue to expand production of the first
good.
o A technological advance in production shifts the production possibilities
frontier outward. This is economic growth.
 A production possibilities frontier only shows the choices available, not which
point of production is the best. What we actually choose to produce depends on the
price of each good.
Demand Curve:
 P1 - P2 / Q1 - Q2
 When people change how much they wish to buy at each price, the demand curve
shifts. If buyers increase the quantity demanded at each price, the demand curve shifts
right. Alternatively, if buyers decrease the quantity demanded at each price, the
demand curve shifts left.
 Demand is the entire demand curve, not a point on a demand curve. A change in
demand is a shift in the entire demand curve, which can only be caused by a change in
a determinant of demand other than the price of the good. A change in the quantity
demanded is a movement along the demand curve and is caused by a change in the
price of the good.
Elasticity of Demand:
 If price elasticity of demand is greater than one, demand is elastic. If elasticity is

less than one, demand is inelastic.
 If elasticity is equal to one, demand is said to have unit elasticity.
 If elasticity is zero, demand is perfectly inelastic (vertical).
 If elasticity is infinite, demand is perfectly elastic (horizontal).
 In general, the flatter the demand curve, the more elastic. The steeper the demand
curve, the more inelastic.

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Total revenue is the amount paid by buyers and received by sellers, computed simply as
price times quantity. The elasticity of demand determines the impact of a change in price on
total revenue:
 If demand is price inelastic (less than one), an increase in price increases total
revenue because the price increase is proportionately larger than the reduction in
quantity.
 If demand is price elastic (greater than one), an increase in price decreases total
revenue because the decrease in the quantity demanded is proportionately larger than
the increase in price.
 If demand is unit price elastic (exactly equal to one), a change in price has no
impact on total revenue because the increase in price is proportionately equal to the
decrease in quantity.
Income elasticity of demand:
 For normal goods, income elasticity is positive.

 For inferior goods, income elasticity is negative.
Cross-price elasticity of demand:
 Cross price elasticity of demand is positive for substitutes and negative for
complements
Profit Maximization

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Monopolies

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Game Theory:
Nash Equilibrium - No player can benefit from unilaterally moving away

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Property Rights:
Pigoviun Taxes
Coase Theorem
1. Property right by the railroad. The railroad is free to throw sparks if it wants to.
2. Property right by the farmers. The railroad may only throw sparks if it has permission to
do so from all the farmers; any one farmer can go to court and enjoin the railroad from
throwing sparks.
3. Liability right by the farmers. The railroad is free to throw sparks but must compensate
the farmers for any damage that results.

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4. Liability right by the railroad. Any farmer may enjoin the railroad from throwing sparks
but must then compensate the railroad for the cost of having to put on a spark arrester.
Crime:
Optimal Cost for Fine: Expected Cost of Ticket / Probability
Torts:

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Accident causes harm of $10,000 to victim.

In particular: Rapidly: 1/100, Moderately: 1/250, Slowly: 1/500.
If an accident occurs, P (victim) can sue, in which case he will win 80% (shared beliefs).
Litigation costs $3,000 to each party.
Expected Benefit: (Benefit from driving) – (Expected damage payments) – (Expected litigation
costs)
Drive slowly: $ 50 - (0.8 x 20) – (1/500 x $3,000)
$50 - $16 – $6 = $28
Socially Optimal Precaution: Probability of Accident x Cost of Accident + Burden
Contracts:
Measuring Damages:
 Compute the expected profit from the contract. (You should get $900.)
 Calculate the actual loss. (You should get $11,100.)
 Calculate the profit from the best alternative contract. (You should get $400.)
 You should immediately see the expectation, reliance, and opportunity-cost damages.
Breach of Contract: Risk Allocation
Buyer's evaluation: $200

Reliance: $10
Seller's surplus with breach: $100

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o In case of no breach (i.e. when B2’s valuation is 0), what is each party’s
wealth level (valuation of that state of the world)?
 B1: Pays for the contract, relies, and gets the widget:
 -P -10 +200 = 190-P
 S: Receives the contract price from B1, and incurs the cost of producing
widget:
 P-150
o If damages are given by D, what is each party’s wealth level in case of breach
(i.e. when B2’s valuation is 250)?
 B1: Pays for the contract, relies, and gets damages from S:
 -P-10+D = D-P-10
 S: Receives P from B1, produces widget for 150$, gets 250$ from B2, and
pays D to B1:
 P-150+250-D =100+P-D
o Valuations:
B1 S
No-Breach 190-P P-150
Breach D-P-10 100+P-D
o What do expectation, reliance and restitution damages equal?
 Expectation: $ 200
 Reliance: P+ $10
 Restitution: P
Expectation damages induce inefficient reliance

Reliance damages induce inefficient reliance
Restitution can induce efficient reliance
Asymmetric Information

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Premium to Assure High Quality:
Adverse selection in health insurance
The expected health costs for sick people are $50000, the expected health costs for healthy people
are $2000.
Assume people are risk averse – healthy people are willing to pay up to $2500 for health insurance
and sick people are willing to pay up to $50500 for health insurance.
If insurance companies can’t price discriminate, what’s the highest percentage of sick people there
can be in the population for the insurance company not to lose money?

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Basis Probability Theory and Stats

Monday, September 4, 2017
6:53 PM
An ordinal utility function for an individual consists of a rank ordering of possible states of affairs for that
individual. An ordinal function tells us that individual I prefers possible world X to possible world Y, but it
doesn’t tell us whether X is much better than Y or only a little better. A cardinal utility function yields a
real-number value for each possible world. If we assume that utility functions yield values expressed in
units of utility or utiles, then individual I’s utility function might score possible world (or "state of
affairs") P at 80 utiles and possible world Q at 120 utiles.
The weak Pareto principle suggests that a state of affairs P is socially preferable to state of affairs Q, if
everyone’s ordinal ranking of P is higher than their ranking of Q. Weak Pareto doesn’t get us very far,
because such unanimity of preferences among all persons is rare.
The strong Pareto principle suggests that state of affairs P is socially preferable to state of affairs Q, if at
least one person ranks P higher than Q and no one ranks Q higher than P. Or to put it more colloquially:
strong Pareto says that it is good to make one person better off if no one will be made worse off.
Because Pareto efficiency assumes no negative externalities, it has significant limits as a normative
concept. For example, there are many questions of legal policy in which externalities are particularly
important--pollution is a classic example. If I operate a factory that pollutes the air or water, my action
may cause harms to my neighbors. If even one person would lose (as measure by that person's
preferences) by the move from state P to state Q, then that move is not Pareto efficient. So if Pareto
efficiency were the only normative principle available to law and economics, the consequence would be

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that economics would have nothing to say about many of the most important legal questions, e.g. many
questions of environmental law.
Kaldor-Hicks is a technique for extending the normative implications of economic analysis. Here is how
it works. We take a situation in which their are externalities, e.g. pollution that affects third parties.
Let's assume that markets can't reach a Pareto-efficient outcome. That assumption might be accurate
because of high transactions costs, as in the case where the pollution impacts on so many individuals
that bargaining is impractical or costly. Counterfactually, however, we can imagine that there were zero
transaction costs. We can then ask what outcome would occur if those who were effected by the
externality (the pollution) entered into a Pareto-efficient bargain that compensated them for their
losses. Outcomes that would be Pareto-efficient if there were zero transaction costs are Kaldor-Hicks
efficient.
Independent Probabilities: if the occurring of one event does not affect the occurring of an other event,
the two probabilities are independent.
If the occurrence of B does not affect the probability of A, and vice versa, then A and B are independent.
If the events are not independent, the occurrence of B updates our belief regarding the probability of A
with the conditional probability formula.
Summation: sign used to abbreviate expressions for additions
Median: value in the middle once observations are re-ordered according to their values
Mode: value that occurs most frequently
Random variable: value determined (at least in some part) by chance (number on a dice roll, amount of
rain that falls).
Expected value of a random variable is basically its average. If Pi denotes the probability with which the
random variable X takes on the value Xi, X's expected value can be calculated as the sum of all
probabilities multiplied by the outcomes.
Variability:
Distributions of observations: How spread out are the observations? Difference between minimum value
and maximum value (range)
Interquartile range: 75%tile to 25%tile
Observation distributions: how close are the values of the observations to its means.
Random Variable: how close are the values the random variables may take to its expected value.
Expected value: average value of an uncertain prospect

 Important when discussing how people decide when there are more than one likely
outcome associated with an action

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How much would you be willing to pay for a lottery ticket that pays $1000 with a probability of 0.1? -
The expected value is $1000
When you have to pay into lottery to gain something, most people are risk averse.
Risk neutral: willing to pay to expected value of lottery to buy it

Risk averse: willing to pay less than the expected value to buy it
Risk loving: willing to pay more than the expected value to buy it.
Risk Attitudes:
 Risk-averse behavior with buying insurance
 Intuition is that we dislike losses more than we like gains (i.e. diminishing marginal returns from
returns)
 Risk premium
o Risk averse individuals are willing to pay a premium to avoid risk
o Consider a lottery with an expected value of $100
 If the risk averse person is willing to pay at most $85 for this lottery, then his
risk-premium is $15.
 If choosing between two lotteries, the risk averse person will choose the lottery with less risk
(expected values of lottery are closer together so less risk of going to $0)
 Need to know how risk averse person is and how values differ across the lotteries
 Utility functions: sum up the utility one gets from values
o Need starting point of income to determine utility
o Diminishing marginal utility of income shows risk averse behavior
Certainty Equivalent and Risk Premium

 Certainty equivalent of a gamble: the sum of money, which, if received with certainty, will yield
the same utility as the game
 The risk premium associated with a game is the maximum amount a person is prepared to pay
to avoid the gamble
Risk Attitudes
 Coin toss: heads you lose, tails you double your money
 You have $4, and you can only place bets in whole dollar amounts
Time Value of Money

 Money today is more valuable than the same amount of money tomorrow
 Find an appropriate discount factor, and discount money earned tomorrow
o Depends on decision makers characteristics, options, the riskiness of the asset he's
investing in
 Comparing current dollars to future dollars
 Calculating future value of current dollars: FV = Present value x (1+r)
o Future amount of money
 Presented discounted value: PDV = Future amount / (1 + r)
o If the present discounted value is higher than money you have right now, then you
would choose the option for money in the future
 Pay 30k today or Pay 17.5k in one year and 17.5 in two years, interest rate at 5%

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MID-TERM:
Perpetuity: infinity
Annuity: Receive $2k for next 100 years
Period of payments = n
Question 17:
5000 / 1.03= $166,666
Game Theory
Tuesday, September 19, 2017
7:45 PM
If either player wants to do something else, taking other factors into consideration, it is not a
Nash equilibrium.
Nash equilibrium are not socially optimal.
Sequential Games
 Backward induction is used to determine the subgame perfect Nash Equilibrium of most
sequential games.
Cooter & Allen:
The law frequently confronts situations in which there are few decisionmakers and in which the
optimal action for one person to take depends on what another actor chooses. These situations
are like games in that people must decide upon a strategy. A strategy is a plan for acting that
responds to the reactions of others. Game theory deals with any situation in which strategy is
important. Game theory will, consequently, enhance our understanding of some legal rules and
institutions. For those who would like to pursue this topic in more detail, there are now several
excellent introductory books on game theory.

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To characterize a game, we must specify three things: 1. the players, 2. the strategies of each
player, and 3. the payoffs to each player for each strategy.
Let’s consider a famous example—the prisoner’s dilemma. Two people, Suspect 1and Suspect
2,conspire to commit a crime. They are apprehended by the police outside the place where the
crime was committed, taken to the police station, and placed in separate rooms so that they
cannot communicate. The authorities question them individually and try to play one suspect
against the other. The evidence against them is circumstantial—they were simply in the wrong
place at the wrong time. If the prosecutor must go to trial with only this evidence, then the
suspects will have to be charged with a minor offense and given a relatively light punishment—
say, 1 year in prison. The prosecutor would very much prefer that one or both of the suspects
confesses to the more serious crime that they are thought to have committed. Specifically, if
either suspect confesses (and thereby implicates the other) and the other does not, the non-
confessor will receive 7 years in prison, and as a reward for assisting the state, the confessor will
only receive one-half of a year in prison. If both suspects can be induced to confess, each will
spend 5 years in jail. What should each suspect do—confess or keep quiet?
The strategies available to the suspects can be shown in a payoff matrix like that in Figure 2.13.
Each suspect has two strategies: confess or keep quiet. The payoffs to each player from
following a given strategy are shown by the entries in the four cells of the box, with the payoff to
Suspect 2 given in the lower left-hand corner of each cell and the payoff to Suspect 1 given in
the upper right-hand corner of the cell. Here is how to read the entries in the payoff matrix. If
Suspect 1 confesses and Suspect 2 also confesses, each will receive 5 years in prison. If Suspect
1 confesses and Suspect 2 keeps quiet, Suspect 1 will spend half a year in prison, and Suspect 2
will spend 7 years in prison. If Suspect 1 keeps quiet and Suspect 2 confesses, then Suspect 2
will spend half a year in prison, and Suspect 1 will spend 7 years in prison. Finally, if both
suspects keep quiet, each will spend 1 year in prison. There is another way to look at Suspect 1’s
options. The payoff matrix is sometimes referred to as the strategic form of the game. An
alternative is the extensive form. This puts one player’s options in the form of a decision tree,
which is shown in Figure 2.14.

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We now wish to explore what the optimal strategy—confess or keep quiet— is for each player,
given the options in the payoff matrix and given some choice made by the other player. Let’s
consider how Suspect 1 will select her optimal strategy. Remember that the players are being
kept in separate rooms and cannot communicate with one another. (Because the game is
symmetrical, this is exactly the same way in which Suspect 2 will select his optimal strategy.)
First, what should Suspect 1 do if Suspect 2 confesses? If she keeps quiet when Suspect 2
confesses, she will spend 7 years in prison. If she confesses when Suspect 2 confesses, she will
spend 5 years. So, if Suspect 2 confesses, clearly the best thing for Suspect 1 to do is to confess.
But what if Suspect 2 adopts the alternative strategy of keeping quiet? What is the best thing for
Suspect 1 to do then? If Suspect 2 keeps quiet and Suspect 1 confesses, she will spend only half a
year in prison. If she keeps quiet when Suspect 2 keeps quiet, she will spend 1 year in prison.
Again, the best thing for Suspect 1 to do if the other suspect keeps quiet is to confess. Thus,
Suspect 1 will always confess. Regardless of what the other player does, confessing will always
mean less time in prison for her. In the jargon of game theory this means that confessing is a
dominant strategy—the optimal move for a player to make is the same, regardless of what the
other player does.
Because the other suspect will go through precisely the same calculations, he will also confess.
Confessing is the dominant strategy for each player. The result is that the suspects are both going
to confess, and, therefore, each will spend 5 years in prison. The solution to this game, that
both suspects confess, is an equilibrium: there is no reason for either player to change his
or her strategy. There is a famous concept in game theory that characterizes this
equilibrium—a Nash equilibrium. In such an equilibrium, no individual player can do any
better by changing his or her behavior so long as the other players do not change theirs.
(Notice that the competitive equilibrium that we discussed in previous sections is an example of
a Nash equilibrium when there are many players in the game.) The notion of a Nash equilibrium
is fundamental in game theory, but it has shortcomings. For instance, there are some games that
have no Nash equilibrium. There are some games that have several Nash equilibria. And finally,
there is not necessarily a correspondence between the Nash equilibrium and Pareto efficiency,
the criterion that economists use to evaluate many equilibria. To see why, return to the prisoner’s
dilemma above. We have seen that it is a Nash equilibrium for both suspects to confess. But you

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should note that this is not a Pareto-efficient solution to the game from the viewpoint of the
accused. When both suspects confess, they will each spend 5 years in prison. It is possible for
both players to be better off. That would happen if they would both keep quiet. Thus, cell 4
(where each receives a year in prison) is a Pareto-efficient outcome. Clearly, that solution is
impossible because the suspects cannot make binding commitments not to confess.
We may use the prisoner’s dilemma to discuss another important fundamental concept of game
theory—repeated games. Suppose that the prisoner’s dilemma were to be played not just once
but a number of times by the same players. Would that change our analysis of the game? If the
same players play the same game according to the same rules repeatedly, then it is possible that
cooperation can arise and that players have an incentive to establish a reputation—in this case,
for trustworthiness.
An important thing to know about a repeated game is whether the game will be repeated a fixed
number of times or an indefinite number. To see the difference, suppose that the prisoner’s
dilemma above is to be repeated exactly ten times. Each player’s optimal strategy must now be
considered across games, not just for one game at a time. Imagine Suspect 2 thinking through,
before the first game is played, what strategy he ought to follow for each game. He might
imagine that he and his partner, if caught after each crime, will learn (or agree) to keep quiet
rather than to confess. But then Suspect 2 thinks forward to the final game, the tenth. Even if
the players had learned (or agreed) to keep quiet through Game 9, things will be different
in Game 10. Because this is the last time the game is to be played, Suspect 1 has a strong
incentive to confess. If she confesses on the last game and Suspect 2 sticks to the agreement not
to confess, he will spend 7 years in prison to her half year. Knowing that she has this incentive to
cheat on an agreement not to confess in the last game, the best strategy for Suspect 2 is also to
confess in the final game. But now Game 9 becomes, in a sense, the final game. And in deciding
on the optimal strategy for that game, exactly the same logic applies as it did for Game 10—both
players will confess in Game 9, too. Suspect 1 can work all this out, too, and she will realize that
the best thing to do is to confess in Game 8, and so on. In the terminology of game theory, the
game unravels so that confession takes place by each player every time the game is played, if it
is to be played a fixed number of times.
Things may be different if the game is to be repeated an indefinite number of times. In

those circumstances there may be an inducement to cooperation. Robert Axelrod has
shown that in a game like the prisoner’s dilemma repeated an indefinite number of times,
the optimal strategy is tit-for-tat—if the other player cooperated on the last play, you
cooperate on this play; if she didn’t cooperate on the last play, you don’t on this play.
These considerations of a fixed versus an indefinite number of plays of a game may seem
removed from the concerns of the law, but they really are not. Consider, for example, the
relations between a creditor and a debtor. When the debtor’s affairs are going well, the credit
relations between the creditor and the debtor may be analogized to a game played an indefinite
number of times. But if the debtor is likely to become insolvent soon, the relations between
debtor and creditor become much more like a game to be played a fixed (and, perhaps, few)
number of times. As a result, trust and cooperation between the parties may break down, with the
debtor trying to hide his assets and the creditor trying to grab them for resale to recoup his losses.

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Monopoly
Tuesday, September 26, 2017
6:35 PM
From the perspective from an individual firm, we assumed they were price takers (the firm has
no influence on what to set the price).
If you try to charge a higher market price, won't sell, if charge lower, then lose money.
When marginal revenue is less than marginal cost, it represents a change in profit.
You need to make sure where marginal revenue equals marginal cost, but also when its positive.
Firms will produce where marginal costs equals marginal revenue (maximizes profit).
Long Run Concepts:

 When you have a profitable industry, you will have more and more firms enter industry
and decrease the amount of profits for the first firm.
 When price is higher than total costs, the firm is making profit.
 In the long run, the price will go down, because new firms will charge less and take
profits.
 Zero profits means that you are indifferent between two choices. Any special advantage
doing one thing over another is whittled away by competition.
 In the short term, business makes large profits. But more competition will drive the prices
down.
 We assume zero profit condition in the long run. If there is a profit to be made
(accounting and opportunity costs), firms will continue to enter market.
Perfect Competition
 Looking at prices and quantity for two big firms to merge, the equilibrium won't tell us
much because it's not a perfectly competitive market.
 Marginal revenue is equal to price

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Monopoly
 Gives insight into how firms make decision and then find middle ground
 A firm is a monopoly if it is the sole seller of produce and its produce does not have any
close substitutes.
 Market power is the ability to have an influence over prices, such as setting price above
marginal costs.
o Downward sloping demand curve rather than perfectly elastic demand curve in
perfectly competitive model
 Monopolies arise because there is barrier to entry.
o Ownership is key resource
o Government gives single firm exclusive right to produce some good.
 Copyright and patents
o Costs of production make a single producer more efficient than a large number of
producers
 Natural monopoly with distribution of water because a firm must build
networks of pipes
o Firms can engage in behavior that increases the barriers to entry for other firms
 Monopolist marginal revenue is always less than the price of its good
o By producing more, people are willing to pay less
o Monopolist does dance knowing they can charge more than marginal cost because
they are the only supplier, but they can't charge so much more because won't buy the
good.
o When a monopoly increases the amount it sells, there are two effects (P X Q)
 Output effect: more output is sold, so Q is higher, which tends to increase
total revenue
 Price effect: Price falls, so P is lower, which tends to decrease total
revenue
o The lower they produce, not as much profits. The more they produce, the less they
can charge.
o Marginal revenue line is the internal accounting of the firm.
o Because a competitive firm can sell all it wants at the market price, there is no
price effect. When it increases production by 1 unit, it receives the market price for
that unit, and it does not receive any less for the units it was already selling. That is,
because the competitive firm is a price taker, its marginal revenue equals the price of
its good. By contrast, when a monopoly increases production by 1 unit, it must reduce
the price it charges for every unit it sells, and this cut in price reduces revenue on the
units it was already selling.
 A monopoly maximizes profit by producing the quantity at which marginal revenue
equals marginal cost. It then uses the demand curve to find the price that will induce
consumers to buy that quantity.
o It's like having a price floor and quantity ceiling.
 Comparing Monopoly and Competition
o For a competitive firm, price equals marginal cost: P = MR = MC
o For a monopoly firm, price exceeds marginal cost: P > MR = MC (this is true for
ANY firm facing a downward sloping demand curve)
 Profit: (P – ATC) x Q

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 Deadweight Loss
o The socially efficient quantity if found where the demand curve and the marginal
cost curve intersect.
o Deadweight loss is similar to deadweight loss caused by a tax. A tax on a good
places a wedge between the consumrs' willingness to pay (as reflected by demand
curve) and producers' costs (as reflected by supply curve). Because a monopoly exerts
its market power by charging a price above marginal cost, it creates a similar wedge.
The wedge causes the quantity sold to fall short of the social optimum.
 Price Discrimination
o Price discrimination is a rational strategy for a profit-maximizing monopolist by
charging each customer a price closer to his or her willingness to pay than is possible
with a single price
o Price discrimination requires the ability to separate customers according tot heir
willingness to pay.
o Price discrimination can raise economic welfare by eliminating the inefficiency
inherent in monopoly pricing
 Public Policy
o Antitrust Laws
 Antitrust laws give government various ways to promote competition
o Regulation
 Two problems with marginal-cost pricing as a regulatory system:
 Natural monopolies have declining average total cost, and when
average total cost is declining, marginal cost is less than average total cost
(Figure 10, p. 322)
 Gives monopolist no incentive to reduce costs.
o Public Ownership
 Rather than regulating a natural monopoly that is run by private firm,
government can run monopoly itself.
 Private owners have an incentive to minimize costs as long as they
read part of the benefit in the form of higher profit.
 If government bureaucrats do a bad job, losers are the customers
and taxpayers
o Do Nothing
Monopolistic Competition
 Product Differentiation
o Each firm produces a product that is at least slightly different from those of other firms
o Rather than being a price taker, each firm faces a downward-slopping demand curve
 Firms can enter or exit the market without restriction
 There are many sellers, each of which is small compared to the market.
 The number of firms in the market adjusts until economic profits are zero
 From the perspective of an individual firm, new competitors results in a downward shfifting on
the demand curve
 Novels, movies
 Competition with Differentiated Products
o Short Run:

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 Monopolistically competitive firm follows a monopolist's rule for profit

maximization by choosing to produce the quantity at which marginal revenue equals
marginal cost, and then uses demand curve to find the price at which it can sell that
quantity.
o Long Run:
 Demand curve just barely touches average-total-cost curve.
 Two curves are tangent to each other. The two curves must be tangent
once entry and exit have driven profit to zero. Because profit per unit sold is the
difference between price (found on the demand curve) and average total cost,
the maximum profit is zero only if these two curves touch each other without
crossing. This point of tangency occurs at the same quantity where marginal
revenue equals marginal cost. This is required because this particular quantity
maximizes profit and the maximum profit is exactly zero in the long run.
 As in monopoly, price exceeds marginal cost
 Profit maximization requires marginal revenue to equal marginal cost
 The downward slopping demand curve makes marginal revenue less
than price
 As in a competitive market, price equals average total cost
 Free entry and exit drive economic profit to zero.
 Monopolistic versus Perfect Competition
o Excess Capacity
 Firms produce on the downward-sloping portion of their average-total-cost
curves.
 Firms could increase the quantity it produces and lower the average total cost of
production (unlike perfectly competitive firm).
 Perfectly competitive firms produce at the efficient scale, or the
quantity that minimizes average total cost.
o Markup Over Marginal Cost
 For a competitive firm, price equals marginal cost
 For a monopolistically competitive firm, price exceeds marginal cost because the
firm always has some market power.
 Monopolistic Competition and Welfare of Society
o Whenever a new firm considers entering the market with a new product, it takes into
account only the profit it would make.
o Two Effects that are external to the firm
 Product variety externality
 Because consumers get some consumer surplus from the introduction
of a new product, entry of a new firm conveys a positive externality on
consumers
 Business Stealing Externality
 Because other firms lose customers and profits from the entry of a new
competitor, entry of a new firm imposes a negative externality on existing firms.
o The invisible hand does not ensure that total surplus is maximized under monopolistic
competition
Oligopoly Models: Markets with only a few sellers

 Cell phone providers, cigarettes

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B
100 95
A 100 10, 10 0, 12
95 12, 0 5, 5 (nash)
Long Run Equilibrium

 Two characteristics
o As in a monopoly, price exceeds marginal cost
 Profit maximization requires marginal revenue to equal marginal costs
 Dead weight loss because prices higher than marginal cost
 The downward slopping demand cure makes marginal revenue less than
price
o As in a competitive market, price equals average total cost
 Free entry and exit drive economic profit to loss
Property Rights and Economic Systems

Tuesday, October 3, 2017
3:02 PM
Property Rights

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What are Property Rights?

 “A property right is the exclusive authority to determine how a resource is used,
whether that resource is owned by government or by individuals” (Alchian)
 Includes not only “right to exclude” but also rights to use
Property Law is concerned with creating and defining property rights

 Doctor needs quiet, but property next door needs to make noise
 Marginal cases where it's not clear what belongs to who
 Economics help to think about what property rights should be, or are going to be the
most efficient
o Spur economic growth, distributional issues with inequality
Thought Experiment #1: Who gets legal possession of the whale when the first whaler strikes but
does not bring down the whale?
Three potential rules:
 First harpooner has no right
 First harpooner gets ½
o Incentive is that too few people will be the first harpooner
o Benefit of splitting the whale does not outweigh the risk or costs
o Incentivize first move by harpooner
 First harpooner gets the whole whale (so long as harpoon is still in the whale when it is
eventually killed)
o Incentive is that advantage is to be the first harpooner
Thought Experiment #2: The United States grants property rights (patents) for the
commercialization of ideas
Choice 1: patent system

 Exclusive use and other rights for a specified period of time
 Incentive to exclude other market participants
 Patents are not static, as technology builds off technology
 Monopoly for 20 years is too long.
Choice 2: prizes
 We give a cash prize to the first to invent a specified idea and bring it to market – but no
“exclusive” right
 There are costs to patent enforcement that lower the net benefit of patent
Choice 3: none of the above
Economics of Property Rights

 An economic approach to property rights is focused on developing rules that encourage
efficiency
 Property rights have economic roles:
o Incentives
o Can internalize externalities
o Facilitate economic exchange
o Minimize uncertainty
 Positive Theory of Property Rights
o Law as endogenous to economic forces (Demsetz)

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 Examples:
o Commonly thought to be "things"
o Rights not obvious nor easy at the margin
 Where the dispute lies
o New beachfront hotel that block's neighbor's sunlight
o Trespass in emergency situation
Why Have Property Rights

 Conflict resolution over resources
 "Fundamental purpose of property rights, and their fundamental accomplishment, is
that they eliminate destructive competition for control of economic resources"
 Various methods of resource allocation in the absence of well-defined property rights -
brute force most popular historically
Paradigmatic Idea: Property Rights & Incentives

 Example: land can be improved by cultivation
o Without ownership rights - dicey
o With ownership rights - investment occurs
 If people work less hard, then incentive for people to work hard. But if
there is ownership of land, there is incentive to work harder
o Farms emerge, produce wealth, trade
o Generally: secure property rights led to economic growth
 Anti-commons: too much property rights can be detrimental
 Internalization Principle
o Economic actors bearing the full cost and benefits of their actions result in
efficiency
Private Goods versus Public Goods

 Private Goods
o Rival: If it's used by one person it can't be used by another person
o Excludable: you can stop someone from using it
 Public Goods
o Non-rival: one person's use does not diminish the use of another person (i.e.
clean air)
o Non-excludable: can't stop someone from using it (i.e. military protection)
 General Idea: private good should be privately owned, public goods should be public
owned
o Public good is shared (when the park is clean, everybody benefits)
o Free-rider problem
 If good is paid for collectively, and government taxes people, then social
benefit greater than the cost.
 But if one person owns the park, because there are so many free-riders,
the individual costs of maintaining park are greater than individual benefit.
Externalities
 A decisionmaker is considering whether to take an action. The action has a variety of
effects.

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 Some effects are important to the decisionmaker, and are taken into account when she
decides whether to take the action.
 Other effects are not as important to the decisionmaker as they are to other people
 If the decisionmaker does not fully take into account the impacts her action on other
people when she is making her decision, then her decision has externalities.
o Throwing firework show has positive externalities that go into decision for
decisionmaker
 Examples:
o Two year old son and decide to get a bigger car. What are the externalities?
 Carbon footprint
 People driving cars more at risk for injury in a crash
o Get a more expensive car, but it’s the same size and same pollution footprint.
Does this have externalities?
 Extra money lost from car that could have been used on vacation
 Car salesperson received a commission
 It is more costly for other people if they hit me
 Every action has externalities
 From social efficiency point of view, externalities do not matter as much because it is a
wealth transfer
o Neighbor trying to sell house, and same as me, and as a result of me putting
house on the market, the neighbor gets $5k less.
 Property law is interested in considering externalities and trying to come to social
efficient action.
o Sometimes this action internalizes externalities
 Externalities can be positive or negative
o Negative externalities: the total costs of an activity are greater than the private
costs to the individual who engages in the activity
o MC(Private) + MC(Externality) = MC(Society)
o Examples:
 A factory releases pollution into the stream
 A laundry uses the downstream water to clean clothes
 The cost of the pollution is a negative externality of the factory

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 Internalizing Externalities
o "Internalizing" such effects refers to a process, usually a change in property
rights, that enables these effects to bear (in greater degree) on all interacting persons.
o A primary function of property rights is that of guiding incentives to achieve a
greater internalization of externalities
o If the same person owned both the factory and the laundry, there would be no
externalities! That person would choose to pollute if it was efficient to do so, or not if it
wasn’t.
 Pigouvian Taxes
o The classic approach to externalities is to impose a tax so that the MPC
(marginal private cost) plus the tax is equal to the MSC (marginal social cost).
o MPC+tax=MSC
o This is a “public” solution – relies on government
o Key is to set the tax so marginal private cost plus tax to the point that is socially
optimal

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 Solving “externalities problem” with Pigouvian taxes

o Problems with this approach?
 How to measure the marginal social cost?
 What if the costs of stopping the pollution outweigh the benefits?
 What if it’s cheaper for the laundry to install a water filter than for the
factory to install a scrubber?
o Externalities involves two parties: it's not necessarily the person injuring other
person, but incompatibility with two sets of demands
o What is doctor moves in next to loud factory?
 Factory doesn't care about noise, but doctor is annoyed by noise.
 It is not necessarily socially optimal to force factory to construct sound
proofing. The doctor could have moved to another office.
 Solving externalities problems through property rights
o Assign property rights so social optimum if reached
 The factory was here first and they have the right to make noise, so if a
doctor wants to move in, the doctor should find somewhere quiet. This is socially
efficient.
o Assign the laundry the right to clean water
o Assign the factory the right to pollute
o But how to decide who gets the right?
o Simple (simplistic?) economic principle >> assign the right so that the efficient
solution is achieved
 Let’s put some numbers on it
o Factory generates profits of $500 per year, can install a scrubber at a cost of
$200
o Laundry generates profits of $300 per year if the water is clean, $150 per year if
the water is polluted, but can install a water filter at a cost of $100
o What is the socially efficient action? (Ie what action maximizes the profits of
both companies?)
 The laundry installs a water filter (benefit outweighs the cost)
 Scenario #1: No mitigating actions
 Factory: $500 profit

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 Laundry: $150 profit = $650 total

 Scenario #2: Scrubber, no filter:
 Factory: $300
 Laundry: #300
 Scenario #3: Filter, no scrubber
 Factory: $500
 Laundry: $200
 If the socially efficient solution is to install a water filter, does this mean we should
assign the factory the right to pollute?
o If there is no transaction costs, and easy to get everybody to the table, the
factory is going to pay to give right to assign clean water. It will be at least $100 (cost of
installation), then profits will be at least as much, all the way to
o Threat value defines what makes somebody to walk away from table.
 Laundry will walk away with less than $100.
 Factory: $200
o Bargain is between $100-$200.
 Coase Theorem
 If property rights are clearly assigned, and if there are no transaction costs (easy
to get parties to hash out agreement and trust other party will abide by bargain), agents will
naturally come to the efficient solution through bargaining
 The initial property rights affect the distribution of profits but they don’t affect
the actions that are taken
 Initial property rights assigned affects distribution of profit, but do not affect
actions that are taken.
o Attractive because made job of government is easier. No longer need to
figure out optimum amount of pollution (understanding costs that both sides accrue),
don't need to collect tax with externalities
 Let’s assume that there are zero transaction costs and that the Laundry was
assigned the right to clean water. What happens?
o Remember: Factory can install a scrubber at a cost of $200, Laundry can
install a water filter at a cost of $100
o The Factory can offer to pay some amount greater than or equal to $100
for the Laundry to install the filter
 True in a vacuum, but not applicable in real life
 Transaction Costs
o Search costs
 Figure out who to talk to and get to table
o Bargaining costs
 Time to arrive at solution
o Enforcement costs
 Once deal is reached, certain that both sides will live up to deal.
Formal or informal process adjudicating conflict, courts, police, punishment
o Are high when:
 There are many interested parties
 Many people use the river
 Communication is difficult
 When deals are hard to enforce

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 Need to have trust that other side is going to live up to

their side of the deal.
 Court costs
 When there are differing ideas of what is fair (ie legal rights are
unclear)
 Making property rights clear is important because when
they are clear, parties have a clearer idea the rights assigned and threat
points
 Implications
o When no transaction costs are reasonably close to true, makes
government's job easier.
o Are laws and property right allocations irrelevant?
 No, they are relevant (for purposes of reaching the efficient
outcome) when transaction costs are likely to prevent parties from bargaining.
o If you, as a legislator, know that the factory is the least cost avoider how
would you allocate property rights?
 Hint: When there’s a right to clean air, the factory has an
incentive to incur the least cost.
 Least cost provider: easiest for party to change actions
 Normative Coase Theorem
 Are there any other normative implications of the Coase Theorem?
o
 Normative Coase Theorem: Create institutions to minimize transaction costs.
o If property rights are clearly delineated, and enforcement is cheap, then
transaction costs are minimized, and people can come to an efficient solution through
bargaining
o Example: Obamacare website to compare health plans
 By making it easier for people to shop around, it would lubricate
the market.
o Example: Stock market, trade associations
 Positive Theory on Property Rights
 Demsetz (1967)
o Why do property rights exist? A positive theory is prescriptive.
o Property rights are costly
 Need consensus over what that right should be.
o Property rights deliver benefits
 Result in efficient use of resources, tragedy of commons
o PRs are created when benefits > costs of enforcement
 Historically, societies generally go from “open access” to “common” or “private”
ownership
o Indians in French Canada (late 1700s)
 System first where Indians would hunt and trap, and the forest
was vast with plenty of animals. There was no trading, so no value in taking
anything more. Because the land was vast, externalities were few. The number of
traps did not decrease the number of traps for the second person.
 Over time, there were more people, which established fur
trading. Because of fur trading, there was motivation to hunt and trap more
animals than before.

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 There was more crowding, thereby increasing externalities. If

you overhunt, then drive animals toward extinction. There is an optimal strategy
for hunting.
 They went from a system where externalities were low to much
higher, and gains from privatization were higher.
 The point of the story is that when fur became valuable, the
Indians privatized land.
o Enclosure Movements in England (1500s-1800s)
 Changed grazing land where common places were privatized.
 Harold Demsetz (1967), “Toward a Theory of Property Rights”
o Property rights develop to internalize externalities when the gains from
internalization become larger than the cost of internalization.”
o Private ownership of land among Native Americans
 Before fur trade…
 externality was small, so gains from internalization were
small
 gains < costs -> no private ownership of land
 As fur trading developed…
 externality grew, so gains from internalization grew
 gains > costs -> private property rights developed
o Useful today: If you observe an externality, there may be a reason why
property rights did not develop. It may be more efficient than it looks because of the
costs of creating and enforcing property rights.
 Friedman tells a similar story: “we owe civilization to the dogs”
o There is a problem with this solution… Private property does not
enforce itself. Someone has to make sure that the lazy neighbor doesn’t solve his food
shortage at your expense.
o [Now] you will have to spend your nights making sure they are not
working hard harvesting your fields. All things considered, you conclude that communal
farming is the least bad solution.
 Positive Theory of Property Rights
o Important point is that the property rights we observe are
“endogenous” to our economic system
o Explaining how property rights develop over time and the relationship
with economic exchange and incentives
o Suggests caution warranted before looking at some allocation of rights
in the real world – full of conflict and externalities – and declaring it inefficient
o Demsetz called this the “Nirvana Fallacy”
o Problems:
 Too many property rights
 Hold-up; “anti-commons”
 Example: Claiming room in house in Soviet Union.
 Not “enough” property rights
 Incomplete or unspecified with respect to particular
uses (always the case at the margin)
o There is always examples where property rights
are never fully explained. Not everything is spelled out.
 Property right “design”

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 Inefficient grant of rights

o how to we determine efficient way of allocating
rights?
 Query: which of these can / does Coasean bargaining solve?
 Property right "design"
 Classic idea is that you do not need to worry about
property rights design because they will bargain to solution anyway.
 Friedman
o In a world where courts could accurately measure value and enforce
liability judgments at negligible cost, it would. The damage payment equals the cost to
you of having your car stolen, so it pays to steal a car where both costs are zero, either
approach would lead to an efficient outcome.
o Reallocating rights by a private transaction is often more practical in the
case of the continuing nuisance.
 If the wrong person is assigned the right by a court deciding
whether or not to grant an injunction, the other person can buy it from him, at
least as long as only one or two people are affected. This doesn't work as well for
accidents. If the legal system gives you an absolute right not to have your
buildings burnt down by accident, enforced after the fact with statutory damages
or criminal punishments, I may not know which of my neighbors I need to buy
what rights from in order to avoid being found liable if an accident occurs.
o Low transaction costs not only make a liability rule work better, they
also make a fine work worse. If transaction costs are low and the fine does not go to the
farmers, the railroad has double incentive to put on the spark arrester; not only can it
eliminate the fine, it can also get the farmers to help pay the cost.
o Think about tort liability as a Pigouvian tax - designed to force
tortfeasors to internalize their externality.
II. A railroad company runs engines that throw sparks which start fires in the fields of the hundred
farmers who live along the rail line. At some cost, the railroad can prevent the fires by installing a
spark arrester. At some cost, the farmers can prevent the fires by replacing the wheat along the rail
line with clover.
A. Assume no transactions between farmers and railroad company are possible. The railroad has the
legal right to throw sparks without being liable for damages. Under what circumstances will this give
the efficient result? Under what circumstances will it not give the efficient result?
1. It will give the efficient result if the cost of switching to clover is less than the cost of the spark
arrester. It will also give the efficient result with regard to precautions if no precautions are worth
taking--i.e. if both spark arrester and clover cost more than the damage done by the fire. But in this
case the activity level (nbr of trains per day) will be inefficiently high (see answer to D).
2. It will not give the efficient result if the optimal precaution is a spark arrester (or if no precaution is
optimal, due to the activity level problem).

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B. Transactions among the parties are possible and costless; answer as in A.
It will always give the efficient result; this is the Coase theorem.
C. Transactions among the parties are possible but not costless. The railroad has the right to throw
sparks; switching to clover costs slightly more than putting on the spark arrester. What happens?
Explain.
No spark arrester. Either the farmers switch to clover or they absorb the cost of fires, whichever costs
less. The reason is that the farmers, in order to pay the railroad to install the spark arrester (the
efficient solution, if cheaper than fires), must solve the public good problem of getting 100 farmers to
chip in. They are unlikely to do so, since the gain is small ("slightly more").
D. The legal rule is that the railroad is liable for damage only if it is negligent. The spark arrester
costs more than the damage done by the sparks, so the railroad, in failing to install the spark arrester,
is not negligent and is not liable for fires started each time it runs a train. Is the result efficient?
Discuss briefly.
The level of precaution is efficient but the level of activity may not be. In deciding how many trains
to run per day, the railroad ignores the additional cost that each additional train imposes on the
farmers in the form of additional fires. If the farmers switch to clover there is no such cost, but if
switching to clover costs more than the fires do, then additional trains cause additional fires, so the
railroad runs an inefficiently large number of trains. This is the "activity level" problem we have
discussed with regard to a negligence rule.
V. Airplanes make noise that disturbs residents of homes near the flight path. Suppose that the airline
can, at some cost, reduce the noise to an insignificant level. Home owners can get the same reduction
by soundproofing their homes. For simplicity ignore the possiblity of different levels of noise
reduction--there either is or is not a noise problem.
There is one airline; it owns the airport. There are two thousand homes near the flight path. Reducing
noise costs the airline a million dollars a year. Sound proofing a house costs $400/year. Airport noise
(if there is neither soundproofing nor noise reduction by the airline) reduces the value of the house to
its owner by $600/year
A. What is the efficient solution?
The airline should (reduce/not reduce) noise:
The homeowners should (soundproof/not soundproof:

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Cost of soundproofing: $800,000/yr
Cost of noise reduction: $1,000,000/yr
Cost of doing nothing: $1,200,000/yr
Note that the question did not specify what the property rights were, since that is irrelevant to which
solution is efficient.
In answering parts B and C, describe first what happens if there is no bargaining between airline
and homeowners, and then whether bargaining will change the outcome. Explain briefly.
B. The airline has no legal obligation to reduce noise.
No bargaining. The airline doesn't reduce (no incentive to do so), the homeowners do soundproof
($400<$600)
With bargaining, the outcome remains the same, since even if the homeowners could overcome the
public good problem of raising the money to pay the airline to reduce noise, it wouldn't pay them to
offer more than $800,000, which the airline would not accept.
C. Each homeowner has the right to a reasonable level of quiet, so if the airline does not reduce noise,
it must pay each home owner for any resulting reduction in the value of his house.
No bargaining: If the airline doesn't reduce, it must pay $1,200,000/year in fines. So the airline
reduces noise.
With bargaining: The airline offers each homeowner $400/year + a little to soundproof, for a total of
less than $1,000,000/year. Any homeowner who refuses gets $600/damages. Since accepting the
offer makes the homeowner somewhat better off, each homeowner accepts.

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What can be privately owned?

 Information Economics
o An economic innovation provides a better way to make something or something
better to make. A better way to make something lowers its cost, so the supply curve
shifts down and to the right. This shift causes the price of the good to fall for
consumers. The amount of their gain is measured by the increase in consumers’ surplus

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in the market for the cheaper good. Similarly, finding something better to make creates
a new good that some consumers buy.
o The reward for innovation depends on how long the disequilibrium persists
from competition.
o Information is generally costly to produce and cheap to transmit.
o Information has two characteristics that make transactions in information
different from transactions in ordinary private goods
 Credibility
 Nonappropriability
 Producers have difficulty selling information for more than a
fraction of its value
 Example; Hong Kong shops traditionally resell American
software at the cost of a diskette.
o Information is nonrivalrous and nonexcludable (similar to non-excludability for
public goods)
o Remedies to private markets undersupplying public goods:
 State supplies or subsidizes art and science
 Charitable Contributions
 Trade Secrets Protection (I.e. Non-Disclosure Agreement)
 Trade secrets laws, however, have weaknesses that impair their
effectiveness. Assume that inventor A employs person B who signs an NDA,
and then person B leaks A’s secrets to company C:
o A has a contract with B and no contract with C. Because
C has no contractual obligations to A (in legalese, A and C do not have
“privity” of contract), A has limited legal powers to prevent C from
using A’s trade secrets or transmitting them to others.
o If C knew or had reason to know that B violated the
NDA, then A could sue C.
o If C induced B to violate the NDA, then A could sue C.
But if C did not know, or have reason to know, or induce B’s breach of
contract with A, then C did nothing wrong in receiving the
information.
o If the information has thoroughly leaked and become
common knowledge in the industry, anyone can use it for free, even if
they know that the information originally escaped into the public
sphere by breach of contract.
 Intellectual Property Law
o Innovation-dissemination tradeoff
o Requires an analysis of innovation and changing technology (growth technology)
o Patents create an exclusive property right in an invention for dimension (# of
years between registration and expiration) and breadth (how similar other inventions
can be without infringing on patent for original invention)
 Breadth: Does a patent for the pioneering discovery extend to the
applications?
 Broad patents encourage fundamental research, and narrow
patents encourage development
 Example: Investment of $100k in research yields a pioneering
invention that has no commercial value. Afterwards an investment of $50k

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in development yields an improvement to the pioneering invention that has

a commercial value of $1 million. If the law grants broad patents, a patent
for the pioneering invention would also cover the improvement, but if the
law grants narrow patents, separate patents would be required for the
pioneering invention and the improvement.
 Questions of breadth decided in law according to "doctrine of
equivalents"
 Refers to a series of court findings about how nearly equivalent
two inventions must be before finding patent infringement.
 This doctrine is obscure and unpredictable. C
 Courts have sometimes reasoned that an improvement with
great commercial value should not be interpreted as infringing on a
pioneering invention with little stand-alone value.
 Howard Chang argues this approach is flawed
o If the people who do fundamental research receive the
sale value of the pioneering invention, but they do not receive any of
the sale value of the commercial applications, there will not be
enough fundamental research.
o Example: Efficient incentives require that shepherds
receive the sale value of their product (sheep), which is the sum of
the sale value of mutton and wool.
 Problems arise under realistic assumption that transaction costs impede
bargaining between suppliers of fundamental research and commercial
development.
 Two legal remedies:
o Lubricate Bargaining (Normative Coase Theorem)
o Normative Hobbes Theorem (allocate rights to the party
who values them the most)
 Patent protection for pioneering inventions should be broader for those
with little stand-alone value, and the patent protection for pioneering inventions
should be narrower for those with large stand-alone value.
 Duration
 Because patents create a temporary monopoly that rewards the
inventor and overcharges buyers, the optimal life of a patent strikes the
best balance between encouraging creativity and discouraging
dissemination.
 As the duration of patents increases, society enjoys more
benefits from more innovation. However, the rate at which these benefits
increase presumably decreases. Consequently, the marginal benefit from
more innovation decreases as the duration of patents increases. As the
duration of patents increases, society suffers more costs from less
dissemination. Society responds to long patents by searching for substitutes
for patented goods. The longer a society searches, the more substitutes it
finds. As with benefits, the rate at which the social costs of patents
increases presumably decreases with duration. Consequently, the marginal
cost from less dissemination presumably decreases as the duration of
patents increases.
 Too Much Patent

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 Hatch-Waxman Amendments allows free use of patented

compounds in research to develop a generic alternative.
 Merck KGaA v. Integra, SCOTUS extended this law to research
aimed at developing entirely new drugs.
 Patenting of business methods
o Network effect: if invention is basis of natural monopoly, the inventor can
obtain monopoly profits even without a patent by innovating faster than competition.
 Copyright
o Copyright system does not require creators to register their work in order to
receive the protection of copyright.
o Fair use exceptions, Sony v. Universal: recording over the air copyrighted
television programs on a videocassette recorder is fair use when done for time shifting
purposes, but not necessarily for purposes of archiving.
o Duration: creator's life plus 70 years
o The optimal duration of a copyright involves tracing costs. The costs of searching
among all novels to make sure idea does not infringe someone else's copyright can be
extensive.
o Celestial jukebox model: every user of digital information will resemble U.S.
radio stations that must pay standardized royalties to a central clearinghouse whenever
they broadcast a song. In digital libertarianism, technical protection through cheap
encrypting will be more efficient than legal protection of intellectual property.
 Trademark
o Federal Trademark Act of 1946 (Lanham Act): successful applicant must
establish that the mark passes certain criteria, most important of which is
distinctiveness.
o Principal economic justification for granting property rights to trademarks are
that they lower consumer search costs and create an incentive for producers to supply
goods of high quality.
o Unlike patents and copyrights, economics of trademarks does not concern
innovation, temporary monopoly, or constrained dissemination.
 Organizations as Property
 According to bargain theory of property, markets tend to move property from
people who value it less to people who value it more. The market for corporations tends to
bring the ownership of each corporation to the people who can make the most profit from
them. Under ideal conditions of perfect competition, profitability measures the social value
created by a corporation.
 As a result of limited liability, people who invest in stock run the risk of losing
their investment and nothing more. Limited liability allows people to invest in a company
without monitoring or controlling the company’s policies so thoroughly.
 A vigorous market for corporations can prevent managers from pursuing goals
other than maximizing the company’s profits. In general, the stock market bids up the price of
a company’s stock until it equals the sum of the company’s expected future earnings
discounted to present value. If managers fail to maximize the company’s profits, then the
expected future earnings of the company fall and its stock price declines.
 Public and Private Property
 Private ownership divides people into small groups. So long as externalities are
private, private owners can advance their interests by cooperating with a small number of
people. Bargaining among small groups of people tends to result in cooperation and achieve

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efficiency. Consequently, the case for private ownership is easy to make when production and
utility functions are separable, or when externalities affect few people. In these
circumstances, public ownership is a costly mistake.
 Public ownership comes in three forms.
o First, open access allows everyone to use a resource, and no one can
exclude anyone from using it. Nothing is spent on boundary maintenance. Open access
works well when the resource is uncongested, but congestion causes tragic overuse.
o Second, political control allows lawmakers or regulators to impose rules
concerning access. Limited access is the most common rule for the state’s property,
including public lands.
o Third, the opposite of open access is unanimous consent, which allows
no one access unless everyone agrees. The need for unanimous consent among multiple
owners causes tragic underuse.
How are ownership rights established?

 Property law encourages production, discourages theft, and reduces the cost of
protecting goods.
What may owners do with their property?

 Theory of Externalities
o Common law approximates a system of maximum liberty, which allows any use
of property by its owner that does not interfere with other people's property
What are the remedies for the violation of property rights?

 Bargaining Theory
o Injunctive remedy is preferred for private bads with low transaction costs for
private bargaining
o Damage remedy is preferred for public bads with high transaction costs that
preclude private bargaining

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Antitrust
6:04 PM
Theory of the firm with supply curve: it got to choose how many widgets and the price. Firms
may bundle products or price products creatively. Firm could buy out another firm.
Antitrust deals with market failure.
Introduction
 The body of law governing business conduct potentially resulting in market failure
arising from monopoly power.
 High stakes:
o Type I error (false positive): condemns conduct that makes consumers better off
and makes everyone worse off
o Type II error (false negative): allows anticompetitive conduct and makes
everyone worse off.
 Increasingly important domestically and around the world.
 Antitrust can be divided into three categories:
o Cartel enforcement
 Business executives collude to set prices
o Mergers
o Monopolization or "single firm" conduct
U.S. Evolution
 In the U.S., the goal of antitrust laws is to protect economic welfare
o Broad concept; values what consumers are willing to pay for
 This has not always been the case
 For much of our history, U.S. sought to use its antitrust laws to serve a collection of
social and political goals
 Shift in 1970s - based on substantial economic literature
o Reiter v. Sonotone (U.S. 1979): The legislative history "suggests that Congress
designed the Sherman Act as a consumer welfare prescription."
o NCAA v. Board of Regents (1984): A restraint that has the effect of reducing the
importance of consumer preference in setting price and output is not consistent with
this fundamental goal of antitrust law.”
Modern Section

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 15 U.S.C. 18
o "in any line of commerce or in any activity affecting commerce in any section of
the country, the effect of such acquisition may be substantially to lessen competition,
or to tend to create a monopoly.”
Merger Policies 1960's-70's

 Trends toward concentration
 Brown Shoe
o Stop mergers in industries with trends toward concentration
 Pabst & Von's Grocery
o Combined 4.5% and 7.5% market shares
 Stewart dissent in Von's
o "the sole consistency that I can find is that in litigation under Section 7, the
government always wins."
 Structure Presumption Emerges
o “…[W]e think that a merger which produces a firm controlling an undue
percentage share of the relevant market, and results in a significant increase in the
concentration of firms in that market is so inherently likely to lessen competition
substantially that it must be enjoined in the absence of evidence clearly showing that
the merger is not likely to have such anticompetitive effects.”
Why Doesn't # of Firms Predict Competition?

 Market conception - the size and number of firms - is an outcome of competitive process
o The type of competition can determine the number of firms and their size; not just
the other way around
 Counting firms that compete and their market shares is not a precise exercise
o Does apple compete with google?
 If we aren't going to be able to predict price using our fingers and counting firms - what
options do we have?
 This is where modern industrialization organization comes in.
Williamson Tradeoff Model

 Merger can do two things at once.
o Economies of scale by acquiring competitor's assets.
o When loss of consumer surplus is bigger than gain in producer surplus due
to merger, then violation of antitrust laws.

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Pre-Merger Pricing - Relationship Between Margin and Elasticity

 When firms are profit maximizing,
 If benefits exceed costs, raise price.
Role of Margins and Diversion Ratios

 Raise price if profitable. It wasn't yesterday, but now it is today. Company recaptures and
internalizes increase in price.
 Unilateral effects from post-merger: Post-merger can increase price (90% of mergers
today).
 Big shift is that what matters in Starbucks/Cosi example is that there is a high diversion
between the two.
o The bigger the diversion, and close substitutes, the incentive is higher to increase
price.
o This is the big development in antitrust.

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 Diversions do not necessarily need to go both ways (Starbucks customers experiment

with Cosi, but Cosi customers don't experiment with Starbucks).
 Analysis: does merger have possibility to raise price. If there an incentive to raise price,
then look at blue rectangle.
Do Starbucks and Folgers Compete?

 Consumers live in different spaces, and not much diversion.
Staples/Office Depot Proposed Merger
 FTC v. Staples - FTC wins the case
 FTC previously lost retail mergers because government claimed prices would go up, but
judge would say maybe, but price will get competed down.
 Income, rent, expense to distribute products impact price in two locations, but FTC
asserted that different in superstore competition driving price increase.
 First line of defense: multiple factors affect prices.
o Trying to predict prices with mergers. Look at pre-merger high prices with single
market. BUT there are supply and demand factors that influence price than the
number of stores.
 Judge Posner describes Staples as coming of age modern merger analysis
o Example of integration of economic analysis and law
o Far cry from strict structural analysis that described most merger analysis through
the 1990s.
 Primary Question for Antitrust Law
o Relevant Antitrust Market
 Consumable office supplies sold through superstores
 Concentrated market with only three sellers nationwide
 Merger would result in duopoly or monopoly markets
 Consumable office supplies
 Un-concentrated market with numerous sellers
 Merging parties with a small 5.5% share of the market.
 Economics of Defense:

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o Cross-section evidence: problem of predicting prices of another market, and if not

controlled, end up attributing price difference to other explanations. FTC is inferring
by looking at single firm prices because they are high for other reasons. FTC has the
burden to prove it.
o Direct approach to spurious correlation would be to:
 Minimize these differences by comparing like regions
 Show other factors do not significantly affect pricing.
o In a cross section regression analysis, economist will attempt to control for these
factors by including them as right hand side (explanatory) variables
 But relevant variables (those that are correlated with entry) are often left
out.
 This results in omitted variable bias.
o Omitted Variable Bias:
 Negative correlation between left out variable (costs of doing business)
and the include explanatory variables (number of office super stores) can cause
spurious negative relationship between OSS firms and prices.
 Defense says FTC hasn't controlled for important factors between different
markets.
 Test proposition that most merger would be profitable and directly testing
price increase.
Proposed Merger Jos A Ban & Men's Wearhouse

 Will they be able to raise prices after proposed merger?
 Who will companies compete against?
o Inquiry is whether they on top of each other in product space.
 What does men's suit produce space look like?
o Based on structure, the post-merger firm will have 40% of the market, but that
doesn't do much to help predict price.
o One way to test whether merger would allow the post-merger to raise price is to
examined effects of MW store openings on JAB's quantity of suits
 Are they close competitors so that a merger would result in loss of
competition and higher prices for some group of consumers that would not
substitute
 We expect MW entry to result in lower JAB sales -- they are substitutes
after all -- but does a large fraction of JAC sales switch to MW when it enters?
 89 total MW entry events to analyze with two stores.
 Is competition between companies more closer (more intense) than competition with
other men's suit outlets?
Platforms and Multi-Sided Markets

 Platforms are about balancing.
 Two or more groups that directly interact; each group is affiliated with the platform in
some manner (typically through platform specific investments)
o Hugai, "Multi-Sided Platforms"
 Direct Network Effect: product more valuable (emails, texts)

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 Cross-Group-Effect: value of product increases for one group the more that another group
participates
o Iphone is more valuable the more apps there are.
o Wal Mart is more valuable to you if greater number of suppliers are available
 Same-side & Positive: Network effects; when more users join a social network, it
increases the value
 Same side & Negative: when more users join a social network, it decreases value
 Cross Group & Positive
 Cross Group and Negative:
 Takeaways
o Platforms balance the interests of all groups of the platform
 Cannot look at just one side of the platform
 Google Search Case
o Google allegedly manipulated its search algorithms to harm vertical websites and
unfairly promote its own competing vertical properties (search bias)
 Vertical websites: specialized or narrow (trivago)
o Through universal search, eliminate a nascent competitive threat (Google killed
them early for future competition)
o Defense:
 Universal search made consumers better off.
 FTC claimed that competitors were shifted up the supply curve. But
Google doesn't have a monopoly on ads.
 Anticompetitive theory to push competitor down the search results
Torts
7:03 PM
 In the context of contract law, it is reasonable to expect parties to be able to bargain with each
other.
o Cannot write a contract with everybody
o L&E perspective: Main objective is to cure potential inefficiencies due to incompleteness
of contracts.
 Tort law regulates relationships between individuals who are not in a position to bargain with
each other
o Externalities: the actions that one person takes have externalities on other people's
lives, and if they do not take into account, they will take actions that are too risky or
disruptive than socially optimal
 E.g. automobile accidents
 It would require enormous TC for each driver to have a contract with each
pedestrian on how they will be driving, what they expect in return, and what they will
pay if they breach their contract…
 Sets default rules for what each person's liability, if any, should be.
 Liability according to Friedman?

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o For property, can't make an injunction for hitting somebody

with a law.
o With liability rules, the government does not need to know in
advance what the socially efficient action might need to be. If something
happens, need to know what is right price is. For every car on the road,
there is a possibility of an accident. If driver can calculate probability of
accident, will take socially efficient action.
 Tort law determines conditions under which parties are liable to others absent a contractual
relationship.
o From society's point of view, moderate speed maximizes society's benefit. There is tradeoff.
o Is Coase Theorem applicable?
 Coasem bargaining deals with agent bargaining.
 Doesn't really apply because driver cannot come up with agreement with everybody on
the road, but legislators play this role.
 Strict liability v. negligence?
o Strict liability: if there is an accident between car and pedestrian, the driver is always
liable for full amount of damages.
o Negligence: only liable if behaving irresponsibly
 What happens under strict liability?
o Completely internalizes cost to pedestrian, then action taking will be the same as
socially efficient net benefit.
o Drive Rapidly:
 Probability of accident: 1/100
 Cost of accident: $100,000
 Expected Benefit: 120
 120 - (.99 + .01 x 10,000) = 120 - 100 = 20
o Drive Slowly: balance tradeoffs
 Does the driver’s expected benefit differ from the collective net benefit?
o It will be the same under strict liability
 What does this assume?
o Assume driver is risk neutral
o Driver undervalued or overvalued expected costs, and driver does not know
probabilities.
 People tend to guess in the vicinity, or center guesses around the truth.
 What if courts usually make mistakes, but they make symmetric mistakes?

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o E.g. assume damages are $ 50 in reality. The court determines them to be $ 40 half of
the time and $ 60 half of the time.
 Suppose there is a negligence standard, and the driver is found liable only if he is driving rapidly.
o Does this induce the efficient outcome?
 If D drives moderately or slowly he gets his benefits and does not need to pay
damages. Among these he chooses driving moderately. -> $80.
 If he drives rapidly, he pays damages in case of an accident -> $20
 This is the same as strict liability standard
o What do courts need to know for this to work?

 The benefit of driver, calculate optimal behavior, and set standard
o We also assumed that the only party who can affect the expected harm to the victim is the
driver.
 This is called the “unilateral accident model”.
 It would not be fair to hold a party liable for driving slowly when somebody jumps on
car
o But, in many cases, both parties can affect the expected harm caused to the victim
 This is called the “bilateral accident model"
o Assuming that the pedestrian only gains $ 5 from running, what is the efficient outcome
here?
 Drive Moderately (40 walks)
o What happens under strict liability?
 Rule: If driver is strictly liability, pedestrian will run because running gives her extra $5 of
utility

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 Knowing that pedestrian is running, the driver will drive moderately.

 Strict liability takes away incentive to take away precautious action.
 30 (runs)
o What about strict liability with defense of contributory negligence?
 If pedestrian running, driver is not liable for cost of accident.
 Pedestrian will have to pay expected cost.
 40 (walks)
o What about negligence?
 Rule: Driver is only liable for costs if they drive rapidly.
 As long as driver is not negligent, the full costs of their actions are taken upon
pedestrian and internalized.
o When would strict liability be preferable?

 Proving negligence is complicated with socially optimal action
 Hand Rule
o the owner’s duty, as in other similar situations, to provide against resulting injuries is a
function of three variables: (1) The probability that she will break away; (2) the gravity of the
resulting injury, if she does; (3) the burden of adequate precautions. Possibly it serves to
bring this notion into relief to state it in algebraic terms: if the probability be called P; the
injury, L; and the burden, B; liability depends upon whether B is less than L multiplied by P:
i.e., whether B < PL.
o The social-cost-minimizing level of care, x*, is the solution to the famous Hand Test.
 If the cost of precaution is less than the expected benefit (the reduction in
expected accident losses), the injurer is liable.
 Otherwise not.

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o If burden (marginal cost) is greater, party could reduce marginal cost and increase marginal
benefit.
 This is same as supply and demand curve.
 Marginal benefits exceed marginal cost = take more precaution
 Driving 100 mph - marginal cost of slowing down (taking more precaution) is going to be
greater than the marginal benefit of going too fast.
o Suppose that the sunken barge in U.S. v Carroll Towing and its cargo are worth $100,000.
Assume that the probability that the barge would break loose if the bargee is not present is
0.001, but if the bargee is present, the probability of the barge breaking loose is reduced to
0.0005. Paying the bargee to stay on the barge will cost the barge owner $25. If the barge
owner does not incur this $25 expense, is his behavior negligent under the Hand rule?
o B=$25, P=.0005, L=100,000
o Expected Loss Bargee (100,000 x .001) - Expected Loss No Bargee (100,000 x .0005) = 100 -
50 = 50
o $25<$50, therefore NEGLIGENT
 Compare the incentives given to potential injurers if the court follows an industry standard in
setting the legal standard of care versus determining negligence on a case-by-case basis using the
Hand rule.
o Industry standard would say hire the bargee because expected loss
 Litigation Costs and Accidents
o We assumed away litigation costs when considering automobile accidents.
o What if we incorporate them?
o Affect optimality of legal rules?
 Litigation costs lowers
o E.g. optimality of strict liability in the unilateral accident model.
 Negligence regime - need to figure out optimal level of precaution and whether
the parties took the level of precaution.
 Strict liability works where it doesn't make sense for court to evaluate
negligence.
 Strict Liability vs. Strict Liability with Contributory Negligence Defense

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 If injurer party knows their injuries will be covered, they have no

precaution to take meaningful precautions. Whereas, if they recover only if they
act recklessly will incentivize precaution.
 Although litigation costs are higher with negligence with contributory
negligence, this liability rule is preferred because it incentivizes precaution.
o Efficiency through strict liability relies on courts’ ability to determine damages
accurately.
o Efficiency through negligence relies on court’s ability to determine optimal care level
accurately. (But determining optimal care requires knowledge of damages!)
o Modified Example:
 Assume strict liability
 Accident causes harm of $10,000 to victim.
 It happens with various probabilities depending on how fast D drives.
 In particular: Rapidly  1/100, Moderately  1/250, Slowly  1/500.
 If an accident occurs, P (victim) can sue, in which case he will win 80% (shared
beliefs).
 Litigation costs $3,000 to each party.
 For simplicity assume that settlement does not occur (how would you
incorporate settlements?)
 What is the efficient outcome?
 Similar idea to backward induction
o Driver wants to know if there is an accident, will there be a
lawsuit.
 What happens if there’s an accident? Does P sue, or lump it?
 Does P’s expected benefit from suing exceed his costs?
($ 10,000 x 0.8) = $ 8,000 > $3,000. (Yes)
 P sues, whenever there’s an accident.
 Therefore, accidents result in costs aside from harms to the victim, namely
litigation costs.
o Now, social welfare has a third component: Litigation costs
o Efficient Result?
o Does strict liability achieve the optimal result?
 Without taking liability costs into account, the drivers actions would be socially optimal,
but with litigation costs, they are not socially optimal.
 Driver not varying litigation cost and 20% cost of accident

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 Negative externalities that are not fully internalized by strict liability (litigation
costs for defendant and 20% of accident)
 Paying for plaintiff's litigation costs:
 Discourages frivolous lawsuits, and it is expensive to resolve every dispute in
court.
o What’s D’s expected benefit from each option?
 P (no accident) x Cost (no accident) + P(accident) x Cost (accident)
 In general: (Benefit from driving) – (Expected damage payments) – (Expected litigation
costs)
 Drive slowly: $ 50 - (0.8 x 20) – (1/500 x $3,000)
 $50 - $16 – $6 = $28
Crime
7:01 PM
Law Enforcement (Fines Only)
 Civil infractions as well as criminal laws are enforced publicly.

o Property/Torts: need injured party to bring lawsuit.
o In crime, do not necessarily need injured party
 Public enforcement has some interesting features:
o Like private actions in tort law, it can regulate relationships between parties who
are not in a position to bargain (unlike contracts).
o Unlike in tort law (with the exception of punitive damages), liability is not capped
at compensatory levels.
o Moreover, sanctions need not be monetary. Imprisonment is possible.
o That the sanction need not be set at the compensatory level leads to an interesting
question: What is the optimal fine?
 Example:
o We are in Econville, where double parking causes expected costs of 10$ to
society
 (in the form of increased traffic, expected likelihood of being late to work
or class!)
o Double parking may benefit a person more or less than 10$ depending on his
particular situation
o When is it efficient for individuals to double park?
 When it is more than $10
o When the person due to special circumstances benefits more than 10$ from
parking.
 Can we achieve the efficient result? How?
o We would like to make sure that potential double parkers internalize the costs
they create
o We can achieve this by penalizing those who double park.

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o In particular, assume that the city council can hire law enforcers to detect double
parked vehicles. It has three options:
 10 full time inspectors @ 1,000,000$
 1 full time inspector at @100,000$
 1 part time inspector at 1,000$
o To make sure potential double parkers internalize the costs of their actions, the
following fines can be used under each enforcement scheme
o Optimal Fine?
 Equation: Expected Cost of Ticked / Probability
 10 inspectors - for the people whose benefit is higher than $10, they will
internalize the costs.
 Impose the highest fine possible, and exert the least costly effort to detect
violations!
 The wages paid to inspectors are way lower than hiring a lot of inspectors
with high probability
 This “low probability, large fine result” is due to Gary Becker’s (1992
Nobel Laureate) 1968 article in Journal of Political Economy.
 This is a very powerful and puzzling result, which many scholars have
tried to challenge or qualify.
 The result relies on risk neutrality and the absence of mistakes, among
other things.
 Polinsky pp. 83-90 for the risk-averse case
Prob. Fine EC Exp. Util.
1 $10 $10 -$10
1/10 $100 $10 EU(2) - 10
1/1000 $10,000 $10 EU(3) < EU2 < -10
 Assuming risk averse people, and adjusting fine is lower, and
expected cost is lower, and risk premium captures disutility.
 When calculating socially optimal cost, higher fine creates
stress for not getting tickets.
 Risk averse person will double park only if his benefit exceeds the
expected fine plus a risk premium that reflects his dislike of risk per
se. The risk averse person would be overdeterred. Optimal
deterrence can be achieved by lowering the probability or fine

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appropriately until the sum of the expected fine and the risk premium
equals the harm caused.
 Marginal Deterrence
o Most analyses of criminal of law and economics proceed with analysis as if a
single criminal decision is possible
o The idea of marginal deterrence relates to this point:
 Caught while stealing a loaf of bread, do we want the offender to kill the
police officer?
 Penalty less severe for stealing than for murder
 Punishment should be proportioned to offenses because, when
costs are all the same, offender will choose which gives them the most
benefit.
 Gives the offender an incentive to refrain from committing the greater
offense.
 A crazy solution to this: punish every crime with the death penalty, but
with different probabilities (e.g. 1/100 for petty theft, 90% for murder…)
 A benefit of this proposal has to do with the cost of imprisonment
 Why Not Hang Them All?
o Cost of imprisonment
 Model with imprisonment will be considered on Wednesday, but, one
defining characteristic is that:
 When sanctions are not monetary, one person’s loss is not another
person’s gain, i.e. the sanction is not transferrable.
 There are additional costs to imprisonment
o Friedman’s proposal, again: Reduce the cost of imprisonment by probabilistically
imposing the death penalty.
 E.g. suppose 10 years in prison with p=0.6 is the equivalent of the death
penalty with p=0.1.
 Impose the probabilistic death penalty equivalent of punishment via
imprisonment, and shut down prison.
o Why don’t we use Friedman’s crazy solution?
 Friedman: Due to public choice problems.
 i.e. if there was more at stake in the criminal law system, we would
observe more corruption, bribery, framing, etc.
 Example:
 “In one case in California, law officers shot and killed the owner of
a valuable estate when he interrupted their search of his house. According
to a report by the local District Attorney, the search had been preceded by
research not into the activities of the victim but the value of his property.”
 This problem is exacerbated by politicians’ small likelihood of being held
accountable by ex-convicts.
 Disenfranchisement:
o Another puzzling question:
 Why do we not increase the deterrence of murder to the maximum level?
 The costs would be extravagant.

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 i.e. we could hire way more police officers, if the objective is to minimize
murder.
 Friedman: We’re not willing to pay more to reduce more murders as a
society (?!?)
 What is the price of a life in L&E? Infinity?
 Perhaps, but there is a finite price of a probability of death. Why?
 Insights on the Economics of Criminal Law
o Many people drive cars
o Many people know that driving a car increases the probability of death in the near
future
o People are willing to take a small risk of death in exchange for having a better life
in general (one where you can drive).
o Similar idea with law enforcement: Pay $100K in taxes and have 5 times more
law enforcement v. keep your $100K and face a greater risk of being murdered…
o There’s a trade-off between reducing the number of murders through
preventive enforcement methods, and increased enforcement costs…
 Positive v. Normative Analyses, L&E, and Research
o The standard normative approach used in mainstream L&E analysis is to use
efficiency as the objective.
o Is there a good justification for using wealth maximization as the primary
normative tool?
 Arbitrariness of normative approaches... (see Munchhausen’s trilemma)
 There are a lot of opinions on what to maximize.
o Beneath economic argument is normative assumption with social efficiency.
 Rational Criminal at Work?
o According to the article the expected benefit from crime is relatively low.
o Less variation on s expected, its theft…

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o p can vary a lot. it must be low. A few possibilities:

 Prosecutors don’t prosecute…
 People do not report bike theft
 Police officers do not go after (or look around for) bike thieves
Imprisonment
 When would it be preferred to use imprisonment instead of fines?
o Fines used for smaller offenses, incarceration used for more serious offenses.
o Incarceration is a way to punish judgement proof wrongdoers
 When considering law enforcement via fines, we did not consider any direct costs
associated with the imposition of fines.
o E.g. David parks illegally and is forced to pay a fine of, say, $100.
o $ 100 is a private cost to David, so why does it not show up as a cost in our
calculations?
 Because it is transferred to someone else (or some other people). - No
value lost
 When considering imprisonment, we cannot assume the same. Why?
o David burns down a house, and is sent to prison for 10 years.
o This is a cost to David, should it enter the social calculus?
 Yes. This cost is not transferred, as in the case of enforcement through
fines, to other people.
 Do not want to assume morals.
 Non-transferability (imprisonment) versus transferability (fines).
 It is not a direct one-to-one shift in utility
o Caveat: But justice is served and people derive pleasure from knowing this.
 Yes. This may be true, but these are not direct transfers. This is a separate
benefit associated with the punishment of an individual. (Just like the benefit
associated with deterrence)
 The non-transferable nature of imprisonment results in a separate cost
associated with imprisonment.
 Furthermore, there are other costs associated with imprisonment, such as
operation and maintenance costs
 Objective: Determine the efficient punishment scheme (i.e. severity and probability of
punishment).
o The main benefit of punishment is deterrence (in this model), or how much
different sentences affect deterrence is crucial in deriving results.
 Three possibilities: Disutility from going to jail
o rises proportionally with the length of jail time
 e.g. steal 100 widgets, get 100 days . . . steal 200 widgets, get 200 days
o rises more than proportionally with length of jail time
 e.g. first day in jail is interesting, second day is terrible, third day gets
worst

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o rises less than proportionally with length of jail time

o Behavioral economics:
 People are present bias in time.
 Why would ‘disutility’ rise at different rates? What does ‘disutility’ mean?
o ‘Utils’ are fictitious units to measure a person’s well-being.
o They describe how people rank lotteries, when it is not meaningful to describe
their ‘willingness to pay’ to achieve their preferences.
 e.g. psychopath who doesn’t care about money.
o How does this guy rank 1 year in jail versus 2 years with probability of 0.5 and no
jail time with probability of 0.5?
o Does he fear the first year in jail more than subsequent years in jail?
 So what does this have to do with the rate at which disutility rises?
o A person who suffers ‘stigma’ costs when he goes to jail will care more about
avoiding jail altogether than avoiding an additional year in jail.
o i.e. he will fear the first year more than subsequent years
o E.g. What do you prefer?
 A: jail with certainty for 1 year, or
 B: jail for 2 years with probability of 0.5, and no jail with probability of
0.5?
o Most (ordinary) people prefer B
 Expected disutility from B= (½ x 250) + (1/2 x 0) = 125
 Expected disutility from A = 200
 B preferred to A
 Are there any other reasons (beside stigma) for people to fear the first year more than
subsequent years?
o Adapt to jail environment after the first year
o Humiliation may happen in the first year, and not in subsequent years
o Imprisonment is forgone income. Time value of money implies that money lost in
the first year is more important than money lost in subsequent years.
 Present Bias
o Present bias means that you value the present more than the future

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 You would rather eat a lot of Halloween candy now, even if it means you
will later regret having eaten so much
o Present bias also means that you are time inconsistent
 If you ask kids if they want two pieces of candy on Sunday or one piece
on Saturday, their answer depends on when you ask them
 If you ask on M, Tu., W, Th. they say they want two candies on Sunday
 If you ask them on Saturday they say they want one candy that day
 Teenagers are myopic (present biased)
 Whatever utility they get from committing crime in the
moment, they are insensitive to probabilities of getting caught.
o How does present bias influence our analysis of optimal punishment?
 If people do, in fact, fear the first year more, how does the optimal
punishment scheme look like?
 Three punishment schemes:
Sentence Disutility Detection Expected Enforcement Costs Imprisonment Costs Total Costs
Prob. Disutility
1 year 100 1 100 $1,000,000 $750,000 $1.750.000
2 years 150 2/3 100 $666,667 $1.000.000 $1.666,667
5 years 194 .516 100 $516,129 $1.935.484 $2,451,613

o Calculations assume:
 enforcement costs = $1,000,000 x probability of detection
 it costs $750,000 to keep a person in jail for 1 year
o Efficient Result?
 $1.666,667 is the lowest Total Cost
o Why is the Beckerian result not optimal?
 i.e. why is it not optimal to lower the probability of detection as much as possible
and raise prison time as much as possible?
o When the probability of detection is lowered, prison time must be raised more
than proportionally to off-set the reduction in deterrence, because people ‘fear’
subsequent sanctions less.
 a greater expected sanction (p x s) is required to deter when the probability of
detection is low.
 greater imprisonment costs for small probability – long sentence punishment
schemes
 trade-off between greater imprisonment costs and lower enforcement costs
o Posts an ad on Cannibal Café: “looking for a well-built 18- to 30-year-old to be
slaughtered and then consumed”
 If yes, should we not conclude that it is Pareto Optimal and ‘efficient’?
 L&E fails to provide adequate explanation for a situation like this.
o Don’t like it? Don’t use it… You can still use L&E as a positive tool.
o However, note that the claim that using L&E to study criminal law implies draconian
measures is demonstrably false:

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 Allow people to expunge their records to reduce recidivism

 High standards of proof to reduce costs of precautionary behavior
 Stigma-dilution to reduce scope of criminal law
 Allow penalty reductions for abandonment for marginal deterrence
 Warn first time offenders to reduce costs of punishing uninformed people
 Pay exoneration compensation to have better separation through plea bargaining
 Get rid of disenfranchisement to reduce over-incarceration
 Distortion of Justice: How the Inability to Pay Bail Affects Case Outcomes
o Why required monetary bail?
 Bail is a deposit, and traditional rationale is that it ensures people will
show up.
o Pre-Trial detention more likely to make you plead guilty
o Heightens need to eliminate racial and socio-economic disparities in detection
o The bail hearing is an important stage
 Public defender
 Greater time and care with evidence
 Increased training and accountability
Cooter and Ulen:
Diminished Rationality
We have explained that emotions cause actors to discount the future unreasonably from time to time.
When people discount the future unreasonably in this way, the immediate gain from doing something
wrong attracts them more strongly than the threat of a future punishment. Increasing the severity of the
future sanction has little effect on their behavior because the future has little effect on their behavior.
Unreasonable discounting of the future, whether probabilistic or systematic, is a form of diminished

rationality that afflicts many people
Civility
Instead of deterring criminals, law can help good citizens move to an equilibrium where many people
perform civic acts and little crime occurs.
Economic Goal of Criminal Law
criminal law should minimize the social cost of crime, which equals the sum of the harm it causes and the
costs of preventing it.

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Optimal Amount of Crime Deterrence
Socially optimal deterrence occurs at the point where the marginal social cost of reducing crime further
equals the marginal social benefit.
Optimal Means of Deterrence
Consequently, the socially efficient combination is the one that costs less. The one that costs less is
almost certainly the fine of $100 applied with probability .10. The reason is that a higher probability
requires more expenditures on police and prosecutors, whereas a large fine costs not much more to
collect than a small fine.
The optimal combination of fines and incarceration includes the maximum fine that the criminal can
pay.
To calculate punishment, divide expected punishment by probability. (I.e. 10 / .50)
Private Deterrence
the state should encourage ex post observable precautions, and the state need not encourage ex ante
observable precautions.

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In what sense are some punishments more efficient than others? Compare the efficiency of imprisonment,
flogging, and stigma as punishments. How might your answer change if we included incapacitation in the
calculation as a benefit--a negative cost--of (some) punishments?
1. Some punishments are more efficient in the sense of having a lower ratio of punishment cost to amount
of punishment.
2.Stigma produces a net benefit, since the information generated by conviction provides net value to
potential employers etc. Flogging has punishment cost roughly equal to amount of punishment.
Imprisonment has punishment cost equal to amount of punishment plus cost of maintaining the prison. So
the inefficiency, the ratio of punishment cost to amount of punishment, is greatest for imprisonment, then
flogging, then stigma.
3. Adding in incapacitation provides a benefit from imprisonment, so might conceivably make it a more
efficient punishment than flogging, and perhaps even than stigma.
A. Assume that we can and do, at no cost, catch and punish the perpetrator of half the offenses. What
ought the punishment to be? Why?
Expected punishment should be equal to damage done, so that crimes will only be committed if the gain
to the criminal is greater than the loss to the victim. So the punishment ought to be 2D (assuming that
everyone is risk neutral, as we must assume in order for punishments to really be costless). A .5
probability of a punishment of 2D has an expected value of D.
B. What are the costs that make up the punishment cost of a one year jail sentence?
The cost to the criminal of being imprisoned for a year and the cost to the legal system of keeping him
imprisoned for a year.
C. If catching and punishing criminals is costly, is the efficient level of punishment higher than the
answer to part A, lower, or sometimes higher and sometimes lower? Explain briefly.
Sometimes higher, sometimes lower. If deterring one more offense requires a increase in the sum of
apprehension and punishment costs, we want to set the punishment lower, so as only to deter offenses that
are inefficient enough to be worth the cost of deterring. If deterring one more offense lowers the sum of
apprehension and punishment costs--because offenses that are deterred do not have to be punished--then
we want to set the punishment higher, so as to deter some offenses that are efficient--but not efficient
enough to be worth the costs that punishing them imposes on the legal system.
VII. Suppose that some offense is currently punished by imprisonment. Someone proposes a practical
way of replacing imprisonment with an equivalent fine; assume his proposal will work. He argues that the
change is clearly an improvement; criminals are no worse off, victims are no worse off, and instead of

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spending money on prisons we can collect fines and use them to help pay for the police force. What
arguments might you offer against his proposal?
The opportunity to collect the fine gives enforcers an incentive to catch people and convict them of the
offense--whether or not they are guilty. That might result in lower than efficient efforts to avoid
convicting innocent people--even in efforts to frame innocent people--or greater than optimal efforts to
catch and convict guilty people.
Contracts
Tuesday, November 14, 2017
6:03 PM
 Dynamic agency game without enforceable contracts

o First player moves first, second player moves second
o Does the first player invest?
 No
o Would each of them be willing to pay to make an agreement enforceable?
 Yes
 Both parties want an enforceable contract. Knowing the first person will
count on it.
 Contracts solve problems that arise from trust problems with agreements
where one party will fulfill duties at some future date.

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 Dynamic agency game with enforceable contracts
o Does the first player invest?

 Yes
 Think of what the second player does first.
 Second player will always perform. Knowing this, the first player will
choose between .5 and 0 and invest.
Does the second player breach?
 No
o In this game, the second player must pay expectation damages if she breaches.
o Expectation damages give the first player as much benefit as she would have received
under performance.
 Efficient Breach
o When would it be efficient to breach the contract?
o What policy can we put in place to ensure that the only breaches that occur are
efficient ones?
 The promisor has efficient incentives to perform when liability internalizes
the cost of breach
 The cost of breach is the loss to the promisee
 Promisee needs to take cost into consideration

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 If make promissor liable for the amount of benefit, they will only be
willing when benefit is greater than the liability.
 Expectation damages internalize the cost of breach
 We want the second player to breach if benefiting of breaching it greater than cost
to first party, but do not want to breach if second.
o Imagine the promisor is uncertain of whether her costs will be high or low. When
would it be efficient to breach the contract?
 Breach is efficient when costs are high

 The net benefit (added together) = when costs are zero, benefit is 1, or when
costs are 1.5, benefit is -.5.
 The socially efficient outcome is to breach, because when not invested, the
benefit is 0 compared to -5.
 First player will always invest, and for second player, when costs are zero, will
perform, and if costs are 1.5, second player will breach.
 Reliance
o After a contract is signed, the promisee may choose to invest in reliance upon the
contract.
 e.g. somebody opens waffle shop and expanding. They want to open a
second shop and contracted with somebody to build store. The owner knows
that once second store is opened, she will need more food for customers, and
will need to know in advance the date of completed for opening date. If she
invests in food prior to launch date, she will lose profits from food.
o When is it efficient to invest in reliance?
 Example: If high probabiliy contractor will get work done on time, and buying
food will increase profits, then high expected benefit in investing in reliance. If
the cost of reliance in buying the food earlier, rather than the same day, is
relatively low, it would be efficient to buy food in advance.
 Dynamic agency game with variable reliance, enforceable contract, and simple
expectation damages.

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o Will the first player choose high reliance or low reliance?

 High reliance
o Is this always socially optimal?
 Not if there is a high likelihood that it is efficient to breach
 Regardless of second player, the first player gets more when investing in high
reliance.
 Not necessarily socially optimal, particularly if high likelihood that second
player breaches.
 If you have expectation damages, can induce inefficiently high amount of
reliance.
 Complete
o If complete contracts were costless to draft, would we need contract law for
efficiency purposes?
o L&E perspective on contract law: Contract law provides default rules to fill in
gaps arising from incomplete contracts.
o In particular, it considers potential remedies for breach of contract
 Expectation damages, reliance damages and restitution damages.
 When is it better to leave gaps in a contract?
o Every point put into argument takes time, and if probability if reasonably low enough,
maybe its not worth the hassle if the parties are not sure it will happen.
 Cost of allocating risk = putting into contract
 Cost of allocating a loss = cost of figure out later
o Contract law provides default rules that cover gaps in contracts
o One purpose of contract law is to minimize transaction costs of negotiating contracts
by supplying efficient default terms
 Why do efficient default terms minimize transaction cost
 Because efficient default terms are what would have been chosen if they
took the time to design them.
 If people had time to negotiate contracts, they would derive an
efficient agreement.

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 Can bargain over terms (Coase Theorem). If in a smaller pie

scenario, and there is a larger pie scenario, parties can trade slices of
pie to expand the pie so everybody is better off.
 Damages
o Expectation damages: the amount that puts B “in the same position she would
have been in had” S performed
o Reliance damages: the amount that puts B in the same position she would have
been in had she not entered into the contract
o Restitution damages: An amount equal to the benefits received by the breaching
party due to contract
o Which remedy is likely to induce efficient breach?
 Expectation Damages
 Breach
o Example:
 S’s cost of producing widget is $ 150
 B1 values widget at $200
 B1’s reliance expenditure is $10
o Timing:
 S and B1 enter into an incomplete contract: S will deliver, B will pay
 B1 pays S a contract price of P
 B1 makes investment of $10 to make widget useful when he receives it
 S Produces widget
 B2 appears, and values widget at $0, $180 or $250, with equal likelihood
o Under what conditions should S breach the contract?
 Only when B2 values the widget at $250. Why?
 It is efficient to breach contract because widget is going to person who
values it the most.
o When does the seller breach the contract?
 Does this depend on the remedy?
o Expectation damages:
 Contract completion B1 gets a widget that he values at $200, which means
expectation damages= $200
 When does S breach?
 No breach: no damages, no further gains
 Breach: -$200 in expectation damages, but a gain equal to B2’s
purchase price
 B2’s purchase price exceeds $200 only when his valuation is $250.
 Expectation damages induce breach only when it is efficient
 Even if the price is only $150, since expectation damages needs
they need to pay full value, they would have to pay $200.
 Assuming there is no other place to buy widgets.
o Reliance damages:
 Had B1 not entered the contract, it would not have paid the price for the
contract, and it would not have made investments = $10
 reliance damages = P + $10
 What is P?

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 B1 willing to pay P < $190 (why?), S willing to produce for P>

$150 (why?)
 Price will be between $150 and $190
 Assume price ends up being $160
 reliance damages = $170
 When does S breach?
 When B2 is willing to pay $250 OR $180
 Breach when B2’s willingness to pay is $180 is inefficient
 Reliance damages can induce inefficient breach.
 We said that the price could be between $150 and $190, but assumed it
would be set at $160.
 Does this affect the analysis?
 What if price was $175?
 S faces damages of $175 + $10= $185
 Breaches only when B2’s valuation equals $250, which is
Efficient breach!
 So what’s the problem with reliance damages?
 Efficiency of breach depends on P when we have reliance
damages, but not when we have expectation damages (because of cost
internalization).
 The cost of breach is not just the price, but also loss in value to the
first value. With expectation damages, this entire cost is internalized (price
+ surplus).
 Reliance damages is only the cost, but not the buyers valuation.
o Restitution Damages:
 What is the benefit captured by S due to contract?
 Exactly P!
 P is between 150$ and 190$ due to reasons explained earlier.
 When does S breach?
 When B2 offers a price greater than P.
 Therefore, if P<180$, restitution damages will induce S to breach
even when B2’s valuation is 180$.
 Restitution damages, like reliance damages, can lead to inefficient
breaches depending on P.
 In general restitution damages more likely to induce inefficient breach
than reliance damages, because it does not require S to compensate for
reliance costs (i.e. 10$)
o Summary :
 Expectation damages = Efficient breach
 Restitution and reliance damages = Inefficient breaches depending on P.
 This is because under the latter two remedies the seller does not internalize
the harms he causes to the buyer.
 The cost of breaching is considered in reference had they performed their
contract.
 Example
 Price = 170

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 Reliance Investment = 10
 Value = 200
 Net Benefit: 200 - 170 -10 = 20
 Expectation Damages = 200
 Reliance Damages = 180
 Restitution Damages = 160
o Previous example assumes that the buyer does not choose its level of reliance
 Realistic?
o Modified Example:
 B1 chooses level of investment to affect the value of the widget.
 Recall that initially B1 had to pay $10 to reap benefit of $200 from the
widget.
 Now, assume that it can obtain an additional $30 value by paying an
additional $24.
 Stated differently, it can choose to pay 10$ to have the widget be worth
$200, or it can pay $34 to have a widget worth $230.
 Which remedy induces efficient reliance? What’s the first question?
o What level of reliance is efficient?
 Assuming B2 values the widget at $ 250 with a probability of 1/3, B1 will
get the widget only 2/3’s of the time.
 Accordingly, B1’s investments will be worth value only 2/3’s of the time.
 The expected benefit (excluding damage claims) to B1 through further
reliance (i.e. paying $ 24 more) is therefore $ 30 x 2/3 = 20.
 Since, $20 < $24, it is efficient for B1 to not make the extra investment of
$24.
 Expected Benefit = (1/3 x 0) + (2/3 x 30) = 20
o Which remedies result in optimal reliance?
 Expectation damages:
 If B1 spends 10$ on reliance, expectation damages are 200$
 If B1 spends 34$ on reliance, expectation damages are 230$
 In case of breach, B1 will receive expectation damages.
 By spending 10$, it gets a benefit of 190$
 By spending 34$, it gets a benefit of 196$
 Higher benefits from spending more in case of
breach!
 In case there’s no breach, results are the same, because the widget
confers a value equal to expectation damages.
 Higher benefits from spending more in case of no breach!
 Expectation damages induce inefficient reliance
o Reliance Damages:
 If S breaches, B1 will get P + the cost of reliance.
 No cost of increased reliance, because B1 will be compensated by
as much as he/she invests in reliance.
 If S doesn’t breach, B1 will get the value of the widget, which is
 $196 with over reliance (i.e. $34)
 $190 with efficient reliance (i.e. $10)

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 over-reliance leads to better result in case there’s no breach.

 No “downside”, but a potential “upside” from increased reliance = B1
chooses to pay the additional 24$.
 Reliance damages induce inefficient reliance
 Don't internalize full cost of reliance
o Restitution Damages:
 In case of no-breach, the value of the widget is increased by 30$ if B1
makes an additional investment of 24$
 “Upside” of increased reliance.
 In case of breach, B1 is only entitled to a refund, i.e. P.
 B1 is not compensated for additional investment, and loses the
additional 24$.
 “Downside” of increased reliance.
 If breach happens with probability of 1/3, what is B1’s expected
benefit from increased reliance?
 [2/3 x 30$] + [1/3 x 0] = 20$
 20$ < 24$ (cost of increased reliance), B1 does not increase
reliance.
 Restitution can induce efficient reliance
o We assumed, in the restitution damages case, that breach would happen with a
probability of 1/3.
 Is this a reasonable assumption?
 Maybe, but it is the easiest way to demonstrate the advantage of restitution
damages.
 If breach becomes more likely, less efficient.
o Shavell, Damage Measures for Breach of Contract (1980) considers interactions
between breaching and relying parties and shows that in general:
 Expectation damages lead to efficient breach
 Restitution damages lead to efficient reliance
 Both restitution and reliance damages may lead to inefficient breaches
 Both expectation and reliance damages lead to over-reliance
 None of the damage measures can be said to be generally optimal, their
optimality depends on the particular contract.
 Shift burden of breach on the seller in the second party.
 If more concerned about investment and reliance, shift burden to
the first party, or buyer in the example.
 Efficiency and reliability have an opposite relationship.
 Reliance: efficiency high when damages are low. When damages
are low, the buyer is internalizing the risk and costs entailed with making
extra investments. When damages are higher, when compensated no
matter what, she does not internalize costs.
 Breach of Contract: Risk Allocation
o Assumed in previous example that parties were risk neutral
o In particular,
 to abstract from reliance related issues, assume that B1 can only incur 10$
as his reliance cost

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 to abstract from efficient breach related issues, assume that B2’s

valuations can only be 0$ or 250$.
o The example becomes:
 S’s cost of production = 150$
 B1’s valuation of the widget = 200$
 B1’s reliance cost = 10$
 B2’s valuation of the widget = 0$ or 250$.
 B1’ pays P (contract price) in advance.
o In case of no breach (i.e. when B2’s valuation is 0), what is each party’s
wealth level (valuation of that state of the world)?
 B1: Pays for the contract, relies, and gets the widget:
 -P -10 +200 = 190-P
 S: Receives the contract price from B1, and incurs the cost of producing
widget:
 P-150
o If damages are given by D, what is each party’s wealth level in case of breach (i.e.
when B2’s valuation is 250)?
 B1: Pays for the contract, relies, and gets damages from S:
 -P-10+D = D-P-10
 S: Receives P from B1, produces widget for 150$, gets 250$ from B2, and
pays D to B1:
 P-150+250-D =100+P-D
o Valuations:
B1 S
o What do expectation, reliance and restitution damages equal?
 Expectation: $ 200
 Reliance: P+ $10
 Restitution: P
o By replacing these values with D, we can figure out how much each party gets under
each case.
o Expectation damages D= $200
B1 S
Breach 190-P P-100

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 B1 is fully insured! He gets the same pay-off in both cases.

 S is not fully insured. He’s carrying a risk: There is $50 difference between how
much he makes under the two cases.
 Expectation damages allocates risk properly when B1 is risk averse, and S
is risk neutral.
 If the seller is risk averse, they want to get rid of risk and have less
uncertainty in the outcome. There could be an agreement they reach where
buyer takes on more of the risk, and to induce buyer to take on more risk,
the seller lowers the price.
 The uncertainty is we don't know what's going to happen after the contract
is agreed upon. The uncertainty is whether the person is going to come
along with a higher valuation.
 Seller 1 is entering a lottery, where probability is rooted in that you have a
buyer with higher valuation that shows up.
 Buyer faces no uncertainty with expectation damages
 Example: Alumni rents bus to take all of their friends to Patriots
game. They are very nervous and do not want any risk involved.
They could say in contract that we want to set level of damages to
take all risk off the table so we know for sure the bus will not mess
up. The bus company may say that is intense, but instead of charging
$1000 to game, the fee is $10,000 to take away all the risk.
 Need to think about allocation of risk for optimal contract.
o Reliance damages: D= P+10
B1 S
Breach P+10 100+P-P-10
-P-10
 Neither party is fully insured.
 Moreover, risk is distributed unequally among parties.
 Assume e.g. P= $170
 B1 risks making $20 less when there’s breach.
 S risks making $70 less when there’s breach.
 If parties are equally risk averse, reliance damages is a poor remedy to
allocate risk
 We want parties to carry equal amount of risk.
o Restitution damages: D= P
B1 S

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 Neither party is fully insured!
 Moreover, risk is distributed unequally among parties
 To see this, pick P= $170 and repeat the steps in the analysis of reliance
damages
 If parties are equally risk averse, restitution damages is a poor remedy to
allocate risk.
o What about liquidated damages? If the parties can choose D on their own, can they
allocate risk better?
 e.g. if S is risk-averse, but B1 is risk neutral, can they choose D so that S would
be fully insured and all of the risk is carried by B1?
 Firms tend to be closer to risk neutral than individual people.
 If you have a seller that is an individual, but firm is the buyer, then shift
more of risk to the buyer.
o
B1 S
Breach 250-P-10 100+P-250
 What about D= 250$ ?
 It works!
 S is fully insured and all the risk is carried by B1.
 EXAM: expected to find amount of damages all of the risk borne by the
buyer.
 What if the parties are equally risk averse and would like to carry an equal
amount of risk?
 Can liquidated damages be used to allocate risk equally among these parties?
 How about D=225$?
 It works!
 Each party carries the risk of making 25$ less under no-breach.
 Risk is distributed equally.
 Takeaways
o If B1 is risk-averse and S is risk neutral, expectation damages can be used to

optimally allocate risk.
o If S is not risk neutral, then previously studied damages do a poor job in allocating
risk.

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o Liquidated damages can be used to allocate all the risk to B1, and this is optimal
when S is risk-averse and B1 is risk-neutral.
o When parties are equally risk averse, liquidated damages can be used to equally
distribute risk among the two parties.
o Liquidated damages require ex ante negotiation by the parties. Costs of such

negotiations can off set benefits from proper risk allocation.
Notes Reading
Cooperation and Commitment:
economic efficiency requires enforcing a promise if the promisor and promisee both wanted
enforceability when it was made
The first purpose of contract law is to enable people to convert games with inefficient solutions into
games with efficient solutions.
In game theory, a commitment forecloses an opportunity.
We answered the first question of contract law—“What promises should be enforced?”—by asserting
that a promise should be enforced if both parties wanted it to be enforceable when it was made. Both
parties want a promise to be enforceable so that the promisor can credibly commit to performing. A
credible commitment to performing enables the parties to cooperate, and cooperation is efficient.
Information
Before they form the contract, the parties have private knowledge about what they hope to get out of
the relationship, the prices and other terms to which they would be willing to commit, the duration of
the relationship that they anticipate, the aspects of the promise that really mean a great deal to them
and the aspects that are not so important.
Asymmetric information can cause problems for arm’s-length transactions.
the second purpose of contract law is to encourage the efficient disclosure of information within the
contractual relationship
Performance
“What should be the remedy for breaking enforceable promises?”

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Think of the remedy as the “price” paid by the promisor for breaching the contract. The higher the price
of breach, the stronger the promisor’s commitment to perform.
The third purpose of contract law is to secure optimal commitment to performing.
Perfect Expectation Damages
In one-time transactions with large stakes, the promisor may show little regard for the loss that breach
imposes on the promisee.
If liability is the promisor’s only concern about breach, he or she will perform when it costs less than the
liability for breach and will breach when performing costs more than the liability for breach.
Efficiency requires maximizing the sum of the payoffs to the promisor and promisee.
The promisor has efficient incentives for performance and non-performance when the liability for breach
equals the benefit foregone by the promisee.
When the promisor’s liability equals the benefit foregone by the promisee, the promisor internalizes the
costs of breach. Consequently, the promisor has efficient incentives to perform when liability internalizes
the costs of breach.
perfect expectation damages create incentives for efficient performance and breach. Consequently,
perfect expectation damages elicit efficient commitment from the promisor to perform.

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Optimal Performance
Perfect expectation damages induce efficient commitment to performance and breach. Efficient
commitment maximizes the surplus from the contract, which the parties can divide between them.
Consequently, both parties to a contract typically benefit from having perfect expectation damages as
the remedy for breach, rather than having an alternative remedy. By awarding expectation damages, the
courts typically give the parties the remedy that both of them preferred when making the contract.
Reliance Damages
Reliance is a change in the promisee’s position induced by the promise.
Think of reliance on a promise as a gamble that increases the gain from performance and the loss from
breach.
The fourth purpose of contract law is to secure optimal reliance.
How much reliance is optimal? The expected gain from additional reliance equals the increase in the
value of performance to the promisee multiplied by the probability of performance.
Optimal reliance is high when performance is certain, and optimal reliance is low when performance is
uncertain.

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Simple expectation damages remove all the risk from reliance, so the promisee always relies to the full
extent, even when efficiency requires restraining reliance.
Simple reliance damages thus create an incentive to rely at the high level regardless of the probability of
breach.
If breach is likely, the first player has an incentive for low reliance, and if performance is likely, the first
player has an incentive for high reliance.
As defined earlier, perfect expectation damages restore the promisee to the position that he would have
enjoyed if the promise had been kept. That position depends upon the extent of the promisee’s
reliance. For the sake of economic efficiency, the promisee’s reliance should be optimal.
Overreliance causes excessive harm from breach. The law can discourage overreliance by limiting
recoverable damages. If courts award perfect expectation damages as defined here, the victims of
breach receive no compensation for overreliance. Because the ideal law compensates the victim of
breach only for actual losses up to a maximum equal to the loss from optimal reliance, the victim must

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bear any additional losses caused by overreliance. Consequently, the promisee has a strong incentive to
avoid overrelying.
Default Rules and Transaction Costs
“Ex ante risks” refer to the risk of future losses faced by the parties when they negotiate a contract. “Ex
post losses” refer to losses that actually materialize after making the contract.
Explicit terms in a contract usually prevail over the terms that the court would supply to fill a gap. When
explicit terms prevail over implicit terms, the implicit terms fill gaps by default, which means “in the
absence of explicit terms to the contrary.” Gap-filling terms in contract law are mostly “default terms.”
replacing inefficient contract terms with efficient terms creates a surplus. Similarly, replacing inefficient
default terms with efficient default terms creates a surplus.
The fifth purpose of contract law is to minimize transaction costs of negotiating contracts by supplying
efficient default terms and regulations.
Hypothetical Bargaining
Impute the terms to the contract that the parties would have agreed to if they had bargainedover all the
relevant risk.
First, the court in structuring a hypothetical bargain must establish the most efficient form of
cooperation. In Chapter 4 we also noted that an equal division of the surplus is reasonable. Second, the
court must divide the surplus that cooperation would have achieved. In other words, the court should
respond to gaps in the contract by allocating obligations efficiently and adjusting the price reasonably.
In general, imputing terms to a contract involves a detailed inquiry into the customs of the trade and the
information known to the parties. When the efficient risk-bearer actually foresaw the risk, or ought to

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have foreseen the risk, the court should presume that the negotiated price included compensation for
bearing the risk.
The ideal contract allocates the risk of unforeseeable losses to the more efficient risk-bearer.
In order to behave efficiently, Wabash needed to know about the unusual losses from delay. The
McGuires failed to provide the information to Wabash. Efficient contracts typically allocate losses
caused by someone’s fault to the party at fault.
The common law rule holds that the promisor must bear the usual costs of breach (“reasonably
expected costs of breach”), whereas the promisee must bear the unusual costs of breach
(“unforeseeable costs of breach”), unless the promisee notified the promisor about the unusual costs of
breach
Remedies
Because negotiating and drafting are costly, an efficient contract will not explicitly cover every
contingency.
Buyer's Breach: perfect expectation damages equal xK (pS - pK). Perfect expectation damages for buyer’s
breach equal the difference between the contract price pK and the spot price pS.
Sale of Unique Goods: vK – vA. perfect expectation damages for Seller’s breach equal the difference
between the value of a performed contract and the actual value of what was delivered.
price pS
spot price pK.
contract price pK
wholesale price pW.

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Opportunity Costs:
If opportunity-cost damages achieve their purpose, the potential victim of breach is equally well off
whether there is breach of contract, on the one hand, or the best alternative contract, on the other
hand. We say that perfect opportunity cost damages leave potential victims indifferent between breach
and performance of the best alternative contract.
The value of the lost opportunity is read off the graph by moving vertically from the 25 percent point on
the horizontal axis up to the “opportunity curve,” and then horizontally to the intersection with the
vertical axis.
For measuring expectation damages, the uninjured state is the promisee’s position if the actual contract
had been performed.
For measuring reliance damages, the uninjured state is the promisee’s position if no contract had been
made.
For measuring opportunity-cost damages, the uninjured state is the promisee’s position if the best
alternative contract had been performed.
The following inequalities typically hold when courts measure damages perfectly:
expectation damages - opportunity-cost damages - reliance damages.
expectation damages typically exceed opportunity-cost damages.

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To attack this problem, we suggest that you first compute the expected profit from the contract. (You
should get $900.) Then calculate the actual loss. (You should get $11,100.) Finally, calculate the profit
from the best alternative contract. (You should get $400.) You should immediately see the expectation,
reliance, and opportunity-cost damages.
Restitution damages requires the injurer to give back what he or she took from the victim.
Perfect compensation completely internalizes the external costs of an injury. When costs are completely
internalized, efficiency requires freedom of action, not deterrence. Given cost internalization and
freedom, a rational person injures others whenever the benefit is large enough to pay perfect
compensation and have some left over, as required for efficiency.
“Disgorgement damages” are damages paid to the victim to eliminate the injurer’s profit from
wrongdoing.
Specific performance usually requires the promisor to do what he or she promised in the contract.
Enforcing Penalty Clauses:
First, the punitive element may be considered as payment on an insurance contract written in favor of
the innocent party by the breaching party.
A second reason for enforcing penalty clauses is that they often convey information about the
promisor’s reliability.
A third reason to enforce penalty clauses, as explained by Avery Katz, is that most penalties can be
restated as bonuses.

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Asymmetric Information & Adverse Selection

Tuesday, November 21, 2017
6:03 PM
 Information Problems at Root of Consumer Protection

o Uncertainty vs. Asymmetry
o Uncertainty - unknown outcomes
o Asymmetry - information known by one party but not the other
 Discovered ex ante: Search
 Objective attributes that are verifiable once seen
 Gaining information comes at a cost to gain desired information
 E.g., price, color, size, shape
 Certain types of products that even after buying them, you may not
know all the true attributes
 e.g. car repair
 Discovered ex post:
 Experience - Attributes that must be experienced to be verified
 e.g., food, quality of wine
 Credence - Attributes that can never be verified
 e.g. closer to credence goods, but trust that mechanic did a
good job.
 e.g., restaurant says meal was light, but don't know for sure
 Demand For Information
o Private Incentives: Optimal information is marginal benefit and marginal cost
 What’s the marginal benefit from collecting additional information?
 Marginal Cost
 Resources
 Time
 There is a marginal cost to gathering more information, and the curve is
increasing. The marginal benefit will decrease.
 Optimal is where marginal benefit equals marginal benefit.
 Rational Ignorance
o How much information do we collect before we make a decision?

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o Gap between total amount of meaningful information and the amount that is gathered
in equilibrium is optimal ignorance.
o The benefit of buying the best or worst toothbrush will be low.
 The amount of rational ignorance has expanded with toothbrushes.
 Price Searching: Example
o I’m shopping for a used car
o The make and model I’m looking for is sold at 80 percent of the dealerships for
$5000; but on average, 20 percent of them will agree to a bargain price of $4000.
o I don’t know ex ante which dealerships will take the low price.
o It costs me $100 every time I go to another dealer.
o The first visit I make, I can get the car for $5,000 --- is it worth it to search
further?
o Equation
 Prob (4000) = 20
 Prob (5000) = 80 = 1-P
 Go to New Dealership if cost of search is less than expected benefit of
the search
 EB (search) = .2 (save 1000) + .8 (0 - same deal) = 200
o The expected value of a second visit is
o Save $1,000, 20 percent of the time
o No benefit 80 percent of the time
o Pay $100 regardless
o Expected value = .80*(0) + .2 *($1000) - $100
 $200 - $100 = $100
o Go!
o What if my opportunity cost of time were higher? Benefits from finding low price
larger?
 If the deal was $3000, or the probability was higher to find a deal, than
more likely to engage in search.
 Implications from search costs
o price dispersion and higher average prices
o The red distribution has a higher mean price, but also a higher variance.
o The blue distribution has a lower mean price, and it also has a lower variance.
o As long as there heterogeneity in costs, there will be heterogeneity in prices.

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 Setting low price on goods: people will exert effort to buy car
 Whereas, charging a high price: people don't have time to go search and
charge higher.
 If a purely competitive market with low search costs, there would be no
dealership selling for $5k instead of $4k.
 This explains the variance, with different strategies of business.
 Adverse Selection
o Assume there are only good cars and lemons
o Consumers are willing to pay:
 $11,000 for a good car
 $7,000 for a bad car
o Sellers’ reservation (bottom line) prices:
 $10,500 for a good car
 $6,000 for a bad car
o The used car market is 80% good cars and 20% lemons.
o Quality is impossible to determine until post-purchase
o Query: Why can’t good car owners just say “I have a good car?”
 Since you can't determine until after purchase, the information is
asymmetric.
 Lemons
o How much will consumers be willing to pay?
 11000*.8+7000*.2=10,200
 Exp Val. = Prob. Good Car + Prob. Bad Car
o Who will sell in this market?
 Sellers with bad cars, priced at or below $7k
o What if 90% of the cars were good?
 Buyers willing to pay 11000*.9+7000*.1= 10,600
 Everyone sells cars
 Don’t know the quality of the car you buy
o What if consumers were willing to pay $8,600 for a bad car?
 11,000*P+8600*(1-P)
 Good cars sell if customers willing to pay more than $10,500.
 Prob Good Car + Prob. Bad Bar
 Willing to pay $10,500 if Exp. Value > $10,500.
 11,000 (p) + 8600 (1-p) > 10,500
 11,000(p) - 8600(p) > 10,500 - 8600

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 2400p > 1900

 P > 1900 / 2400 = 0.79
 good cars will sell if P>.79
o What can a car dealer do to convert cheap talk into a credible commitment?
 Offer a warrantee!
 Adverse Selection
o Adverse selection occurs when there is asymmetric information in the
marketplace, resulting in a “selection” of people that participate in the
marketplace
 For example, those with a family history of cancer may be more likely to
buy life insurance
o Adverse selection in health insurance
 There are two types of people in the world, healthy and sick.
 The expected health costs for sick people are $50000, the expected health
costs for healthy people are $2000.
 Assume people are risk averse – healthy people are willing to pay up to
$2500 for health insurance and sick people are willing to pay up to $50500 for
health insurance.
 If insurance companies can’t price discriminate, what’s the highest
percentage of sick people there can be in the population for the insurance
company not to lose money?
 Equation
 2000*(1-p) + 50000*p<=2500
 2000+p(50000-2000)<=2500
 P*48000<=500
 P<=.01
 What if more than 10% of the population is sick?
 If more than 1% if sick without price discrimination, the only
people that will get health insurance will be sick people. The firm will
charge $50,500. There will be adverse selection for only sick people.
 Medicare: there is some redistribution where healthy people are
paying to take care of sick people.
 People making decisions about what type of healthcare to use are
not internalizing costs.
 What if insurance companies were allowed to exclude certain customers?
 Firm can pool together sick people and charge much higher
 What if insurance companies were allowed to price discriminate?
o Where else might we see adverse selection?
 Business lending
 Safe investments tend to have a lower return. So if you are a firm
and know that you will make a safe investment, probably that return will
be low. The lower risk firms know they will be successful, the return is
lower than the high business rate.
 Car Insurance
 Drivers spending on comprehensive coverage are those that tend to
drive recklessly.

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 Schools that don't grade on the curve

o Private Incentives to Reveal Information
 Incentives for firms to reveal:
 Good information
 Less bad information than rivals
 Unraveling - counterargument
 What do consumers assume from silence?
 Does Ben & Jerry’s advertise the fat content of its ice
cream?
 Does Range Rover advertise gas mileage?
 Advertising
o Reduces search costs & enhances competition
 Let's consumers know the availability of outlets
 Conveys information on price
 Conveys information on other objectively verifiable attributes
o Advertising Spurs Competition
 Case study: Health Claims in Cereal
 Pre 1984: FDA prohibited companies from making health claims
 1984: Kellogg's makes claims related to fiber in All Bran
 Prohibition relaxed
 What would you expect to happen?
 Cereals began to advertise fiber
 By 1988, all cereals with any fiber advertised that fact
 Fiber consumption up
 Increased competition to provide fiber: Entry of new cereals,
increased fiber in existing cereals
o Advertising Reduces Differences Among Demographic Groups
 Some people are better at processing information, or have more time to do
so, than others.
 Non-advertising information sources (government, press) are available,
but only to those with the time and inclination.
 Advertising makes information more widely available.
o Advertising Bans Benefit Incumbents
 C. Robert Clark, Advertising Competition and Competition in the
Children’s Breakfast Cereal Industry, 50 J. Law & Econ 757 (2007):
 Examines ban on advertising children’s cereals in Quebec:
 The market shares of non-established childrens’ brands are 38
percent lower in Quebec than in the rest of the country.
 The market shares of established and non-established adult/family
brands do not appear to be significantly different in Quebec.
 Implication is that advertising children's cereal disadvantages non-
established brand
o Commercial Speech Doctrine
 Va. St. Bd. of Pharmacy v. Va. Cit. Cons. Council, 425 U.S. 748 (1976):
 Ban on price advertising by Virginia Pharmacists

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 Supreme Court holds that purely commercial speech deserves

protection based on consumers’ right to have it:
 “As to the particular consumer’s interest in the free flow of
commercial information, that interest may be as keen, if not keener
by far, than his interest in the day’s most urgent political debate. . . It
is a matter of public interest that [private economic decisions] be
intelligent and well informed. To this end, the free flow of
commercial information is indispensible.”
 By restricting pharmacists free speech, it also pertains to the
consumer.
 Summary
o Demand for information and rational ignorance
o Adverse selection
o Supply of information:
 Unraveling
 Advertising
 Commercial Speech
 Asymmetric Information & Market Responses
o Pooling and Separation
 Pooling - everyone is treated the same
 e.g. can't distinguish good cars from bad ones
 Separation - treat different types differently
 Benefits from separation:
 Better matching of action and type
 Good types don’t leave the market
 How do we get separation?
 Reputation
 Screening
 Signaling
o Can Prices Signal Quality
 Separating equilibrium:
 High quality charge high price, low quality charge low price
 Because of reputation or signaling factors, a consumer can
distinguish between two types of goods
 Pooling:
 High and low quality firms charge the same price and can lead to
lemons problem if too many low quality firms
o Price Premium as a Return to Keeping Promises (Klein & Leffler)
 Why should we believe quality representations?
 Reputation:
 Firm can produce high or low quality.
 High quality sells for a higher price than low quality:
 PH = $10
 PL = $5
 It is more costly to produce high quality:
 cH = $8

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 cL = $3
 Consumers cannot tell quality ex ante, but can detect after
purchase.
 What are the incentives for the firm to produce high quality?
 Earn higher profit right now, but consumers won't trust you
later on.
o Price Premium for Not Cheating
o Signaling
 Going to college is more a signaling idea that I will be a hard worker.
o Privacy and Statistical Discrimination
 Prohibit signaling or screening on an attribute
 What is the rational response?
 Will uninformed parties assume the best from no information?
 Find an attribute correlated with hidden attribute
o Ban the Box Regulation
 Designed to help end cycle of criminal activity by giving ex-offenders non-
criminal options in the labor market
 Prohibit employers from asking about criminal record
 Some form of BtB in 25 states
o Statistical Discrimination and “Ban the Box”
 Want to hire only if P>P*
 Believe odds of P>P* much greater with no criminal history:
 Use criminal records as screen to separate high and low productivity
 If you can't determine who has a criminal record, will draw statistic
generalizations (people of color have more criminal records)
 Empirical Evidence:
 Agan & Starr:
 Randomize race and criminal history on applications filled out before and
after BTB initiatives in NYC and NJ
 Increased racial disparities because if there was no information about
white people, assumed no criminal record. But with people of color, if
there was no information, people assumed they had a criminal record.

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Law and Economics Notes

Law And Economics (George Mason University)

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Incentives, Rationality, & Intro to Economic

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The Primacy of Efficiency over Distribution in Analyzing

Why Should Lawyers Study Economics?

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There benefit of this small increase is called the

Economic Approach to Human Behavior

Price Theory - Demand

Consumer Choice & Demand

If people are rational, their references can be represented by utility functions.

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If bundle x and bundle y are such a u(x) = u(y), then x is indifferent.

The value of an apple or an orange depends on how many you have.

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Example: opioid crisis

Price elasticity of demand:

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Applications of Supply, Demand, and Elasticity

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Costs in Short Run and Long Run

Supply curve: as you produce more of a good, it gets less efficient.

If average produce is negative, the average product is going to decrease.

Fixed costs: sunk or salvageable; do not change with output

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Total Cost(2) - Total Cost (1) / Q(2) - Q(1) = marginal cost

Always produce where marginal revenue = marginal cost.

The marginal cost curve is the supply curve.

Look at costs as in reference of what those costs could be used for.

"I"nelastic - Straight vertical line like "I"

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Consumer surplus market = total of all consumer surpluses

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o If the economy is operating on the production possibilities frontier, it is

 If price elasticity of demand is greater than one, demand is elastic. If elasticity is

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Income elasticity of demand:

 For normal goods, income elasticity is positive.

Cross-price elasticity of demand:

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Nash Equilibrium - No player can benefit from unilaterally moving away

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Optimal Cost for Fine: Expected Cost of Ticket / Probability

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Accident causes harm of $10,000 to victim.

Socially Optimal Precaution: Probability of Accident x Cost of Accident + Burden

Breach of Contract: Risk Allocation

Buyer's evaluation: $200

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Expectation damages induce inefficient reliance

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Premium to Assure High Quality:

Adverse selection in health insurance

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Basis Probability Theory and Stats