Unit 1: Introduction to Law and Economics
Why law and economics?
Historically, law and economics were separate disciplines and had little to do with each other. The
study of the law had more to do with history, philosophy and social norms. The first areas where
economists made any real legal contributions were to patent law and antitrust law. But these are
special cases, and it’s obvious why economics is important for understanding these.
By contrast, economists now apply economic reasoning to virtually every area of the law. Why?
You may not have thought about it before, but there is a natural synergy between the two.
Economics is about understanding how people make rational choices. The law is about getting
people to behave a certain way. Thus, if you want to understand the impact of the law on people’s
behavior, it’s important to understand how people make decisions and especially how they respond
to incentives.
Many of the questions we ask in this course will fall under three main umbrellas.
1.
Predicting the effects of legal rules – As economists, we want to study the incentive
structure that laws create, and how they affect decision-making.
2.
Designing legal rules that create good outcomes – As a society, we want to design laws
that produce good outcomes for society. Predicting the way in which the law is going to
impact people’s behavior is obviously important in designing good laws.
3.
Explaining the existence of legal rules – Economists tend to think that most social
institutions evolve for a reason, so it must be true that laws that have developed make sense
in some way.
Some Examples
A good way to start is to think about how to apply simple economic reasoning to legal questions.
Many of these examples touch on ideas we will cover in detail later.
Burglars and the death penalty
Question: A country is having a very serious problem with house burglary and a lawmaker suggests that the state impose the death penalty on burglars. Can you think of any incentives this creates for criminals that might harm homeowners?
Loose camels
Question: Many countries in the Middle East have a serious problem with car accidents involving camels wandering on the road. Suppose the law makes drivers completely responsible for these accidents. Do you see any issues?
Answer: Both camel owners and drivers can take precautions that reduce the chance of accidents. Drivers can watch carefully and not drive too fast, but camel owners can monitor their camels or keep them in enclosed areas. If drivers are completely responsible for these accidents, camel owners have no incentive to invest in precautions that are available to them.
Generally, assigning 100% responsibility to either side is problematic in liability law. We will cover this issue extensively when we talk about tort law.
Consumer product liability
Question: Do manufacturers have an obligation to make their products 100% safe?
Answer: An economist would say that the idea of 100% safety is ludicrous. Adding additional safety precautions creates benefits and costs. We could make cars safer by building the bodies out of solid titanium, but it seems hard to believe that the additional safety is worth the enormous cost. We all trade off dollars for safety every day.
Efficient penalties
Question: Catching criminals is costly. Why don’t we only catch half as many criminals, but punish the criminals we do catch twice as severely? The level of deterrence against crime should be the same since the average penalty doesn’t change, and the system would be less costly to run.
Answer: In theory, the argument is correct. We could deter crime by catching only a few criminals but having extremely harsh penalties for those we do catch. The problem is that very harsh penalties often violate people’s moral conscience, especially when one introduces the chance of making mistakes. Mistakenly giving someone a $200 speeding ticket doesn’t seem that bad. Mistakenly executing him seems unacceptable.
Burden of proof
Question: Why is it that criminal cases involving jail time have to be proven “beyond a reasonable doubt” (99.9% certainty), but civil cases involving monetary judgments only have to meet a “preponderance of the evidence” standard (more likely than not)?
Answer: The court system is not perfect. While Sadaam Hussein was fond of saying “I’d rather kill all of my friends than leave one enemy alive”, in democratic countries we accept that some guilty people might not be held responsible if the tradeoff is that innocent people are not convicted.
Habitability laws
Question: Would it help poor renters if rental properties were required to meet higher standards?
Answer: If we make rental housing more attractive by law, demand for rentals rises and the supply of rentals fall as landlords find it more costly to meet the standard. Both of these will push rents up, ultimately harming the people the law was designed to help. The lesson is that contract restrictions have to be examined based on all of the consequences they create, not just on the restricted terms.
Rich uncle
Question: You push your rich uncle off a cliff. Your lawyer argues that it’s a waste of resources for the state to punish you since you’ll never have any reason to kill anyone again. Even if the judge is certain that you won’t harm anyone again, does punishment make any sense?
Answer: A lawyer would just mutter “justice”. An economist would point out that failure to punish you encourages future murders. We have to examine laws from the perspective of their impact on society as a whole, not just on the private parties involved in a particular case.
