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ECO320 Final Notes

Economic Analysis of Law (University of Toronto)

Scannen om te openen op Studeersnel

Studeersnel wordt niet gesponsord of ondersteund door een hogeschool of universiteit

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ECO 320 Economic Analysis of Law Final Exam Review:

Economic Analysis of Law Test 1 Review Notes:

CU Chapter 1: Introduction to Law and Economics

Efficiency over Distribution in analyzing private law:

• A possible way to pursue redistribution is through private law (property, contract,
torts). Courts should make private laws to redistribute income to deserving groups
of people (Consumers in favor over investors)
• 4 Reasons this is inefficient:
1. Redistribution by private legal rights relies on crude averages
2. the distributive effects of reshuffling private rights are hard to predict
3. Transaction costs of redistribution through private legal rights are typically
high
4. Redistribution by private law distorts the economy more than progressive
taxation does
• Law needs economics to understand its behavioral consequences, and economics
needs law o understand the underpinnings of markets

CU Chapter 3: A brief introduction to law and legal institutions

Common Law:
• Judges justify findings of law using precedent and social norms
• Lawyers make arguments for their respective sides, judges act as a neutral referee
• Juries are used most often in common law
• In a jury trial judge decides question of law and jury decides question of fact

Civil Law:
• Judges justify interpretation of a code directly by reference to its meaning
• In civil law judges take active role in directing questions and developing
arguments

Nature of Legal Dispute:

• Cause of action – a valid legal claim
• Parties have a right to appeal from a summary judgment or a dismissal
• Preponderance of evidence – if plaintiff (or defendants) arguments are more
convincing then defendants (or plaintiffs) the plaintiff (or defendant) wins (for
private parties as litigants)
• For criminal cases prosecution must convince jury that the defendant is guilty
beyond a reasonable doubt
• Judgment non obstante verdicto – judgment nonwisthanding the verdict, judge
thinks jury got it wrong

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• Grounds of an appeal are usually about mistake of law including general

principles and procedures the court applied, but not about the facts, no new
evidence or facts are brought in at the appellant level
• Doctrine of Last clear chance Rule: If both parties to an accident are negligent,
the party who had the last clear chance to avoid the accident will be held
responsible for losses arising from the accident (Some cases at the end of the
chapter to show how rule developed, go over if time)

Chapter 4: An economic theory of property

Legal Concept of property: property is a bundle of rights. These rights are impersonal.
The owner is free to exercise the rights over his or her property. Owners are forbidden to
interfere with the owner’s exercise of his rights

Bargaining Theory:

• Moving property from someone who values it less to someone who values it more
• Cooperative surplus is the name for the value crated by moving the resource to a
more valuable use
• Payoffs to the parties in the non-cooperative solution is called their threat values
• The surplus from cooperation: Net cooperative solution – net non-cooperative
solution
• Process of bargaining can be divided into three steps: establishing the threat
values, determining the cooperative surplus, and agreeing on terms for
distributing surplus from cooperation

The Origins of the institution of property:

• Why are owner ship rights established: Societies create property as a legal right to
encourage production, discourage theft, and reduce the costs of protecting goods.
Law also prescribes ways we can get property rights

An Economic Theory of Property:

• Law is unnecessary and undesirable where bargaining succeeds, and the law is
necessary and desirable where bargaining fails

Coase Theorem:

• Transaction costs encompass all of the impediments to bargaining

• If transaction costs are zero to low, then we do not need to worry about specifying
legal rules regarding property in order to achieve efficiency. When transaction
costs are high however to prevent bargaining, the efficient use of resources will
depend on how property rights are assigned.

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• Net value of bargain is the cooperative surplus minus the transaction costs. If it is
(-), transaction won’t occurs
Elements of Transaction costs:

• Three forms of transaction costs corresponding to three steps of an exchange:

1. Search costs – Search costs tend to be high for unique goods or services and
low for standard goods and services
2. Bargaining Costs – Negotiations tend to be complicated and difficult when
information about threat value and the cooperative solution is private. In
general bargaining is costly when it requires converting a lot of private
information into public information. Rights of the parties define threat values
in legal disputes so cooperation is more likely to happen when rights are clear
(that’s why we have registration of ownership)
3. Enforcement costs : For complex transactions, monitoring behavior and
punishing violations of the agreement can be costly. Enforcement costs are
low when violations of the agreement are easy to observe and punishment is
cheap to administer
• Examples of Low: standard good, clear rights, few parties, friendly parties,
reasonable behavior, instantaneous exchange, low monitoring cost, cheap
punishment
• Example of High: unique good, complex rights, many parties, hostility,
unreasonable behavior, delayed exchange, high monitoring and punishment costs

Normative Coase and Hobbes Theorems:

• Some transaction costs are endogenous to the legal system in the sense that legal
rules can lower obstacles to private bargaining. Coase theorem suggests that the
law can encourage bargaining by lowering transaction costs. If transaction costs
are made lower where net benefit from private exchange is positive then the
exchange occurs.
• One way the law can lubricate private bargains is by defining simple and clear
property rights. By doing so private parties can exchange legal rights, relieving
lawmakers the difficult task of allocating legal rights efficiently
• Normative Coase theorem – structure law as to remove impediments to private
agreements (Injunctions)
• Normative Hobbes theorem – structure the law so as to minimize the harm caused
by failures in private agreements (the law not only decreases transaction costs but
minimize disagreements then can be costly to society)
- to minimize the resulting harm of a non-agreement, law should allocate
property rights to the party who values them the most making exchange
unnecessary (Damages)

Lubricate or Allocate? Coase Vs. Hobbes:

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• IC denotes the information costs to a court of determining who values a legal right
the most. TC indicates transaction costs of trading legal rights. Efficient courts
would follow this rule:
If IC < TC => Allocate the legal right initially to the person who values it the
most
If TC < IC => Follow Precedent

How are property rights protected?

Damages and Injunctions:

• Principle legal remedy is the payment of compensatory money damages for the
wrongs inflicted on the plaintiff, the court determines its amount
• Injunction – an order by the court for a defendant to do or to refrain from doing a
specific act (injunctive relief is only enforceable by the person who holds its right,
they can choose to contract to not enforce it)
• Damages are the usual remedy in law of contracts/torts and injunction is the usual
remedy in the law of property
• Once a property right is clearly assigned, its owner can strike a bargain to sell it
• If owner of rights values it less then another individual then there is room for
bargain
• The most efficient outcome is a situation in which the total profit (joint profit) is
the greatest. Only happens via bargaining.

Efficient Remedies:

• Injunctions and damages are both efficient when transaction costs are zero thus
transaction cost matter when considering which right.
• If transaction costs are high, then the efficient remedy is damages (if low then
injunction because it is more clear and simpler then damages, because the
determination of damages is costly and unpredictable)
• When transaction costs are too high, a switch makes the victim no worse off but
the injurer may be better off and cannot be worse off
• When transaction costs are high:
- Court should protect via injunction if it knows which party values the right
relatively more
- Protect via damages if it knows how much one of the parties values the right
absolutely
• When they are low:
- Injunction although the better remedy, do not solve the problem that private
information (threat values) about costs and values that inhibit bargaining

What can be privately owned? Public vs. Private Good:

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• When one persons use precludes another then it’s a purely private good (relatively
cheap to enforce property rights)
• A purely public good for which there is no rivalry in consumption
• Efficiency requires the use and consumption of each private good by the party
who values it the most . Law can help by lowering transaction costs so bargaining
happens until property is in the hands of someone who values it the most
• People who do not pay for their consumption of a public good are called free
riders
• Public ownership of a private good typically results in its misallocation by which
we mean that it is used or consumed by someone other than the person who
values it the most
• The choice between private or public ownership depend on whether the costs of
private enforcement and exchange are more or less than the costs of public
administration and political bargaining

What may owners do with their property?

• Do anything as long as it doesn’t impose an external cost on other peoples

properties and rights
• Private bads may be self correcting through private agreements

Redistributive Goals:
• Several reasons against basing property law on redistributive goals. Specifically,
imprecise targeting, unpredictable consequences, high transaction costs, and large
distortions in incentives

Chapter 5: Topics in the Economics of Property Law

Information Economics:
• Property law can help to secure rapid economic growth
• A competitive advantage from an innovation eventually diffuses. When diffusion
is complete the economy reaches a new equilibrium whose benefits diffuse even
more broadly than the innovation
• If information is not protected then people will not reap from its benefits and thus
not many people would want to spend time inventing. Property rights can help
prevent this
• Information is nonrivalrous (one person’s use of an idea does not diminish its
availability to others) and it is also nonexcludable (expensive to exclude people
from learning about a new idea)
• Three remidies to private market not providing the efficient amount of
information due to nonappropriability (information is expensive to produce but
cheap to transmit)
1. State to supply or subsidize art and science especially in terms of basic
research

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2. Charitable Contributions (more efficient then government because donors

monitor their use of money more then tax payers monitor the governments use
of taxes)
3. Trade secrets protections from contract and tort law. Has a problem of
information leakage, if info has thoroughly leaked anyone can use it even if it
originated from a breach of contract
4. Intellectual property law: patent, copyright, trademark. Esentially property
rights over produced information

Intellectual Property:

• Intellectual property may result in too high user fess and too low dissemination
• Developed countries focus on benefits of strong intellectual property rights that
protect their creators. Developing countries benefit form wide diffusion of
technology at low cost

Patents:

• Holder of patent at his or her discretion can license the use of a patent for money
• When applying for a patent you release information out, thus some people avoid
getting patents but use protective contract laws such as nondisclosure agreements
• Broad patents encourage fundamental research (more profitable to patent
fundamentals) and narrow patents encourage developments (more profitable to
make a product)
• If social value of fundamental research exceeds the social value of investment on
developing applications the patents should be broad. If other way around then
narrow
• However the joint product is really what is efficient. If we just look at one piece
the joint product will be undersupplied.
• If TC are zero, Coase theorem applies: breadth of patent does not matter to
economic efficiency so long as inventors can bargain
• If TC are high, Hobbes applies: patent protection for pioneering inventions should
be broader for those with little stand alone value and should be narrower for those
with large stand alone value
• Optimal life of a patent strikes a balance between creativity and discouraging
dissemination
• In information technologies, industry standards provide an additional element of
natural monopoly
• Natural monopoly is such a common feature of networks, make money faster then
anyone and then price it lower then anyone who wants to join the game can afford
thus excluding everyone else. No need for patent.

Copyright:

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• Copyrights tend to have a narrow breadth to limit copyright infringement in terms

of creativity and a long life because of the ease of copying information thus a long
life provides sufficient gain to the author
• In the model of digital libertarianism technical protection through cheap
encrypting will be more efficient than legal protection of intellectual property

Trademark:

• Trademarks help to solve the problem of consumer ignorance about the quality of
a product
• They lower consumer search costs and create an incentive for producers to supply
goods of high quality

Public and Private Property:

• Public ownership comes in three forms.

1. Open access allows everyone to use a resource and no one can exclude anyone
from using it
2. Political control allows lawmakers or regulators to impose rules concerning
access, usually the case is limited access
3. Unanimous consent, which allows no one access unless everyone agrees

How are property rights established and verified?

Over fugitive property:

• Two general principles that can solve the problem of establishing ownership:
1. first possession: first to possess owns it
2. Tied ownership: owner of the surface has ownership over surface and
subsurface deposits, etc.
• Social efficiency requires investors to invest in a resource until the marginal cost
equals the marginal increase in productive value. However first possession causes
people to invest in a resource until MC equals the MB of the sum of increased
production plus transferred ownership (inefficient)
• Rule of tied ownership ties fugitive property to settled property. Based off the idea
of accession – new thing is owned by the owner of the proximate property,
however there is a difficulty of establishing and verifying ownership rights (like
oil that flows under multiple owned lands)
When to privatize open-access resource:

• Property that is owned in common and accessible to the public is an open access
resource
• This can often lead too overuse and unproductivity (problems with fisheries and
overfishing)
• A method of prevent is privatization or tied ownership

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• Thus when a resource is uncongested and boundary maintenance is expensive,

open access is cheaper then private ownership but as time passes and congestion
increases, technology for boundary maintenance and ability to exclude others may
become cheaper. A point where private ownership is cheaper than open access.

Can a thief give good title?

• Efficiency of traded stolen goods requires:

1. If cost of protecting by original owner < cost of buyer to check what he/she is
buying then it is more efficient for the good faith buyer to acquire good title
(owner bears cost)
2. If Co > CB then it is more efficient for the original owner to retain title (buyer
bears cost)

Externalities:

• Public externalities typically have characteristics of nonrivalry and

nonexcludability
• In property law a harmful externality is called a nuisance
• Two solutions temporary and permenant damages
• Temporary damages impose high transaction costs for dispute resolution but
create an incentive for the injurer to continually adopt technical improvements
that reduce external costs
• Permenant damages however have high error costs (predicting the extent of the
harm for “x” years)
• Temporary dmages tend to be more efficient given easily measured damages and
rapid innovation (easy measurement means lower trial costs)
• Permenant damages tend to be more efficient given costly measurement of
damages and slow innovation
• LOOK AT GRAPHING ON Pg 172

ECO320 Term Test 2 Review

Chapter 6: An Economic Theory of Tort Law:

I. Defining Tort Law

A. Economic essence of tort law:

• Tort law deals with private agreements where transaction costs for private
agreements are relatively high
• The economic purpose of tort liability is to induce injurers and victims to
internalize the costs of harm that can occur from failing to take care

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• The economic essence of tort law is to use liability to internalize externalities

crated by high transaction costs

B. The traditional theory of tort liability:

• Three element must be present for recovery by the plaintiff under the traditional
theory of torts:
1. The plaintiff must have suffered harm
2. The defendant’s act or failure to act must cause harm
3. The defendants act or failure to act must constitute the breach of a duty owed
to the plaintiff by the defendant
• Harm: harm results in a downward shift in the victims utility function or profit
function
- Money damages.
- If health can be restored. Damages = the difference (W0 – W1). It equals the
sum required to go from shitty health to better health. By providing that
difference his health is resorted and he is back to his original position and
utility

- If health cannot be restored, she must provide him with wealth, W*, so that he
is indifferent with much higher wealth then W1 but worst health then H0

• Cause: two types of causes

- The first is cause in fact which is determined using the “but for test” (the but
for test is useless involving cases with multiple causes of harm) Liability
should be to the most substantial cause

- The defendants act must be a cause in fact and also be a proximate cause

- Cause in tort law involves an externality created by interdependent utility or

production functions

• Breach of duty:

- Just harm and causation is strict liability

- a rule of liability requiring plaintiff to prove harm, causation, and fault is a

negligence rule

- a duty of cars is a legal standard prescribing the minimum acceptable level of

precaution, if X ≥ X* (reasonable level of care)

- objective test and regulations in law impose legal duties

II. An economic theory of tort liability

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A. Minimizing the social costs of accidents:

• the probability of an accident, p, decreases with precaution

• p = p(x)A is a decreasing function of precaution, A = monetary value of harm
• the linear function wx, captures the amount spent on precaution, each unit of
precaution cost w.
• Expected social costs = E(SC) = wx + p(x)A
• X* is the level of precaution that is at the minimum of the U-shaped curve of
expected social cost. Thus X* is the optimal level of precaution to reduce social
costs
• X* can be founf by solving the following equation
• W = -p’(X*)A , marginal social cost = marginal social benefit
• If X< X* then the marginal social cost of precaution is less then the marginal
social benefit, efficiency requires taking more precaution

B. Incentives for precaution under no liability and strict liability:

No liability: causes the victim to internalize the marginal costs and benefits of precaution
which gives the victim incentives for efficient precautions. Minimize wv + p(xv)A and
victims marginal cost equals victims marginal benefit. The injurer has no incentives to
take precaution because they externalize cost of harm (this is because the minimum cost
they bear is at zero precaution)

Strict Liability: Rule of strict liability with perfect compensation causes the injurer to
internalize the marginal costs and benefits of precaution. Which gives him incentives for
efficient precaution. Victim takes inefficient precaution because they externalize cost of
harm.

Depending on the liability rule either the injurer or victim becomes indifferent b/w
accident and no accident

C. Bilateral Precaution:

• The above don’t create incentives for efficient precaution by both parties
• Bilateral precaution is when both take precaution
• E(SC) = wvxv + wixi + p(xv, xi)A
• Simply dividing the cost b/w them wont work because by externalizing some,
both have incentives for deficient precaution (paradox of compensation)

D. Incentives for precaution under a Negligence Rule

• Solution to the paradox lines in the negligence rule

• The legal standard of precaution is the reasonable amount of care which equals x*

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• A negligence rule with perfect compensation and the legal standard equal to the
efficient level of care gives the injurer incentives for efficient precaution
• The will not take precaution beyond x* because they pay for their own precaution
per unit, w, but their liability remains zero
• When the injurer is not liable due to proper care, the victim receives no
compensation and thus responds as if the rule is no liability. This means the victim
will also take efficient care

E. Contributory Negligence and Comparative Negligence

Simple negligence:

Injurer at fault if xi < xi* and liable

If “> or equal” then not liable

Negligence with a defense of contributory negligence:

Injurer at fault if xi < xi* and victim faultless xv >= xv* (injurer liable)
Injurer faultless if xi “>” or if victim at fault

The above forms have been displaced in the united states by comparative negligence

Comparative negligence:

If injurer at fault and victim faultless based on reasonable precaution -> injuerer bears
100 percent
If injurer is faultless and victim at fault -> victim bears 100 percent
If injurer at fault and victim at fault -> both are liable in proportion to negligence

Strict liability with a defense of contributory negligence:

If victim is at fault -> injurer not liable

If victim is faultless -> injurer liable

*Difference is doesn’t matter if injurer took reasonable care or not, all depends on the
victims level of care to see if the injurer is liable

Comparing them all:

• Assuming perfect competition, each legal standard equal to the efficient levevel of
care. Every form of negligence rule gives the injurer and victim incentives for
efficient precaution

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• This is because under any rule atleast one part escapes bearing cost by taking the
efficient level of care. The other party will consequently internalize the cost of the
harm from accidents

Activity Levels:

• Reasonable precaution does not take into consideration activity level. Thus under
a negligence rule if someone takes reasonable care it doesn’t matter how much
they increase the activity because there expected liability does not change
• Under strict liability however, the injurer internalizes the social cost of accidents
from too much driving or dangerous driving. Strict liability can induce both
efficient precaution and an efficient activity level by drivers
• Under simple negligence, victim is ultimate bearer of harm. Under strict liability
with a defense of contributory negligence, injurer is the ultimate bearer of harm
• In general the ultimate bearer of harm internalizes the benefits of any of his/her
actions that reduce the probability of severity of accidents, including more
precaution and less activity
• These provides a guide for law makers to choose which liability rule:
1. if efficiency is unilateral, strict liability or no liability
2. if bilateral, negligence rule because more efficient then the above
3. Efficiency requires choosing a liability rule so that the party whose activity
level most affects accidents bears the ultimate costs of accidental harm (so if
you want to reduce driving, make injurer the ultimate bearer of harm)
Bilateral activity levels create a dilemma

G. Setting Legal Standards: The Hand Rule

The hand rule sates that the injurer is negligent if the marginal cost of his or her
precaution is less than the resulting marginal benefit. Solve the marginal social cost =
marginal social benefit from above inequality

Repeated application of the hand rule enables adjudicators to discover the efficient level.
To apply it the decision maker must know if a little more precaution cost more or less
than the resulting reduction in expected accident cost.

Instead of case-by-case application, another approach is to draft regulations or statues

specifying legal standards that equals the efficient level of precaution. Another way is for
the law to enforce social customes or the best practices in an industy ( the social custom
has to be efficient)

Courts have overlooked risk to self and only cared about risk to others and thus set the
standard to low for most applications of the hand rule

In general the hindsight probability of something happening is higher than the foresight
probability of something happening, thus at the times something might be reasonable care
but after an accident occurs it no longer was.

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H. Errors:

• Negligence seems more efficient then strict liability yet the latter has seen more of
an appeal, why?
• Causation is easier to prove than negligence.
• Mistakes are often main concerning the extent of harm
• If under strict liability, damages fall short from perfect, then the injurer will
externalize part of the cost of accident (take less then efficient precaution)
• In general, consistent court erriors in setting damages unser a rule of strict liability
cause the injuerers precaution to respond in the same direction as the error
• Consistent errors in failing to hold injurers liable under a rule of strict liability
causes injurers to take less precaution
• Situation is under a negligence rule:
• The injurers expected costs jump up (big or small) as his precaution is under the
legal standard. Injurer than still has an incentive to escape liability even if the
court errors in measuring damages. In general injurer precaustion does not
respond to modest court erriors in setting damages under a negligence rule. (only
time it has an effect on precaution is if the error is damages awarded is very large
and saw precaution will be below the efficient level)
• In general injurers precaution does not respond to injurers modest errors in
predicting damages under a negligence rule (but does for large error)
• In general injurers precaution does not respons to a courts modest errors in
determing who caused an accident under a neg. rule. (error in det, is diffrenct cost
curves)
• Injurers precaution responds exactly to court errors in setting the legal standard
under a negligence rule.

Vague Standards and Unceartinty:

• In general, the injurer who minimizes expected cost does not change his her
precaution to random errors in computing or predicting damages under any
liability rule (errors of excess offset errors of deficiency on average)
• Random errors in concerning the legal standard in a negligence rule:
- over precaution over the efficient level cost them a little
- precaution of the efficient level and a court error thinking its not efficient and
makes them liable cost them a lot
- thus small ransom errors in the legal standards imposed by a negligence rule
causes potential injurers to increase precaution
• A court that assesses damages more accurately than standards should favor a rule
of strict liability (because negligence is inefficient due to over precaution by the
injurer and strict liability will cause an efficient level of internalizing the cost of
harm). A court that asses standards more than damages should favor negligence
(negligence forces efficiency on both injurer and victim)

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J. Administrative Costs and Tailored Rules:

• a rule of strict liability lowers administrative costs relative to a rule of negligence

by simplifying the adjudicators task. And no liability is even cheaper because
there is zero relocation of the cost of accidental harm.
• The rule of negligances lowers administrative costs compared to strict liability by
reallocating the cost of harm in fewer cases
• Whole sale rules save administrative cost but distort the relationship b/w marginal
cost of precaution and marginal reduction in harm, case by case does the opposite
• Increasing liability and reducing the number of trials often saves administratives
cose without affecting the number of accidents

K. Consumer Product Injuries:

• Under no liability, perfectly informed consumers will choose most efficient

product
• Uninformed will not necessarly choose most efficient (does not know the
expected accident cost)
• Thus imperfect informed consumers will choose the most efficient product under
a rule of strict liability

Chapter 7: Topics in Tort Liability:

A. Relaxing core assumptions:

Rationality:

• For tort liability system to work, actors have to be rational

• People are not rational for low prob events they think prob is zero
• Some people exaggerate the prob of accident
• Thus people may inaccuatley set p(x)
• Thus people may or may not take efficient precaution
• If people think prob is zero, they take little precaution making the situation
unilateral than bilateral.
• Actors are liable under a negligence rule for the harm caused by their lapses
(inefficient level of precaution)
• Reducing the role of moreal luck imporves incentives and reduces inefficiencies
• Intentional negligence instead of negligence would reduce the effects of moral
luck (however the burden of proof is way to high)

Regulations:

• Administrators may set standards better than courts when technical knowledge
allows them to have a better understanding of reasonable precaution (regulation)

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than the courts. Courts in this case can accept the regulation as the legal standard
of care
• If cases show give the court better information about harm than administration, if
liability law imposes a higher standard of cae than safety regulations then most
potential injurers will conform to the higher standard to avoid liability. (conform
to regulation to avoid fines* opposite case)
• Regulations often dominate liability
• Suborgation – victim recovers some damage from insurance and injurer, insurance
of victim recovers their loss from injurer. Liability insurance covers the injurer for
tha bove costs.
• In a system of universal insurance and competitive insurance market, the goal of
tort law can be described as minimizing the total cost if insurance to policyholders
• No liability means victims buy more insurance, and SL means injurers buy more
• Insurance externalizes risk and thus gives the insured incentive to reduce
precaution, this is a moral hazard.
• The insurance company prevents this with deductibles, coinsurance, and
experience rating
• Thus liability insurers impose safety standards policyholders must meet to remain
insured. Increasing incentives for precaution
• The phenomenon whereby an increase in the insurance premiums drive out good
risks while retaining bad risks, resulting in a double round of prem rise is called
adverse selection

Bankruptcy:

• Limited liability can cause too little precaution and too much dangerous activity
• If potential damages exceed net worth the frim externalizes part of the risk via
bankruptcy
• Thus risky industris may have too many accidents and too little capital.
• A way to stop this is to target parenting companies instead of letting sub
companies go do to bankruptcy
• Bankruptcy meanse secured creditors get priority over tort victims, a firm can
shield its assets from the claims of tort cictims by lending debt to secure creditors
• Securiztixation allows firms buy securities with income and sell them to investors,
future income belongs to owner of securities , and tort victims cant tap into this
• *A negligence rule mediates this problem because it allows firm to escape liability
all together by confirming to a reasonable care

Litigation Costs:

• If litigation cos more then damages earned victims will not sue
• Injurers will thus not take efficient precaution because expected cost are lower
• If its expensive for injurer to litigate they maky take more precaution then if it
was costless

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• A legal system can save administrative costs by reducing the prob. Of liability
( half cases) and offsetting this fall with increase in damages (twice as much)
Expected liability stays the same.

3. Evidentiary Uncertainty and Comparative Negligence:

• under contributory negligence, victim could not recover anything if they were
negligent and so were the injurer. Too harsh.
• Uncertainty about the courts assessment of a partys precautionary level with
regard to the legal standard of care induce most injurers to take more precaution
than is prescribed by the legal standard of care
• They give themselves a margin of error
• The overprecaution caused by unceartainty is less under comparitaive negligenve
than it is under any other form of negligence. This is because the party who makes
the precautionary mistake does not bear the full cost of the mistake. They would
under any other rule.
• It is costly however at times for the court to find exact percentages of fault.

4. Product Liability:

• The liability standard is strict product liability

• To be held under this standard product has to be defective:
1. defect in design – flawed design
2. a defect in manufacture – lose bolt
3. a defect in warning – not warning about dangers
• if precaution is bilateral negligence rule
• if unilateral (only injurer can reduce probability) strict liability is appropriate
• most efficient is strict liability because manufacture is in control of the design and
special dangers
• however some victims wont take efficient precaution thus you want negligence or
bilateral
• thus product strict liability is middle ground. By holding them only liable for
defective grounds, they escape liability if victims assumed the risk or misused
product
• if it could not exlude liability, it would have to insure and charge higher price

II. Computing Damages:

A. Hand Rule:

• victim is indifferent b/w injury and damages

• this concept is relevant which a substitute for a lost good is available in the
market
• some injuries like loss of life have no market substitutes

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• people make decisions that balance the cost of additional precaution against
reduction in prob of injury
• court would compute the value of fatal risk by solving the equation L = B/p
• L = value of fatal risk/loss, B = burden of precaution, and p = prob of fatal risk
- comes from the idea that efficiency requires taking additional precaution until
the burnden equals the change in p multiplied by loss B = pL
- if the indifference meathod is appropriate, damages are perfect

B: Punitive Damages:

• Stric liability and if liability system is imperfect you may have enforcement error
• if enforcement error lowers expected liability of a manufacturer, they will chose
lower then reasonable precautions. Thus in a specific example a manufacturer will
have low rather than high quality control. Inefficent
• this inefficncy can be augmented by introducing punitive damages
• punitive damgaes are excess of compensatory damages
• L = Aem
• L = liability, A = compensatory damages, e = enforcement error, m = punitive
multiple and should be set as 1/e

Part II.

B. Medical Malpractice:

• Totrt liability system should provide incentives for physicians and other health
care professional to take precautions against injuries
• Due to insurance rates not changing much for physicians, they may only bear a
fraction of the costs of patiens injuries
• Defensive medicine may show that docter rake too much care in the hope of
forstalling injury or demonstrating “everything possible” to prevent harm
• Patients have little reason to resist unnecessary procedures tha do no harm so long
as insurance companies pay the bill
• Administrators were better than jurers to calculate damages

C. Reforming Product Liability:

• In some instances insurers have found produce liability to be so uncertain that

they withdraw causing some manufacturers to stop making products or increase
prices
• Manufacturers are asking for reform at the federal level
• Uniform product liability would save costs, leading to savings to the consumer
• Many believe product liability is flawed awarding too many and too generous
awards
• State reform is usually capping amount and type of damages

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• Current system however is working well and prod liability insurance is cheap

D. Mass torts:

• Liability law does not compensate exposure but realization of risk

• Health uncertainty’s want plaintiff to sue as fast as possible while defendants wan
to delay if health does not worsen
• To deal with mass torts the courts have been willing to entertain novel practices
• One way is making funds
• The second is market share liability – liability in plaintiffs damages in proportion
to market share at the time

Chapter 8: An Economic theory of contract law:

I. Bargain Theory:

A. What promises should be enforceable at Law?

• A promise is legally enforceable if it is given as part of a bargain, otherwise a

promise is unenforceable
• A bargain requires an offer, acceptance, and consideration
• Promisor gives the promise, and promise receives it
• Consideration means promise gives something to promisor to induce promise,
without it promise is unenforceable
• Doesn’t require the bargain to be fair
• Will theory - when wach party intender the promise to bind their will meets,
which creates the contract (like Pareto efficiency)

B. Remedy for Breach:

• Benefit of the bargain, that is to the benefit he or she would have obtained from
performance
• Expectation damages

C. Criticism of the Bargain theory:

• Bargain theory denies enforcement when the promise did not arise from a bargain
and thus when both parties want a promise to be enforced, it is not, inefficient
(dogmatic legal theory because it frustrates peoples desire)
• Car dealer “deal” example
• Calls for routine enforcement of “outrageous bargains”.

II. Economic theory of contract enforcement

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A. Cooperation and Commitment:

• Deffered exchanges require enforceable promises

• The first purpose of contract law is to enable people to cooperate by converting
games with non cooporative solutions into games with coopoertaive solution
• If no contract, player 2 will breach and player 1 inticipating that will not play and
no surplus created from coop. If contract player 2 will not breach and player 1
will play both benefit.
• Cost of breach is expectations damages in the game theory scenario
• The purpose of contract law is to enable people to convert gmes with inefficient
solutions into games with efficient solutions.
• Appropriate is redistributive and not creating. Look at net payoff, not playing is
zero and appropriating is zero

III. Contract Remedies

• If N(perform) ≥ then Net breach – L -> Perform

• If N(perform) ≤ then Net breach – L -> Breach
• When a contract only affects the parties to it. Liability for perfect expectation
damages gives the promisor efficient incentives to perform or breach. If bad luck
and high cost more efficient to breach, and if low cost more efficient to perform
(off the game map)
A. Precaution against breach:

• When a contract only affects the parties to it, liability for perfect expectation
dmags gives the promisor efficient incentives to take precaution against breach

B. Reliance:

• Reliance is a change in the promise position induced by the promise.

• Perfect expectation damages cause the promise to overely relative to the efficient
reliance
• Thus liability for perfect expectation damages gives efficient incentives for
promisor but not promisee

IV. Economic interpretation of contracts:

Perfect contracts – when transaction costs are zero, the contract is perfect instrument for
exchange. Every contingency is anticipated

Real contracts are not perfect and courts have to supply there on terms to fill the gaps

A. Default Rules:

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• Party save transaction costs by leaving gaps when costs of negotiating outweigh
cost of filling gaps
• They add default terms parties are free to negotiate over them
• If terms are inefficient, parties should replace them with explicit terms of their
own
• Economic analysis stats that default terms are efficient if the parties would have
agreed to it if they had beared the transaction costs over all relevant risks (courts
must find the efficient hypothetical bargain)

B. Mandatory Rules:

• Mandatory rules regulate a contract parties have no input on them

• The further the facts depart from the ideal of perfect rationality and zero
transaction costs, the stronger the case for judges regulating the terms of the
contract.

V. Relational Contracts: The Economics of the Long Run:

A. Repeated games:

• Tit for tat is an efficient equilibrium to a repeated strategy game because by

appropriating, player one stops playing for a few rounds and thus players 2 incurs
a loss
• In the long run player 2 benefits more from cooperating
• Traditional forms of commitment are better then state imposed contract law in
certain situations and when the state is hostile

B. Endgame Problem:

• Eventually long term relationships deteriorate

• The final round of the agency game has the same logic as a one shot agency game
• The players cannot cooperate in the last round without enforceable contracts
• In general, the demonstrations that they cannot coop in any given round means tit
for tat does not work and thus they cannot coop in preceding round because
preceding round cannot be used to reward for a round that doesn’t happen so it
becomes a one shot game with no contract
• Contracts are thus needed when relationships begin to deteriorate
• Thus contracts should be enforced if they are written for dissolution of
relationships
• The strategy of coop in long run must yield the same payoff as the strategy of
appropriating in one shot.

Chapter 9 Topics in the economics of Contract Law

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I. Remidies as incentives:

• Damages and specific performance are two general types of remidies for breach

A. Alternative Remedies:

Expectation damages:

• Perfect expectation damages leave the victim indifferent b/w performance and
breach
• The expectation damage thus must be the difference b/w the value someone
wanted and the value they got so they can be back to the value they wanted
• Baseline is performance

Reliance Damages:

• The promiser may invest in reliance on the promise

• Increases the loss resulting from breach
• Damages computed to a base line of no contract
• Perfect reliance damages leave potential victims indifferent b/w no contract and
breach
• Thus reliance damage equals the amount of reliance the person had on the
contract, but does not include the expected gains of the contract

Opportunity Cost:

• Lose opportunity provides baseline

• Perfect opportunity cose damages leae the potential victims indifferent b/w breach
and performance of the best alternatice contract
• Hedging forms contracts buyer edges from higher price, and seller hedges from
possibility of having to sell cheap tickets

4. Problems of subjective value: Hawkins v. McGee

• Hairy hand case

• In general perfect compensation means a sum of money to make the cictim of an
injury equally well off with the money and with injury as he or she would have
been without the money and the injury
• In general expectation damages≥ oppurtunity cost damages ≥ reliance damages
• This is because gain from this contract > gain from alternative contract > gain
from no contract
• Sometimes these damages are not in order because courts award imperfect
damages

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• Sometimes subjective value exceeds market value, if courts only award market
value, reliance is higher then expected (market value)
• If the person makes a mistake and contract makes a person worse off then better
reliance will be higher however never happens because contract favors promisor
and they wont breach

5. Restitution:

• When one person gives for a promise to do something later

• Restitution just returns what was given
• Lowest but most simple and enforceable damages

6. Disgorgement:

• Are damages paid to the victim to eliminate the injurers profit from wrongdoing
• The victim thus suffers no loss do to disloyality and the injurer achieves no gain
from being disloyal
• Stockholders and directors (land with resources example)

7. Specific Performance:

• Specific performance forces promisor to perform

• The typical case involves specific performance involves the sale of goods which
no substitute exists and thus expectation damages are hard to come up with due to
the subjective value on the item
• Error of expectation damages decrease as the ease of sub. Increases

8. Party Designated Remedies: Liquidated Damages:

• Contract might stimulate the sum of money paid on breach (liquidated damages)
or assets that are given upon breach (performance bonds)
• Parties also may specify a process for resolving disputes b/w them
• A penalty is when stipulated damages exceed actual harm of breach
• Common law enforces stipulated damages and rejects penalties
• Civil law enforces both
• Penalties can serve 3 functions:
1. Punitive element may be considered as payment on an insurance contract in
favor of the innocent party. When innocent party places high subjective value
on performance, the other party is the best possible insurer to their loss
(penalty > price > reg price)
2. Often conveys information about the promisors reliability – cheap way of
conveying credibility
3. Penalties can be restated as bonuses:
- increases the prob. Of enforcement by courts

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- penalty contract can be illegal but bonus is legal with the same gains and loss
from breach
- instead of seller paying buyer a penalty on breach, buyer pays seller a bonus
equal to the penalty upon performance
- price is then equal to penalty price – penalty , bonus is equal to penalty
- the payoff in penalty is higher but the amount paid in bonus is lower to equal
same loss from breach

B. Efficent Breach and Performance:

• renegotiation the contract can release a party from its terms, and it usually
involves giving something to one party something thay value more than
performance
• parties will renegotiate whenever transaction costs are low according to the coase
theorem
• renegotiating will create surplus they can divide
• remedy effect bargaining power

1. Unfortunate contingency:

• high costs are unfortunate contingency that makes breach efficient

• specific performance as a remedy does not allow for this and thus they may need
to renegotiate
• the difference b/w joint performing at high cost and breaching at high cost equals
the surplus of renegotiating
• the principal then must receive their expected value and atleast half of the surplus
to renegotiate
• damage remedy is always efficient, and specific performance is sometimes
inefficient if renegotiation fails
• thus under successful renegotiation, any rule of law is efficient

2. Fortunate Contingency:

• injuctive remedy (specific performance) increases the promise bargaining power

in the ensung negotiations relative to a damages remedy, the promise can extract a
larger share of the surplus created by fortunate contingency
• the law effects distribution not efficiency
• when subjective value is difficult for the courts then specific performance is better
however if transaction cost to renogtiation lead to a failure of renegotiation and if
courts cost for computing dmages is lower than the cost of failure, damages is
more efficient
• damages is more efficient when a lot of substitutes

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C. Investment in Performance and Reliance:

1. Paradox of compensation:

• promiser hase an incentive to invest more on performing when liability for breach
is higher, the prmisee has incentive to rely more and increase the loss of breach
• for efficient incentive ths promise must internalize loss from breach (expected
damages do not do this)
• general form of the paradox compensations:
1. inorder for injurer to internalize cost he must fully compensate victim
2. in order for her to internalize cost she must not receive compensation
3. private law cant internalize costs of injurer and victim

2. Unverifiable Acts:

• in general the efficient supply of unverifiable inputs require each of the two
parties to be liable for 100 percent of the output so that their roral liability adds up
to 200 percent.
• This can be done by having a 3rd party receive damages not the victim (anti
insurance)
• Just theoretical

3. Contract solutions to the paradox of compensation:

• Efficient incentives require internalization of marginal cost and not total cost
• Hypotherical expectation damages equal the gain that the promise would have
obtained from performance if the promise had relied efficiently
• Promise bears cost of overreliance and thus internalizes ther marginal cost of
actual reliance leading to efficency
• First the contrct can stipulate damages at the level required for hypothetical
expectation damages
• Second courts can decide not to award damages based on over reliance
• Forsseibility doctrine in common law compensates for forseeable reliance and not
unforceeable reliance
• In principle then informing the promisor of the reliance makes him liable for it
and thus it reduces transaction cost of information if a high reliance individual
tells the expected damages from breach, and when they don’t tell the promiser can
infer that the cost will be lower and reasonable

4. Time

• Look at if time permits

II. Formation defenses

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• Formation defence – conditions for creating a contract were not satisfied

• Performance excuse – denies liability for breach because of circumstances that
prevented performing

A. Incompetence:

• Competent contractual partners can usually protect incompetent contractual

partners from harmful contracts at less cost than anyone else. Competent people
must protect the interest of incompetent partners or assume liability for doing so

B. Dire constraints and Remote risk

[Link] – a promise extracted as the price to cooperate in creating calue is enforceable

and a promise extracted by a threat to destroy value is unforcable. Failed bargains do not
create wile coercion can destroy.

If parties wanted something unenforceable than court shouldn’t enforce it unless both
wanted it enforceable (renegotiation screwing one part over is unenforceable,
renegotiation by both parties should be enforceable) *Boat example (renegotiation due to
changed circumstances)

2. Necessity- the promise makes a destructive threat and the promiser is forced to make a
promise in duress and necessity. Duress (threat = act), necessity (threat = not act). An
appropriate award should provide incentives for resucue. A lucky rescue should have
moderate awards. An anticipated rescue should reward more for being prepared. And a
planned resuce should have even more reward for resources required for search and
resources required for rescue.

As probibality and seriousness of risk increase, so does the type of rescue and thus the
reward

3. Impossibility If the contract is silent about a contingency, the law must deicde if
physical or economical impossibility is an excuse.
- assign liability to the party who can bear the risk that performance becomes imposible
at least cost
- risk should thus be assigned to the party who can take precautions to reduce it at least
cost
- if you cant reduce it someone can spread it (risk is easier to bear when spread)
- if a contingency maks performance impossinle, assign liability to the party who could
reduce or spread the risk at least cost

4. Fusturation of purpose:

• Contingency arises during contract making it useless

• If contingency makes performance pointless, assign liability to the party who
could bear the risk at least cost (Buildings rented for coronation)

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5. Mutual mistake about facts:

• Contingency happens before the contract without anyone knowing about it

• if a contingency makes performance pointless, assign liability to the party who
could bear the risk at least cost. (owner of a frim, or promiser is the cheapest
avoider of the contingency)

6. Mututal Mistake about identity:

• if reasonable parties disagreed about the identity of the performance offered and
accepted, the contract is void (car and rusty)

C. Information:

• efficiency requires unitting knowledge and control over resourses at least cost,
including the transaction cost of transmitting information and selling goods

1. Unilateral Mistake:

• withhold enforcement from contracts involving involuntary exchange, and

enforce contracts that reward discovery and unite knowledge with control
• contracts based upon one party’s knowledge of profuvtive information –
especially if that knowledge was the result of active investment – should be
enforces. Whereas contracts based upon one party’s knowledge of purely
redistributive information or fortune of acquiring information should not be
enforced. One creates incentive to create while other waste resources on
redistribution
• enforce contracts based on mix information (red.: buy classic from a guy who
thinks its old, take care of classic)

2. Duty to disclose:

• by not disclosing safety, you are separating knowledge from control

• thus do not enforce contracts that don’t include safety
• when bargaining to a contract, the parties should divulge safety information
• termite house example

3. Frauds and Misrepresentation:

• victim of fraud is entitles to damages

• lowers the cost of concluding coop agreements, because adds reassurance of truth

4. Vague Promises:

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• courts should enforce prmise when the parties want enforcibility at the time the
promise was made. (Vaugue terms to the extent they needed to be enforced)
• The courts to make a good decision need to understand thoughrouly the contracts
purpose

D. Monopoly

• cartels were outlawed by antitrust laws because no competition allowed for unfair
advantage and high prices, bargain theory would not allow such laws

Fill in a form: contracts of adhesion

• standard form contracts suggest cartle because it reduces competition
• reduces buyer bargaining power and thus is a contract od adhesion
• however standard from can also increase efficiency by reducing product
diferentation and promote price competition. And secondly, by reducing
transaction cost by making bargaining cheaper
• efficient and inefficient non price terms. Efficent when a monopoly can extract all
surplus. If not inefficient.

Unconscionability –

Chapter 10: An Economic Theory of the Legal Process

I. The Goal of the Legal Process: Minimizing Social Costs

• Administrative costs are the sum of the costs to everyone involved in passing
through the stages of a legal dispute
• Errors made in the process distort incentives and impose a variety of costs on
society
• The economic objective of procedural law is to minimize the sum of
administrative costs and error costs (minSC = ca + c (e))
• When a court gives ideal decisions relative to existing law and facts we call it
perfect information judgment denoted, j*
• Extent of court’ error: e = j* - j (actual judgment)
• Can use formula to calculate error case by case
• The extent of the error does not equal its social cost. The social cost of an error
depends additionally upon the distortion in incentives caused by the error

II. Why Sue?

A. Decision Trees

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• Using the probabilities of winning and losing, amount gained by lawyer for
winning, and cost to lawyer, one can make a probability tree
• the lawyer should take case if expected value is zero. The tipping point for taking
case is when j, makes expected value zero
• For a probability case (Settle or suit), find the lowest probability of the consumer
winning at which the business expects to gain by settling the case
• Reject settling if expected to win at least as high as found probability
• Look at pg 387 for both the examples

B. Computing the Value of a Legal Claim:

• To decide whether to initiate a suit, a rational plaintiff compares the cost of the
complaint and the expected value of the legal claim. EVC depends on what the
plaintiff thinks will occur after filing a complaint
• In order to compute expected values in a sequence of events, one begins with the
last possible event and works towards the first event. Which in the legal process is
appeal -> decision to file complaint
• When the expected value of the step is negative such as appeal, the rational
plaintiff will not pursue this step. EVA = -10
• EVT = 30, EVT = p(win) + (1-p)(lose) – trial cost
• For the bargaining stage it’s EVB = p(settlement – settlement cost) + (1-p)(EVT)
• If EVB is (+), the plaintiff who reaches this stage will bargain
• Parties may settle or fail to do so, when they fail they go through discovery, then
if EVB(+), they bargain
• EVC = p(Settlement – settlement cost) + (1-p)(EVB- discovery cost)
• The FC (filing cost) = the cost of hiring a lawyer, drafting the complaint, and
paying the filing fee
• Expected net pay off is EVC- filing fee
• The rational plaintiff files a complaint if their net payoff is (+)
• EVC >= FC (file)
• EVC < FC do not file
• The decision problem of the defendant parallels he decision problem of the
plaintiff with their task is minimizing the expected cost of his or her legal liability

III. Exchange of Information

A. Bad News is Good for Settlements:

• Trials occur because parties have different expectations about the outcome
• If the plaintiff’s expected value of the judgment at trial exceeds the defendant’s
expected value of the judgment at trial, we say that the parties are relatively
optimistic
• Defendant’s offer reflects the expected value of his legal liability

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• Relative pessimism makes settlement out of court easy

• If the defendant overestimates the plantiff’s injury, and the plantiff overestimates
the defendant’s precaution, then both parties are relatively pessimistic, so
settlement is easy
• To correct relative optimism, one party gives the other some news – information
previously unknown to the receipient. The news is bad if it causes the receipient
to expect a worse result at trial and thus is good for settlements

B. Bad News is Free

• Voluntary pooling of info occurs informally through discussions b/w parties and
formally when a judge holds a pretrial conference
• Some pooling is compulsory
• This practice is called discovery
• In general the parties tend to disclose information voluntarily before trial to
correct the other’s side’s relative optimism, thereby promoting settlements (bad
news is free)
• Similarly the parties tend to withhold information that would correct the other
side’s relative pessimism thereby promoting settlemetns
• Discovery tends to uncover the information that was withheld
• Parties tend to discover information that corrects their relative pessimism, thereby
causing them to demand better terms to settle out of court
• Voluntary disclosure -> corrects false optimism -> causes settlement
• Involuntary disclosure (discovery) -> correct false pessimism -> cause trials

C. USA. Vs. Europe (time permitting look over)

D. Minimizing Social Costs:

• Voluntary pooling of information usually reduces both components of social costs

– administrative and error. This is because involuntary information reduces the
gap b/w the terms of settlement and the expected trial judgment thus reducing
error costs
• Unsure if discovery reduces admin. Costs
• Discovery also corrects some miscalculations, thus it also reduces error costs

IV. Settlement Bargaining

• Bargaining can happen anytime in the legal process

• Bargaining is more important than trials for the resolution of most disputes.
However, expectations about trials determine the outcomes of bargains

A. Settlements Replicating Trials

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• The difference b/w the joint payoff from coop and the noncoop value of the game
equals the coop. surplus
• If parties agree to terms without a trial, judge would have enforced it thus a
settlement could achieve the same outcome as a trial, and the parties would save
the cost of litigation
• A settlement out of court is cooperative solution and a trial is not because the
savings in the cost of a trial could have been divided b/w the parties making them
both better off and thus trials are usually inefficient
• Because a trial requires no coop. the plaintiff’s expected value of trial equals his
threat value in bargaining
• The sum of the threat values equals the noncoop. value of the game
• Coop surplus = coop value – noncoop. value
• A reasonable settlement equals threat value plus half the coop surplus. The
defendant should pay him that plus how much it will cost the plaintiff in
settlement cost
• You can check if the reasonable settlement reflects the expected judgment
• Admin costs are lower and error costs are the same, therefore a settlement that
replicates the expected judgment at trial reduces social costs
• In general the reasonable settlement equal the expected judgment at trial when (1)
the plaintiff and defendant have the same expectation about trial and (2) the
plaintiff and defendant bear the same transaction costs to resolve the dispute

B. No settlement

• The computation of the surplus from cooperation as perceived by the parties can
be called the putative cooperation surplus
• Higher relative optimism can reduce the putative cooperative surplus
• If relative optimist reduces the putative cooperation surplus below zero, then
settlement cannot occur
• Relative optimism is measured by the difference in the expected judgement of the
two parties and can be denoted DeltaEJ
• By settling parties save the costs b/w litigating and settling LC- SC
• The expected surplus from settling becomes negative, making trial inevitable,
when relative optimism exceeds the difference in costs b/w litigating and settling
• DeltaEJ > LC – SC -> Trial

V. Trial

• Litigation costs come in three kinds

1. Fees – lawyers command high fees, bar monopoly and specialization
2. Delays – Trials can be backed up and thus can take a while for trial to occur
3. Uncertainty – Lack of clarity in law and uncertainty about how a cour might
resolve an issue imposes unpredictable costs on people caught in legal
disputes

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• Compared to litigation, arbitration procedures have fewer formalities, weaker

procedural rights, and tighter restrictions on appeals. This makes them simpler
and quicker then trials
• Arbitration means following the rules of an arbitration association
- one issue is that given ignorant consumers, business can often stipulate
arbitration procedures and arbitration organizations that favor business

A. Independence Vs. Alignment:

• When judge develops case actively, lawyers must respond to the judge, lowering
the scope of lawyers developing an argument. When Judges are more passive
refereses, lawyers take more of an active role
• Instead of aligning public and private interests, independence severs the link b/w
the judge’s decision and their own wealth and power
• With judicial independence the outcome of a case decided by a judge does not
affect his or her wealth or power
• Judges thus gain nothing material from devoting more effort to a case
• Thus judges have incentives to do what is right and easy, whereas lawyers have
incentives to do what is profitable and hard. Thus finding facts is more vigorous
under lawyer dominant system (adversarial vs. inquisitional)
• Unlike Judges, jurors are required to serve and their compensation is nominal
• Jurors and lay judges tend to give more weight to social norms, which they
understand more so then to formal law in deciding cases

B. Should the loser pay all?

• Most civil disputed involve two issues: liability and damages. The expected
judgment equals the probability of liability multiplied by the damages
• In suits with low probability that the plaintiff will win, a rule of loser pays all
increases the expected costs of the plaintiff relative to a rule of each pays his own
• In general the rule of loser pays all discourages suits with low probability that the
court will find liability
• When the parties estimated probability that the court will find liability for the
plantiff is not low, the rule of loser pays all generally encourages trials caused by
false optimism
• In disputes that concede liability and contest damages, the winner can be defined
by the difference b/w the last offer to settle and court judgment. (if judgement <
settle, party rejecting offer pays litigation costs
• In disputes that concede liability and contest damages, the rule of loser pays all
discourages trials by penalizing hard bargaining because an increase in what you
ask for means a greater chance you wont get it in court and thus you increase the
risk of paying the litigation costs

VI. Appeals:

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• Appeal courts have two functions

1. Correct mistakes in decision made by lower courts
2. they make law, either directly as in common law or indirectly through the
interpretation of statutes

A. Correcting mistakes:

• the system of appeals keeps monitoring costs low because litigants typically
appeal when the lower court makes a mistake
• a rational litigant does not appeal a case unless the expected value of appealing
exceeds its cost
• Look at pg.411 for an example of how it lowers social costs
• Appeal courts are likely to lower social costs when
1. When the appeals court is more likely to reverse an error by the lower court
than to reverse a correct decision
2. When this behavior by the appeals court causes litigants to appeal errors with
higher probability than the probability of appealing correct decisions by the
lower court

B. Efficiency of the litigation market:

• What should be the size of government subsidy in Trials:

• When an appeals court decided a matter of law, the precedent affects many people
other than the parties to the dispute. Because the parties to the dispute do not
internalize most of its effects, they should not pay most o its costs. The state
should subsidize appeals on matters of law because of the public value of
precedent. This argument does not apply to deciding disputes that mostly affect
the plaintiff and defendant.
• Litigation can make the law more efficient without the conscious help of judges
• This might occur through what is called selective litigation.
• Assume that inefficient laws are litigated more than efficient laws
• By assumption inefficient laws are repeatedly challenged in court, whereas
efficient laws are challenged less frequently
• Under these assumptions, selective litigation works like a strainer that catches
inefficient laws while allowing efficient laws to slip past
• In order for selective litigation to cause the law to evolve toward efficiency,
selection must be biased against inefficient laws
• In general the party who values a legal entitlement the most will spend more on a
suit to obtain it than anyone else. So an inefficient allocation of an entitlement
will provoke more expenditure on litigation than will efficient allocation

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• Litigation against inefficient laws will tend to be more successful than litigation
against efficient laws
• This effect of automatic efficiency however is weak compared to markets
• A law is by its nature general in the scope of its application, so challenging a law
affects everyone who is subject to it. The effects of new more efficient precedent
spill far beyond the litigants in the case in which the precedent is set
• People free ride on the befits of the plaintiffs success
• Free riding is more powerful than inefficiency in channeling litigation pressure

C. Enacting Social Norms:

• Besides litigation pressure, another possible cause of efficiency is competition

among “social norms” by which we mean norms that arise outside of the legal
system
• If judge make laws evolves in the same direction as social norms then competition
in the market for norms will drive judge made law toward efficiency
• Instead of making rules, English judges then tried to find out what rules already
existed among the merchants and selectively enforced them. Thus, the judges
dictated the conformity to merchant practices, not the practices to which they
should conform
• The modern economy creates many specialized business communities and norms
arise in them to coordinate the interaction of people
• As the economy develops and becomes more complex, social norms should
become more important as a source of law
• More efficient norms win competition of norms alliance
• Social norms evolve toward efficiency when they coordinate the behavior of
people in long-run relationships and when the effects of the norms do not spill
over to other people

D. Efficiency as a Judicial Motive:

• Private decision makers face efficient incentives when they bear social costs
• Judges may call tort law, a requirement that injurers show equal concern for
harms suffered by others as for themselves
• In a common law system, a court may take such a case as the occasion to change
the law from the old all or nothing rule to the new rule of comparative neg.
• Judges have the power to abandon a rule in favor of an alternative that makes
everyone better off in the future
• A change in which there are some losers is not a Pareto improvement, so the
Pareto standard of efficiency in its simplest interpretation does not provide a
guide to adjudicating disputes
• If the prospective application of a new rule makes some people better off and no
one worse off, we will say that the new rule is an improvement by the Pareto
standard

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Chapter 11: Topics in the Economics of the Legal process:

I. Complaints, Lawyers, Nuisances, and Other Issues in the Legal Process:

A. Filing Complaints:

• Three immediate causes of the filing of legal complaints:

1. Injuries that trigger disputes
2. The cost of filing complaints, and
3. The expected values of the claims
• An increase in the money damages awarded at trial increases the expected value
of a trial (EVT), which increases the expected value of the legal claim that leads
to more claims being filed
• At the same time, if the damages awarded increase, or the likelihood of the
plaintiff winning increases, or both, then the expected damages increase may
induce potential defendants to take more precaution and thus give potential
plaintiff’s less opportunity to file legal complaints
• Graphically there is a point d́ (expected damages) where number of
complaints filed is the highest. Before it, a small increase will lead to more filed.
Past it, a small increase in expected damages will decrease the number filed

B. Filing Fees and the Number of Legal Complaints:

• Countries government often subsidize a portion of the legal fee from tax payers
dollar, this ranges from 0-100 percent
• Where the litigants pay low fees (Mexico and Chile), the court often spends little
on deciding a case, relying primarily on written documents rather than hearing
testimony
• Filing cost (FC) act as a filter for disputed, high value disputes pass through the
filter and result in lawsuits, whereas low-value disputes are caught by the filter
and do not result in suits because Expected value of legal claim (EVC)<FC
• An increase in FC increases the min. value of suits while decreasing the number
of complaints filed (Reverse effect if FC is decreased)
• Authorities should set the fees charged by the court for filing a legal complaint to
minimize the sum of the admin. Costs and error costs: min [ca + c(e)]
• For the marginal case, the filing cost equal the expected value of the legal claim
FC = EVC
• This model predicts that free trials will result in the filing of more claims than a
system with court costs

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• Costs in America by individual parties fall short of the full cost to the state of a
trial, endind subsidy would result in fewer trials
• Furthermore, is the true cost of the jury were included in the court fees assessed
against the parties then fewer parties would request a jury trial and more of them
would be consent to let the judge decide the facts of the case

C. Supply of Legal Services:

• The effect of an increase in the number of lawyers depends upon the organization
of the market for legal services, which the bar regulates in all countries
• In a free market with “lax regulation” an increase in the supply of lawyers should
lower the cost of filing suits
• A fall in the price of lawyers causes the equilibrium demand of lawyers to go up
which can be interpreted as more suits to be filed
• The cost a lawyer will work per hour on min is equal to his expected gain from a
case divided by the amount of hours it will take him to prepare
• As the number of lawyers increases, opportunities available to them decrease and
thus they start taking cases that no lawyer previously would have taken
• The bar exercises this power to primarily by setting high professional
qualifications for the right to argue in court or supply other legal services
• When the law prescribes a schedule of fees for legal services and the fee schedule
is enforced effectively, an increase in the supply of lawyers cannot change the
fees for legal services thus an increase in lawyers causes an excess in supply
(quantity supplied – quantity demanded) leading to unemployment
• In general prohibition of price competition leads to quality competition and secret
discounting (free bonus services)
• An increase in the difficult of the bar exam reduces the supply of members of the
bar

D. Agency Problem:

• In a legal dispute, the plaintiff puts a legal claim under the lawyer’s control, the
lawyer can serve or exploit the client
• To maximize joint payoffs, the lawyer should work on the case until the marginal
cost equals the marginal benefit for both parties. The marginal cost of the lawyer
time spent on a suit equals its value in the best alternative use (opportunity cost)
• Contracts with lawyers usually focus upon three variables (1) time spent working
(2) services performed (3) outcome of the disputes
• Hourly billing causes lawyers to externalize the cost of working on a case, which
gives them an incentive to devote too much time to it
• Fee for service contracts cause lawyers to internalize the cost of additional time
spent on the service and to externalize the benefit, which gives lawyers an
incentive to devote too little time to performing a service

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• For contingency fees, the lawyer internalizes the cost of additional time spent on
the service and internalizes a portion of the resulting benefit
• All thee ways distort incentives in different direction
• A lawyer who is paid by the hour or per service may exaggerate the EVC
inducing a client to pay for filing a complaint
• A lawyer that takes a contingency, may mislead in the opposite direction because
they internalize the full cost of filing a complaint and only internalize a portion of
the benefit thus they might refuse even if EVC> FC
• In general the agency problem b/w lawyer and client has two causes: asymmetric
information and randomness
1. Asymmetric information: the lawyer knows more about the law then the client
2. Randomness: the judge, availability of witness, jury, prevent the client from
inferring the lawyers performance from the case’s outcome
• To overcome these problems, people often chose lawyers based upon reputation
and long run relationships

E. Nuisance Suits:

• The reasonable settlement equals the expected judgment at trial when (1) the
plaintiff and defendant have the same expectations about the trial (2) the plan tiff
and defendant bear the same transaction costs (litigation costs)
• The party that costs litigation more has a weaker bargaining power
• The plaintiff files a complaint to extract settlement
• The plaintiff expects to win nothing at trial and expects the defendant to buy him
off. The defendant pays off in order to avoid high costs
• Before settling, a defendant has to ask if a plaintiff is able to afford going to trial
or if they are just bluffing

F. Offers as Filters:

• Defendant can use settlement offers to filter plaintiffs and determine the true
extent of their injuries
• Defendant cannot determine the true extent of injuries before trial and the
defendant cannot make a settlement offer to each plaintiff that equals the
individuals injury
• Defendant contemplates making the same offer to each plaintiff and those with
minor injuries will accept and those with more will not
• Plaintiff will reject the offer if the true cost of injury exceeds the offered
settlement plus how much it cost them to go to trial (Award at trial – cost of trial >
settlement)
• Minimize liability by balancing the costs of settling and judgment/litigation
• Defendant does this by continuously raising settlement until the decrease in cost it
results is zero (Look at numerical example on pg.432)

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• The equation of cost goes: (Past number settled)(change in settlement) –

(additional number settled)(Admin/litigation cost) + (new settlement)(new
plaintiff who accept) – (an average of court settlement)(number of people who
settle instead of court)
• When it comes to nuisance cases, plaintiffs bluff. When players sometimes bluff
in a game, their opponents usually benefit from calling the bluff some portion of
the time (This implies settle with nuisance cases with low probability and settle
with all of the other plaintiffs with higher probability that minimizes cost)

I. Burden of Proof and Standard of Proof:

• Economic theory has developed a precise calculus for making decisions under
uncertainty called maximizing subjective expected utility
• Procedural rules impose constraints on decision making under uncertainty. Within
these constraints judges and juries presumably strive to reason like rational
decision makers
• Within constraints of fairness, the rules of statistical reasoning provide an
appealing standard of rationality to which courts should aspire
• A good model of court behavior assumes consistency with statistical rules, even
though courts seldom use the language of probabilities and statistic
• A juror asked by the judge to construct a probability estimate (called a prior by
stats) of the defendants liability or guilt, this assumes no knowledge of particular
facts pertaining to the case
• Without prior evidence, the jury should revise their beliefs exclusively in light of
the evidence admitted during the trial
• The constructed prob. Estimate favors the defendant because the plantiff has the
burden of proof
• The jury updates the constructed prob. Estimate in light of the evidence allowed
to enter the trial, called posterior distribution
• If this prob. is above 50 percent the plaintiff has proved the case by the
preponderance of evidence and deserves to win
• Reasoning in the courtroom may thus be describes as constrained rational choice
under uncertainty where the constraints are formed by rules of evidence
• Evidence based upon mere probabilities is unfavorable by the court
• Evidence by eye witness is more favorable but still cautiously viewed
• Instructions in court for combining evidence often obscures or contradicts the
rules of prob. theory (Example from pg. 339-340)
- The decision tree clarifies the fact that independent and sequential application
of the preponderance of the evidence standard sometimes gets a different
result from an over all judgment. The latter approach of joint probability in the
tree is more correct from the viewpoint of prob. theory then independent

Chapter 12: An Economic Theory of Crime and Punishment

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I. The traditional Theory of Criminal Law:

• Economic theory of crimes distinguishes between harms caused by crime and the
cost of preventing it. Law should minimize the sum og the costs of crime and its
prevention which yields the optimal amount of crime
• An act should be treated as crime and punished if doing so reduces social costs.
The severity of the punishment should be calibrated to minimize social cost.
Highly utilitarian
• Retributivist on the other hand say punishment extent should be proportional to
the seriousness of the crime, or how morally wrong it is. Disproportionate
punishment is wrong even if it reduces social costs
• Criminal law based on the traditional theory of crime differs from civil law by the
following characteristics:
1. The criminal intended to do wrong
2. The harm done by the criminal was public and private
3. The plaintiff is the state
4. The plaintiff has a higher standard of proof
5. If the defendant is guilty she will be punished

A. Criminal Intent:

• The law makes a distinction between accidental and intentional harm. Tort law
mostly concerns accidental and criminal law concerns intentional
• Careful (blamless) | Legal Standard | Negligant -> Reckless | Seperating Civil and
Criminal Wrongs | intentional -> cruel

B. Public Harm and Public Prosecuion:

• In criminal law much of the harm is public

• A murder threatens the peace and security of society at large
• Blackstone (traditional view) -> crime harms the public while tort merely causes
private harm
• Crime harms the public has several implications:
1. it justifies the difference between plaintiffs in a civil and criminal suit
2. Idea that crime harms public implies the possibility of victimless crimes,
which the traditional theory claims has victims, namely the peace and security
of society
3. The traditional theory of public harm justifies punishing attempts to cause
harm, even when they fail because the cause fear to the public

C. Standard of Proof:

• High standard of proof

• Traditional theory gives three reasons to why:

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1. Convicting innocent is worse then failing to convict a guilty. Type II error vs.
Type 1 (false positive is worse then false negative)
2. Heavy burden diminishes the advantage of the prosecution having a lot of
resources provided by the state
3. Citizens may need protection from overzealous prosecutors who seek
advancement
- Some countries have strong relationships b/w prosecutor and judge to
minimize error cost due to wasting the courts time

D. Punishment:

• Three most common forms of punishment: imprisonment, probation, and fines

• Punishment in criminal law makes the injurer worst off without benifiting the
victim. Thus issues of compensation and punishment are independent of each
other
• Monetary punishment is a sum of money that makes the injurer prefer no injury
rather than the injury with payment of money (see example pg. 460)

II. Economic Theory of Crime and Punishment

• Goal of criminal law policy: minimize the social costs of crimes

A. Inadequacy of Tort Law, Necessity of Criminal Law:

• For several reasons, civil suits such as tort law cannot internalize the costs of
crimes
• The first reason concerns some inherent limitations on compensation
• In some cases damages can deter unreasonable risk but cannot compensate for
actual harm. It would be better if these in-compensable harms did not occur
• Criminal punishment aims to deter intentional harms, not to compensate for them
(indifference is a hard concept to apply to crimes such as assault)
• Thus criminal law is a necessary supplement to tort law when perfect
compensation is impossible (even if its possible, there is no objective way to
know how much the loss is worth because injuries are not sold on the market)
• Second if perfect compensation is possible, going about your business without
interference from others is part of liberty. Protecting interests secures wealth, and
protecting rights secures liberty
• Good economic arguments for protecting rights more vigilantly than interests
• Remedies in criminal law should in part, be set so to protect and encourage
voluntary exchange through markets
• Third, punishment is often necessary for deterrence. Civil liability alone without
punishment makes things like theft profitable
• Punishment be impose so the expected net benefit of a crime to the criminal is
negative

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• As the actor’s psychological commitment to the act increases, deterring the actor
requires a larger sanction (for repeat offenders and more serious crime such as
first degree), this commitment however does not affect the goal of internalization
because the cost to other depends on the harm caused by the act, not the actors
commitment to doing it
• In conclusion acts should be punished when the aim is deterrence, whereas acts
should be priced when the aim is internalization. The law should aim for
deterrence when perfect compensation is impossible in principle or in practice,
when people want law to protect their rights instead of their interests, or when
enforcement errors systematically undermine liability

B. Rational Crime:

• A rational amoral person is someone who carefully determines the means to

achieve illegal ends without restraint by guilt or internalized morality
• Crimes can be ranked by seriousness (x)
• More serious crimes have larger payoffs (y)
• y = y(x), increases in x
• Punishment can be ranked by severity, f
• More severe punishment to more sever crime
• so f = f(x) increases in x
• Thus for punishment to be effective, f(x) > y(x)
• If every crime were punished with certainty, committing rime would not pay and
the criminal would choose x = 0
• In reality punishment is probabilistic
• The expected punishment curve pf lies below the actual punishment curve f
because probability of punishment is less then 1
• Probability p of a sanction is a function of the crime’s seriousness, p= p(x) and
increases in x because more effort is given
• Thus the expected sanction p(x)f(x) increases in x
• Sometimes people are in positions where crime does pay, this is when y(x) lies
above p(x)f(x)
• As seriousness of crimes increase, the actual payoff increases more slowly than
the expected punishment
• The expected profit equals the dif. b/w y(x) and p(x)f(x)
• The vertical distance is maximized (graph pg. 466) when the seriousness of the
offense equals x* (the amount a rational criminal is serious)
• x* solves max y(x) = p(x)f(x)
• the criminal maximizes the net benefits of the crime by embezzling an amount of
money up to the point at which the marginal benefit of an additional amount
embezzled equals the marginal expected punishment
• y’ (criminal’s marginal benefit) = p’f + pf’ (criminal’s marginal expected cost of
punishment)

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• for values below x* MB>MC so criminal increases seriousness

• the marginal expected punishment for embezzling has two components: (1) the
change in the probability of punishment, p’, multiplied by fine, and (2) the change
in the severity of punishment, f’, multiplied by probability
• p’ and f’ are usually positive thus the expected punishment curve slopes up
• According to the equation changing p’ or f’ will decrease the seriousness of the
offense

C. Applying the model of rational crime to public policy

• Instead of interpreting x as the seriousness of a crime that someone commits, we

interpret x as the number of crimes of given seriousness that someone commits
• For crimes of given seriousness the criminal’s payoff y, is an increasing function
in the number of crimes he or she commits, same goes for punishment and
probability of punishment
• Summing the number of crimes of a particular type committed by each criminal
gives the aggregate number of these crimes in society, denoted X where
X =∑ x
• As expected punishment, pf, rises, less crime is committed/ stopped thus
aggregate crime is downward sloping (First law of deterrence)
• Economists have a lot of confidence in the first law of deterrence
• Another question is about how much do crimes respond to increases in expected
punishment, in other words the interesting question concerns the elasticity of the
supply of crime
• If supply is elastic, pf is effective. If not variables encompassed by the economic
model of rational crime are less important then other variables such as
employment, family structure, drug addiction, schooling
• Our simplifying assumptions: We assume an informed criminal, who knows the
costs, benefits, and probabilities associated with crime; we assume a risk neutral
criminal; and we assume that all the criminal’s costs and benefits are monetary

D. Criminal Behavior and Criminal Intent:

• Economists usually describe the economic model of decision making as an

account of behavior not as an account of subjective reasoning processes yet
criminal law concerns reasons (intent) not just behavior
• Criminal intent is often distinguished according to the level of deliberation
• The economic model may be understood as an account of the deliberations of a
rational, amoral person when deciding in advance whether to commit a crime
• In the case of premeditated crimes, the economic model may correspond to the
actual reasoning process of a criminal
• In the case of spontaneous crimes, where there is no deliberation, the economic
model may nevertheless be understood as an account of the criminal’s behavior
but not of his reasoning (act as if rather then acting because)

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• Act as if they deliberated = when presented with the opportunity to commit

crimes, they respond immediately to benefits and risks as if they had weighted
them
• If the statements above are true, empirical investigations should demonstrate that
crime rates respond to considerations identified in our model, specifically, that
crime rates respond in the predicted manner to punishments and payoffs

E. Diminished Rationality – Saturday night fever

• Many crimes occur under conditions of diminished rationality, which may result
from lapses which are temporary aberrations in behavior
• Prudence involves giving reasonable weight to future events, whereas imprudence
involves giving unreasonably little weight to future events
• Occasional imprudence is a kind of lapse in which the actor temporarily discounts
the future consequences of his or her behavior at a much higher level than
ordinarily would be the case
• In terms of illegal acts, a high discount rate prevents the actor from giving as
much weight on future punishment as he/she would ordinarily give
• In a probability distribution, when a person draws a very high discount rate from
the tail of the distribution, the person may lapse and commit a crime
• The tipping point denoted r* is the discount rate at which the immediate benefits
equal the expected future costs. If discount is above r* they commit and if not
they don’t (shaded area of distribution is the probability they commit)
• The probability distribution on pg. 471 assumes that mood is unpredictable at any
point in time but distributed predictably over time
• An increase in the variability of moods increases the probability of wrongdoing
by the actor
• Young people have volatile emotions which corresponds to high variance and the
tipping point being closer to the center
• Whenever the actor draws a discount rate close to the tipping value r*, a small
change in punishment c, can tip the decision one way or another
• The prob that r is close to r* is low
• When r is not close to r*, a small change in punishment cannot tip the decision
one way or another
• For lapses that cause crime, more severe punishment is not a very effective
deterrent. This is because increasing the punishments severity gets discounted too
much to have a large effect on behavior
• This implies that certainty of punishment is relatively important for impulsive
youths that cause crime cause of lapses, and severity is relatively more important
for deliberative adults
• Empirically data shows no decrease in the probability of committing crime when
a person turns 18 even though severity of crimes goes up
• More certain punishment may deter suggesting that redirecting money from
prisons towards police might reduce youth crime

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• This model also predicts that social policies can reduce crime by reducing the
variability in moods
• When people discount the future unreasonably (future vs future, present vs.
future), the immediate gain from doing something wrong attracts them more
strongly than the threat of future punishments and thus increasing severity has
little effect

F. The economic goal of criminal law:

• Crime imposes various costs on society which can be reduced to two kinds
• (1) Criminals gain something and the victims suffer harm to their persons or
property
• The net loss equals value destroyed, not redistributed
• (2) The state and the potential victims of crime expend resources to protect
against it
• Criminal law should minimize the social cost of crime, which equals the sum of
the harm it causes and the costs of preventing it
• Another cost is opportunity cost. Criminals divert the efforts from legal to illegal
activities, opportunity cost may be large enough to deter
• Another complexity concerns the criminal’s perceived benefit from crime and if it
is a social benefit or not
• When policy makers disagree about the social benefits of crime, a good strategy
for economists is to clarify the issue without trying to resolve the dispute

G. Optimal amount of crime deterrence and of efficient punishment

• The curve MSCD represents the marginal social costs of achieving a given level of
crime reduction (slopes upward because easy deterrence to harder deterrence)
• MSB measures the marginal social benefit of achieving various levels of crime
reduction or deterrence (slopes downwards because benefit to a small reduction in
the amount of crime declines as the total amount of crime declines)
• Socially optimal deterrence occurs at the point where the marginal social cost of
reducing crime equals the marginal social benefit
• Changes in both can change the optimal level of deterrence
• Suppose that the opportunity cost of resources devoted to deterring crime falls,
and MB stays the same. MSCD would fall and the optimal level of deterrence
would increase
• One important simplification is that we have not modeled an optimal schedule of
punishments for related crimes, using powerful deterrents on less serious crime
often precludes using them on more serious crime
• Thus harsh penalties for minor crimes undermine the deterrence of serious crime
• Noneconomic considerations such as the morality of punishments and the bap b/w
severity of crime and punishment can operate as constraints upon the computation
of optimal deterrents

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H. Mathematics of Optimal Means of Deterrence:

• There are many allocation decisions to be made

• Consider a choice b/w more certain or more severe
• To keep the analysis simple, assume that the amount of crime is constant when
expected punishment is constant
• Thus the socially efficient combination of severity and certainty is the one that
cost less
• One reasons fines cost less are because the higher probability of certainty requires
more expenditures whereas a severe fine costs no much more to collect than a
small fine
• Large fines with low probability are cheaper then low fines with high prob.
• Criminal who cant pay fines require incarceration
• In economic jargon, we say that the incarceration enables the sanction to escape
the criminals bankruptcy constraint
• Incarceration is more costly then fines
• The optimal combination of fines and incarceration includes the maximimum fine
that the criminal can pay. Thus it can be more efficient to increase a criminal
ability to pay fines
• In respect to the length of incarceration, with unreasonably high discounting,
adding time at the end of the prison sentence has little deterrence value
• The cost of one additional police = 3 years of incarceration
• If hiring an additional policeman and reducing average prison sentences by three
years results in less crime, crime can be reduced at no additional cost

I. Private Deterrence:

• Do private citizens have incentives to inves optimally in dettering crime

• In general the answer is no
• Private citizens are mostly concerned with private cost and benefits, which do not
align with public costs and benefits
• Private deterrence such as door locks benefit the private investor in precaution
• Public deterrence benefits the public
• Private deterrence has little social benefit if it results in redistributing rather then
preventing crime
• Private investment in preventing crime usually has all three effects
• The state should only encourage private investments that contributes to public
deterrence
• Ex-ante observable precautions (bars, alarms) tend to redistribute crimes
• Ex-post (begin committing a crime) include locks, interior alarms, guns. These
precautions promote public deterrence by reducing the average profitability of
crime

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• Thus state should encourage ex-post

J. Bad Crimes and Good people: *Confusing Section Re-read if time

• The reluctance of citizens to support the police perpetuated high crime rates in
some neighborhoods and encourages gang acitvites
• The sacrifice required of each person to do a civic duty often decreases with the
number of people who do it
• With groups pressures an increase in an act’s popularity lowers its cost
• Demand and supply intersection shows the equilibrium level of civic acts
• If the actual proportion is below, people are willinf to pay more then it cost so the
proportion of actors increase
• Where the proportion s low, high crime occurs
• The criminal law can coordinate citizens so that society achieves a low-crime
equilibrium

Chapter 13: Topics in the Economics of Crime and Punishment:

I. Crime and Punishment in the US

A. Crime Rates:

• Trends:
1. rate of most crimes decreased to a low point in early 60s
2. B/w 60s and late 70s a rapid and unprecedented increase in the rate of all
crimes
3. B/w 80s and the early 90s the rate of most nonviolent crime decreased, the
rate of violent crime decreased slightly
4. From the early 90s to 2008 both violent and nonviolent crime continued to
decline but at a slower rate
• The united stats has been the leader of the instrialized world in homicide rates
• Homicide and other violent crime rates in the US have been falling

B. