Econ 3468 Course Notes Jan \'22 PDF

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Econ 3468Economics of the LawClass NotesThomas J. MiceliRevised, January 2022© 2022 Thomas J. Micelito achieve this end, but rather that the law has evolved to embody that value. Much of this course will be directed toward providing evidence for, and evaluating, this claim.Normative analysis of law ...

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Econ 3468 Economics of the Law Class Notes Thomas J. Miceli Revised, January 2022

© 2022 Thomas J. Miceli

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Chapter 1: Introductory Concepts What is Law and Economics? Economics is about rational choice, which requires people to be responsive to incentives, usually in the form of market prices. But a wider view encompasses rational choice outside of traditional market settings, including an economic analysis of the family, politics, religion, sports, and of course, the law. Law is about establishing and enforcing rules in an effort to guide people’s behavior in certain socially desirable directions. The idea that people can be influenced by the threat of legal sanction for failing to obey rules also suggests rational behavior. In this way, laws act like prices, thereby providing the link to economics. The greatest American judge, Oliver Wendell Holmes, writing over 100 years ago, captured the essence of the link between law and economics in a classic article in which he tried to offer a definition of law. The key figure in his definition, called the “prediction theory of law,” is the “bad man,” about whom Holmes wrote: “If you want to know the law and nothing else, you must look at it as a bad man, who cares only for the material consequences which such knowledge enables him to predict.” The bad man is thus the counterpart to the rational economic person because both act by weighing costs and benefits. Most people adhere to the law out of moral duty because they have internalized a sense of right and wrong, but everyone at some time reckons the consequences of acting in certain ways that might result in a legal sanction—whether to park illegally or to exceed the speed limit when there is a gain from doing so. The less one has internalized moral values, the more often he or she will potentially come in contact with the law. But economic analysis of law is not based on moral values, which often are subjective. It is based on efficiency, which is morally neutral. On the other hand, law is undoubtedly based in part on moral values, and so there will be departures of law from purely economic principles in those areas where morality and efficiency diverge, most notably in some areas of criminal law. Positive versus normative analysis Economic analysis of law comes in two varieties: positive analysis and normative analysis. Positive analysis seeks to explain how people actually behave, and to explain laws and legal institutions as they actually exist. For example, are people deterred by the threat of criminal sanctions? And, Does the law governing the enforceability of contracts promote efficient exchange? A more ambitious form of positive economic analysis of law is the claim that the structure of the law (specifically, the common law—to be described below) broadly reflects the goal of efficiency. It is not a claim that this was the result of a conscious effort of judges and lawmakers

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to achieve this end, but rather that the law has evolved to embody that value. Much of this course will be directed toward providing evidence for, and evaluating, this claim. Normative analysis of law is aimed at prescribing ways in which the law can be made more efficient—it is about making policy. This objective relies on the acceptance of efficiency as a valid norm for evaluating law. In some cases, this is uncontroversial (for example, in examining contract law, which is about exchange), but in others it can be controversial (for example, in evaluating criminal law doctrines). Efficiency concepts It is important for us to review the concepts of efficiency that we will use. The most basic concept is Pareto optimality, or Pareto efficiency. This consists of two definitions: Definition 1: When comparing two allocations, A and B, we say that A is Pareto superior to B if everyone is at least as well off under A as under B, and some are strictly better off. Definition 2: Considering all possible allocations, we say that an allocation A is Pareto optimal if there does not exist another allocation that is Pareto superior to it. This concept can be understood in terms of the following graph, which reproduces Figure 1.1 in the text. U1 U1(A)

B Utility possibility frontier C A D

U2(A)

U2

Figure 1.1 This diagram considers an economy with only two people, 1 and 2. The frontier defines those points that are feasible given available resources and technology. It defines the Utility Possibility Frontier. Start from an initial (arbitrary) point A. The “triangle” ABC defines the set of points that are both feasible and Pareto superior to A. Now move to a new point inside the triangle, and redo the exercise. Only when we reach a point on the frontier are we at a Pareto optimal point. Thus,