Pregnant cows
Question: A farmer sells a cow to a rancher for $10,000. After the sale is already completed, the farmer learns that the cow was pregnant when he sold it, and a pregnant cow is worth much more than $10,000. The farmer sues the rancher and demands that the original contract be voided and that the rancher pay a higher price. Would you enforce the original contract or void it and force the rancher to pay a higher price? Would your answer change if the farmer was an amateur and the rancher was a professional who likely knew the cow was pregnant when he bought it?
Answer: You may have your own value judgment here, but an economist would say that it doesn’t matter. The cow has the same value no matter who owns it.
Punitive damages
Question: A doctor performs a surgery on a patient and makes a mistake that costs $10,000 for the patient to have corrected. The patient suffers no damages other than paying for the correction. The patient sues the doctor and demands 20 times his actual damages to punish the doctor for his mistake. Would you award the full $200,000 the patient asks for, or only the actual damages?
Answer: Your first thought might be no, but there are two important things to think about.
What if you learned that the doctor frequently made the same mistake but that other patients didn’t bother to sue him? That might be a good reason to award the punitive damages, to deter the doctor from being careless in the future.
Wedding hall
Question: Sara rents a hall for her wedding and orders food from the caterer (nonrefundable) for 500 guests. The day before the wedding, the owner of the hall informs Sara that she will not be able to use it. The other available hall seats only 200 people. The owner of the hall refunds the fee for the hall, but Sara also wants him to reimburse her for the catering costs for the 300 guests who will not be able to attend. How would you decide the case?
Answer: You might be inclined at first to award Sara the reimbursement for the wasted food, but there are two things to keep in mind.
What if you learned that the food was outrageously expensive and the hall owner had informed Sara months in advance that there was a chance the hall might not be available? That’s an important consideration. Sara could have taken actions to reduce her damages in this case, but she has no incentive to do so if the hall owner is liable for everything.
What if you learned that the reason the hall was unavailable was a fire that was outside the hall owner’s control? That’s actually not important for the answer. If anything, the hall owner has more ability to control fires than Sara has, so that’s not a very strong argument in favor of reducing the damages we require him to pay.
Didacticism and Consequentialism
One thing that strikes most people initially about economic study of the law is how strongly it is
based on pragmatism and consequences rather than on moral principles. Traditional study of the
law is
didactic
– Moral principles that determine right and wrong are taken as given, and this is
the foundation for the legal system. By contrast, economic study of the law is
consequentialist
–
It focuses on producing the best possible outcome for society.
Racial discrimination
Question: Why is racial discrimination illegal?
Answer: A didact would immediately say that racism is immoral and therefore the law should be designed to discourage it. An economist (consequentialist) would be more likely to talk about efficiency losses – not matching people to productive jobs, failing to utilize the full value of people’s talents, etc…
Breach of contract
Question: Should the law always penalize breaches of contract?
Theft of car radios
Question: At one time, there was a big problem with theft of car radios. Companies could design the radios so that they wouldn’t operate if taken outside of the vehicle, but won’t do it unless consumers want it. How would a didact and a consequentialist suggest solving this problem?
Answer: A didact would say to catch and punish car thieves. But that might be expensive. A consequentialist might say that a cheaper way to solve the problem is to legalize car radio theft. Then consumers will demand radios that don’t operate outside the car, and thieves would have no incentive to steal car radios anymore. It seems shocking to didacts that we would legalize theft, but that may well be a cheaper way to prevent car radio theft. Economists look at efficiency and pragmatic consequences.
Efficiency and Distribution
A second feature of economic study of law that surprises many people at first glance is its
laser-like focus on efficiency over distributional matters. That is, economists who think about the law
tend to prioritize producing efficient outcomes over a moral judgement about who should get what,
and what is right or wrong.
Train tracks and sparks
Question: A railroad track is built adjacent to a farm, and occasionally sparks fly off the train tracks that burn some of the farmer’s crops. If you were the judge, would you force the railroad to install a protective cover that prevents these sparks?
Answer: Most people would immediately say yes – The railroad is responsible, and should correct the problem. What if you learned that the spark protector is very expensive, but that the farmer can solve the problem at essentially zero cost just by moving his crop a few feet back from the tracks? An economist would jump all over this, and would definitely want to design a legal rule that ends up solving the problem the cheap way (moving the crops back) rather than solving the same problem the expensive way (spark protectors). Who pays for it is not all that important to economists, and economists generally have little interest in “fairness” – whatever that means. We’re more interested in efficiency.
Why is theft illegal?
Question: How would you measure the major social problems associated with theft?
Sub-branches of Law and Economics
Overall, law and economics isn’t so much about what the law
is
as it’s about how to use economics
to
analyze
laws. While we may mention it from time to time, unlike a business law class, this class
it not mainly about technical details of how the law works. While each area of law has its own
nuances, ultimately there is only a single set of intellectual tools. That said, we will divide the
course into seven main areas.
1.
Property law – How are private property rights defined and protected?
2.
Tort law – What do we do when one party’s negligence harms someone else?
3.
Contract law – How should the legal system enforce private contracts people enter into?
4.
Legal process – Study of the procedures that the system uses to address complaints
5.
Criminal law – How should the law deal with people who commit deliberate misconduct?
6.
Family law – What is the impact of legal rules with respect to family interactions?
7.
Private law – Can a legal system arise outside the traditional framework of the state?
The Coase Theorem
The Coase Theorem is the most important result in the economic study of the law, and we will
encounter it frequently and in many different contexts throughout the course.
In brief, the
Coase Theorem
states that – if there are no negotiation costs – then private bargaining
always leads to an efficient solution, regardless of how the legal rights are assigned. Informally, if
people can negotiate easily then they can work out their own problems and will reach an efficient
solution.
This is one of the most deep and insightful results in economics for a few reasons.
1.
The legal rule does not affect the efficiency of the final outcome. As long as people can
negotiate easily, they will reach an efficient outcome on their own. In particular, inefficient
legal rules can be “undone” by private negotiation.
2.
Negotiations costs are the real enemy to efficiency. If it’s too expensive for people to
negotiate, then an inefficient legal rule might
not
be undone via private negotiation.
3.
While the legal rule does not impact the
efficiency
of the final outcome, it may well impact
distribution
. The Coase Theorem therefore shines a very clear light on the separation in
The candymaker and the doctor
Question: A candymaker and a doctor have adjacent offices. The candymaker runs a machine that generates $25 of profit for him every day. But the machine is loud and the noise reduces the doctor’s profit by $15 a day. Assume that the candymaker and the doctor can negotiate costlessly with each other.
a. What is the efficient outcome?
b. Suppose the candymaker has a right to run the machine. What will happen when the doctor and the candymaker negotiate?
c. Suppose the doctor has the right to stop the candymaker from running the machine. What will happen when the doctor and the candymaker negotiate?
d. Does the legal rule impact the efficiency of the outcome? e. Does the legal rule impact distribution?
f. Suppose now that negotiation between the doctor and the candymaker is prohibitively costly. What will happen now when the candymaker has the right to run the machine?
g. When negotiation is prohibitively costly, what will happen when the doctor has the legal right to stop the candymaker from running the machine?
h. Does the legal rule impact the efficiency of the outcome now?
Answer:
a. Running the machine is efficient since the benefits to the candymaker ($25) exceed the costs to the doctor ($15).
b. The candymaker will run the machine. The doctor isn’t willing to pay him enough to stop. c. The candymaker will pay the doctor between $15 and $25 if the doctor agrees to let him run the
machine. Notice that this is a good deal for both of them compared to the machine not being run. d. No – The candymaker runs his machine either way.
e. Yes – When the candymaker has the right to run the machine, he just runs it. When the doctor has the right to stop him, the candymaker has to pay some money to the doctor to get him to agree to let the candymaker run the machine. This is purely distributional. The outcome is the same. The difference is just transferring some money around. There are no efficiency consequences. f. The candymaker will run his machine.
g. The doctor will order the candymaker to stop running his machine, and there will be no further discussions.
h.
Yes – If the parties cannot negotiate, then the legal rule that assigns property rights to the doctor will lead to the inefficient outcome where the candymaker shuts down his machine.The previous example is a good one for illustrating our main points. When there is easy
negotiation, the outcome is efficient even when the doctor has the property rights. The difference
is purely distributional – when the law favors the candymaker, the doctor is forced to pay for the
noise, but when the law favors the doctor, the candymaker is forced to pay for the noise. But, either
way, the candymaker runs his machine, which is the efficient outcome. However, if negotiation is
not
easy, then an inefficient outcome is possible. In this case, the legal rule
does
matter.