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all points on the frontier represent the set of Pareto optimal points. There are infinitely many of these. There are two drawbacks of Pareto optimality as a criterion for evaluating laws or policies: First, points on the frontier are non-comparable. This is true because movement along the frontier (e.g., from B to C) necessarily makes one person better off and one person worse off. Second, if we compare points D and A in the graph, we see that they are also non-comparable for the same reason. Thus, we cannot say that the Pareto optimal point D is preferred to the non-P-O point A! Since most interesting questions of policy or legal reform will necessarily require making some people worse off, Pareto is not a practical criterion. In its place, we will use a “relaxed” form of Pareto optimality called Kaldor-Hicks efficiency. Kaldor-Hicks Efficiency This criterion is also sometimes called “potential Pareto optimality.” To see why, reconsider the comparison between points A and D. Moving from A to D makes person 2 better off and person 1 worse off, so 1 would block the move under Pareto. But suppose that the gain to 2 is worth $500 and the loss to 1 is worth $400. If 2 were required to compensate 1, that would still leave 2 with a net gain of $100, and so the move would satisfy Pareto. Such compensation is not practical in actual policy settings, however. Think of something like a law requiring all cars to have more safety features—some people would be better off and some worse off. Kaldor-Hicks efficiency therefore does not require actual compensation of losers, but only that the net gain be positive, so compensation could be paid in theory. Kaldor-Hicks is therefore equivalent to cost-benefit analysis, or wealth maximization. It is the approach we will take in this course. Note that the comparison of Pareto and Kaldor Hicks relates to the idea of consensual versus non-consensual exchange. Consensual exchange is the basis of markets, and is implicit in the definition of the Pareto criterion. Kaldor Hicks involves non-consensual, or forced, exchange, which is what laws do. However, it is rationalized based on the idea of implied consent, which comes from the possibility of compensation whenever a change promises a net gain in wealth. Implied consent for Kaldor-Hicks changes relies on people agreeing, as if from behind a Rawlsian “veil of ignorance,” that they will sometimes be winners and sometimes losers, but that they will (hopefully) gain on average provided that all changes satisfy the Kaldor-Hicks criterion. The Coase Theorem The relationship between markets (consensual exchange) the law (non-consensual exchange) in promoting efficiency is the subject of the Coase Theorem. We will discuss this important 4

concept in detail later, but it will be desirable to give an overview of it here, as it establishes themes that will run throughout the course. On its face, the Coase Theorem is about controlling externalities like pollution. I will discuss it here using one of Coase’s examples—the dispute between ranchers and farmers in which straying cattle cause crop damage. Table 1.1 contains the relevant data for the example. The only choice concerns the size of the rancher’s herd, which can range from 1 to 4. More cattle result in greater profit for the rancher but also more crop damage for the farmer. Let the marginal benefit per cow to the rancher be a constant equal to $3.50; the table shows the crop damage to the farmer as a function of the herd size. (Note that the marginal cost is increasing.) Table 1.1 Herd size

Total damage

Marginal damage

Net benefit

1 1 1 3.50−1=2.50 2 3 2 7.00−3=4.00 3 6 3 10.50−6=4.50* 4 10 4 14.00−10=4.00 ______________________________________________________ The optimal herd size is 3, which maximizes the net benefit of ranching and farming, as shown in the final column. (For herd sizes 1-3, the marginal benefit > marginal cost, but the reverse is true for the fourth cow.) Graphically, this looks as follows: MC

$

MB

h*

herd size

Figure 1.2. If a single person owned the ranch and the farm, he or she would choose the optimal herd size. However, with separate ownership we have an externality problem. Thus, the rancher would presumably increase his herd to 4 unless he is held responsible for the crop damage. This is the usual remedy—namely to impose a tax or fine on the rancher equal to the farmer’s crop damage, which would result in an efficient herd size of 3. (In that case, the rancher’s profit would coincide with the social return.) This outcome coincides with the traditional (Pigovian) solution to an externality that economists usually prescribe. 5

But consider more carefully the case where the rancher is not liable for the damage. Would he necessarily expand his herd from 3 to 4? Doing so increases his profit by $3.50, but note that the farmer would be willing to pay $4 to prevent the rancher from adding the fourth cow. They could therefore make a deal whereby the farmer pays the rancher $3.75, say, not to add the fourth cow, and both parties would be better off. The farmer would not be able to pay the rancher to lower the herd below 3 because his damage from cows 1-3 is less than their marginal value of $3.50. Thus, the herd will stabilize at three, which is the efficient size. This example shows that the efficient herd size can be achieved whether or not the rancher is legally responsible for paying for the crop damage, provided that the rancher and farmer can bargain. This conclusion is called The Coase Theorem. _____________________________________________________________________________ Exercise 1.1 Suppose in the preceding example that crop damage from straying cattle can be entirely eliminated by fencing in the farmer’s land at an annual cost of $9. Show that the optimal herd size is now four, and that this outcome will be achieved regardless of whether the rancher or the farmer is legally responsible for crop damage (assuming that the parties can bargain). _____________________________________________________________________________ We note two implications of this result here. First, the distribution of wealth is not independent of who must bear the costs of the crop damage. Obviously, the rancher is better off when he is not liable, and the farmer is better off when the rancher is liable. Thus, when the conditions of the Coase Theorem are met, the liability decision can be made based purely on fairness grounds because efficiency will be achieved no matter what. In other words, there is no necessary conflict between fairness and efficiency. Second, transaction or bargaining costs—the cost of reaching a consensual exchange—will be important for assessing the impact of different legal rules. This idea will have important implications for our subsequent study of various legal doctrines, and for the larger question of “when the law matters.” The Law in “Law and Economics” There are multiple “sources” of law in the United States, so it is important to identify what we will mean in this course by “law.” There are basically three categories: the Constitution, legislation, and the common law (also called “judge-made” law). Our focus will be on the last of these (though we will touch on some constitutional issues). We will therefore be discussing numerous court cases in the course of our study. The common law represents the accumulated decisions of judges (called “precedents”) from cases aimed at resolving disputes between private parties. These disputes will involve accidents (torts), contracts, and property rights. In all cases, one party seeks court-enforcement of some claimed legal right, usually (but not always) in the form 6

of a demand for some amount of monetary compensation for a legal wrong. We will also discuss criminal law and legal procedure (civil and criminal). The scope of our analysis therefore essentially covers the subject matter of the first year of law school. Of course, we will take a very different perspective.

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Chapter 2: An Economic Model of Tort Law What is a Tort? Tort law is the area of the common law that is concerned with accidental harms to person and property. Examples are personal injury, products liability, workplace accidents, medical malpractice, and environmental accidents. Most if not all of these harms are an accidental (unintended) by-product of socially beneficial activities. Thus, some amount of these risks must be tolerated. Tort law is both about minimizing that risk, and compensating victims. Tort law is only one remedy society has developed for controlling these risks. Safety regulation and in some cases criminal penalties are also used. What makes tort law different is that it is a private remedy—that is, a victim of an accident initiates the legal remedy by suing the injurer for monetary compensation. In order to be able to collect damages against an injurer/defendant (i.e., to win a tort suit), the victim/plaintiff must first establish two things: (1) that she has sustained some injuries, and (2) that the injurer was the “legal” cause of those injuries. (We’ll see what that means shortly.) Once these are established, the plaintiff may also have to prove that the injurer was at fault (i.e., negligent). We will assume hereafter that the plaintiff has successfully shown that she sustained an injury, and turn immediately to causation. This requires proving two things: that the defendant’s actions were the cause-in-fact of the injury, and that they were also the proximate cause. Cause-in-fact is the common-sense notion of causation, and is proved using the “but-for” test: the plaintiff must show that “but for (or except for) the defendant’s actions, the accident would not have occurred.” This is physical cause and effect: the defendant’s car ran a red light and hit plaintiff’s car, injuring her. There are sometimes complications with this, as when more than one defendant contributes to an accident, but this notion is usually straightforward. Why is this form of causation not enough? The second notion of causation, called proximate cause, concerns the remoteness of the causal connection. As an example for why it is needed, consider the case of Palsgraf v. Long Island R.R. (p. 17 of the text). In this case, cause in fact is clear, but the court found the connection to be too remote, and so defendant’s action was not proximate cause. The usual test here is the “reasonable foresight” test: could the defendant have reasonably foreseen the consequences of his actions? Once causation is established, the court applies the relevant liability rule, which is the rule that determines how the damages from the accident will be apportioned between the injurer and the victim. There are three basic rules: No liability: the injurer is not liable at all, even though he or she caused the accident. Strict liability: the injurer is fully liable once causation has been proved. 8

Negligence: the injurer is only liable if he or she is found to be negligent. This is the most common liability rule in tort law. Note that these rules imply different criteria for assigning responsibility for harm given causation, ranging from no responsibility, to responsibility only if negligent, to unrestricted responsibility. Also note that “intent” is not present—if it were, it would fit in between negligence and strict liability. The concept of intent will become relevant when we get to criminal law, as it is one way in which tort law and criminal law differ. The negligence rule is based on the concept of fault—that is, being found negligent is equivalent to being found legally at fault. Much of our discussion of tort law will center on the negligence rule—how negligence is determined and what the function of a fault-based rule is. The Model of Precaution The economic theory of tort law is based on what we will call “The model of precaution,” which is about minimizing the costs associated with risky activities. There are three types of costs: (1) the damages suffered by the victim, (2) the precautions of the injurer and victim, and (3) administrative costs. This chapter will, for the most part, consider only the first two. Chapter 9 will be concerned with the costs of the legal system. In the simplest version of the model of precaution, called the unilateral care model, only the injurer can take precaution (or care). The victim is passive. Later, we will also allow the victim to take precaution. Throughout the analysis we will assume that only the victim incurs damages. The Unilateral Care Model Let: x = spending on precaution by the injurer p(x) = probability of an accident D(x) = damages from an accident. We assume that both p and D are decreasing in x at a decreasing rate. Thus, there is a diminishing marginal benefit of precaution. The product, p(x)D(x), which is the expected damages, is therefore also decreasing at a decreasing rate in x. (See Figure 2.1.) The social problem is to choose the value of x that minimizes total accident costs: x + p(x)D(x) Figure 2.1, reproduced here, shows the solution graphically. Denote by x* the optimal level of precaution. In the graph, this occurs where the slopes of the two curves are equal in absolute value. This is where the marginal benefit of precaution in the form of reduced damages equals the marginal cost of precaution (which =$1 in this model). It is also where the U-shaped curve, which is the vertical sum of the individual curves, reaches its lowest point.

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The point of intersection of the individual curves, where x=p(x)D(x), is not relevant for current purposes, though we will comment on its significance later.

$

x + p(x)D(x)

x

p(x)D(x) x*

x

Figure 2.1 The Actual Choice of Care by the Injurer The injurer will not automatically choose x*. Rather, he will choose x to minimize his own costs, which will depend on the liability rule. Suppose first that the injurer faces no liability. His costs are therefore just x, his cost of precaution, which is obviously minimized at x=0. Thus, he will take no precaution. Conversely, suppose that the injurer is strictly liable for the victim’s damages. Although he must choose x before any accidents occur, we assume that he knows the p and D functions and so can calculate the expected damages, which in this case will also be his expected liability. The injurer’s problem thus coincides with the social problem above, and he will choose x=x*. In this case, the injurer fully internalizes the harm that his actions will cause, which results in the efficient outcome. Finally, consider the negligence rule. An injurer is negligent if he or she fails to take “due care,” which is defined to be a minimum level of care, . Thus, an injurer is negligent if x< and hence fully (strictly) liable, but an injurer is not negligent if x≥ and hence not liable. In this sense, negligence is a combination of strict and no liability, separated by the due standard. How is determined? We’ll examine this in more detail later. For now, we note that the law talks about a reasonableness standard—what would a reasonable person do when facing the risk in question? Let us conjecture that ; that is, the due care standard coincides with the efficient (costminimizing) level of care. This results in the following problem fac...