The way that the Coase Theorem works is this. Any time there is a
surplus
– an overall net gain
from bargaining – the parties will negotiate in a way that realizes this surplus. The Coase Theorem
does not specify
how
the surplus is divided between the two parties, but for various reasons
economists tend to think that an even 50/50 division of the surplus is the most likely outcome. The
The candymaker and the doctor revisited
Question: A candymaker and a doctor have adjacent offices. The candymaker runs a machine that generates $25 of profit for him every day. But the machine is loud and the noise reduces the doctor’s profit by $15 a day. Assume that the candymaker and the doctor can negotiate costlessly with each other.
a. Suppose the law allows the candymaker to run his machine. What is the surplus from negotiations? What is the outcome in the reasonable solution?
b. Suppose the law allows the doctor to stop the candymaker from running his machine. What is the surplus from negotiations? What is the outcome in the reasonable solution?
Answer:
a. The candymaker will run his machine, which is already the efficient outcome. There is no surplus from negotiating, so the outcome is simply that the candymaker runs his machine.
b. There is a $10 surplus if the candymaker and the doctor can strike a deal for the candymaker to run his machine (the net improvement benefits-costs from the machine being run). If they split it in half, then the candymaker would pay the doctor $20 for the right to run the machine – to recover his $15 costs plus half of the surplus. Both parties are $5 better off than they would have been if the candymaker had not run his machine.
The beekeeper and the farmer
Question: A beekeeper has an opportunity to keep more bees, but it would cost him $1000. However, the bees would pollinate the neighboring farmer’s crops and would increase the farmer’s profits by $1500. How will the farmer and the beekeeper resolve this matter in the reasonable solution?
Answer: There is a $500 surplus (benefit-cost) if the farmer keeps more bees. In the reasonable solution, the farmer would pay the beekeeper $1250 to keep the extra bees. Notice that both the farmer and the beekeeper are $250 better off. The $500 surplus is split in half.
A noisy rave
Question: A group of homeowners complain about the noise from a nearby nightclub. The owner of the club claims that the profits of the club are higher than the irritation to the homeowners – higher even than the total value of their homes. The judge says he has no way to determine whether this is true or not and orders the club to be closed. Can you think of a better solution?
Answer: If it’s really true that the profits from the club exceed the total value of the homes, the club owner should be able to buy the homes at more than market value, leaving everyone better off.
FCC broadcast spectrum auction
Question: The government is trying to figure out how to allocate scarce broadcast bandwidth. How should it figure out which companies are the efficient users of the broadcast spectrum?
Sunbathing
Question: Mariam likes to sit in the shade and is thinking about planting one or two trees. Her payoff rises as more trees are planted. Unfortunately, the trees block the sun from her neighbor Tali’s yard, and Tali likes to sunbathe. Her payoff falls as more trees are planted. The table below shows the payoffs.
Trees Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀
0 $2000 $2000
1 $3000 $1900
2 $3200 $1000
a. What is the efficient number of trees? What are the payoffs in the efficient solution? b. Suppose the law allows Mariam to plant as many trees as she wants.
i. If there is no negotiation, how many trees will Mariam plant?
ii. What are the payoffs for Mariam and Tali when there is no negotiation? iii. What is the surplus from cooperative negotiations?
iv. Describe what happens in the reasonable solution. Be precise. v. What are the payoffs for Mariam and Tali in the reasonable solution.
c. Suppose the law allows Tali to stop Mariam from planting trees.
i. If there is no negotiation, how many trees will Mariam plant?
ii. What are the payoffs for Mariam and Tali when there is no negotiation? iii. What is the surplus from cooperative negotiations?
iv. Describe what happens in the reasonable solution. Be precise. v. What are the payoffs for Mariam and Tali in the reasonable solution.
Answer:
a. 1 Tree – Highest total payoff ($4900). Payoffs are Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 3000 and Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀 = 1900 b. Mariam has the property rights
i. 2 trees (for Mariam to maximize her payoff) ii. Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 3200 and Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀 = 1000
iii. $700 – Moving to the efficient solution costs Mariam $200 but benefits Tali $900. Another way to see this is that total payoffs are $700 higher with 1 tree than with 2 trees. iv. Tali pays Mariam $550 to plant only one tree – compensating Mariam for her $200 loss
and providing her with half of the cooperative surplus.
v. Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 3000 + 550 = 3550 and Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀 = 1900−550 = 1350. Notice that both
Mariam and Tali are $350 better off than they were when they didn’t negotiate.
c. Tali has the property rights.
i. 0 trees (for Tali to maximize her payoff) ii. Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 2000 and Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀 = 2000
iii. $900 – Moving to the efficient solution costs Tali $100 but benefits Mariam $1000. Another way to see it is that total payoffs are $900 higher with 1 tree than with no trees. iv. Mariam pays Tali $550 for permission to plant one tree – compensating Tali for her
$100 loss and providing her with half of the cooperative surplus.
v. Π𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 3000−550 = 2450 and Π𝑇𝑇𝑀𝑀𝑇𝑇𝑀𝑀 = 1900 + 550 = 2450. Notice that both
Mariam and Tali are $450 better off than they were when they didn’t negotiate.
Common Law and Civil Law
While legislators are responsible for making laws, in any judicial system judges are also
responsible for “making law” to some extent because they have to interpret the law with respect
to specific cases. Broadly, there are two Western legal traditions – Common Law and civil law.
•
Common Law
originated in England and is practiced in the UK, USA, Canada, Australia,
New Zealand and India, among others (basically places with British influence).
Civil law
originated in France and is practiced in the rest of Western Europe and in most of Central
and South America (basically places with continental European influence).
•
Common Law
is based on prevailing social norms, tradition, reason and societal needs.
Civil law
is based on a comprehensive set of statutes. This is the central difference.
Common Law is based on precedent and reason, while civil law is based on strict adherence
to the written code.
•
The origin of
Common Law
is English royal courts, which created precedents that lower
courts followed. The origin of
civil law
is Napoleonic-era France. Napoleon thought that
the judges and courts were corrupt, so he wanted something concrete to form the basis of
legal rulings. To this day, civil law is sometimes called
Napoleonic Law
.
•
Common Law
is grounded in heritage and history.
Civil law
is theoretically grounded in
pure reason, used by legal scholars in constructing statutes.
•
In
Common Law
, judges make decisions by looking at precedent and by appealing to
social norms. In other words, they justify their decisions using tradition, reason, previous
case history and prevailing norms. In
civil law
, judges make decisions based on the exact
language in the code. They justify their decisions by direct reference to the code or
scholarly interpretations of it.
•
In
Common Law
, lawyers are trained mostly by studying prior cases and decisions. In
civil law
, lawyers are trained mostly by reading the code and studying commentaries on it.
•
In
Common Law
, lawyers present cases and fashion arguments. The judge is basically a
neutral referee on matters of process. In
civil law
, judges take an active role in questioning
and ferreting out information and arguments.
•
Appeals in
Common Law
courts typically have to address some specific procedural
problem with the original case; they are not simply to get a rehearing of the case. Appeals
in
civil law
courts tend to review the whole case from start to finish.
As usual, all of these things are generalizations. The real world is more complicated, and all
systems practically blend elements of both. For example, Common Law systems typically have
some
written rules that take precedence over judge-made Common Law (e.g. the US constitution).
One final point – the scope of judicial review over government actions has no connection to
whether the system is Common Law or civil law. There are examples of both systems with courts
that have varying degrees of independence.
Legal Disputes
If a victim and an injurer cannot resolve their own dispute, then the victim files a legal claim called
a
cause of action
. The victim is the
plaintiff
and the party alleged to have injured the victim is the
defendant
.
1The plaintiff files a
complaint
with the court explaining why he believes he was injured, what area
of law or statute is involved and what solution he proposes. The defendant files an
answer
which
typically will argue either that: (1) The facts alleged by the plaintiff are incorrect, or (2) The facts
are correct but the defendant is not legally responsible.
Most cases are settled privately before they reach trial. The judge may also issue a
summary
judgment
in favor of the defendant if he thinks that the evidence is insufficient to proceed to trial.
If the case proceeds to trial, the judge or the jury decides the case and determines whether there is
sufficient evidence to rule in favor of the plaintiff. There are different standards.
•
Preponderance of the evidence
means that the plaintiff’s arguments are more likely /
believable than the defendant’s. This is typically the standard of proof used for monetary
judgments.
•
Beyond a reasonable doubt
means that there is no reasonable doubt whatsoever that the
plaintiff is correct. This is typically the standard of proof used in criminal trials.
•
Clear and convincing evidence
is somewhere in between. This is used in the US court
system, e.g. for awarding punitive damages.
If the parties are unhappy with the decision, either party can file an
appeal
.
2As mentioned earlier,
in Common Law jurisdictions appeals are typically limited to problems with the procedure or
application of the law,
not
about re-litigating the facts of the case.
The appeals court makes one of three rulings
•
The appeals court can
affirm
the original court’s decision.
•
The appeals court can
reverse
the original court’s decision.
•
The appeals court can
remand
the original court’s decision – send it back to the original
court with instructions to reconsider some specific element.
2 One important exception is that, in the US system, acquittals in criminal trials cannot be appealed unless the original
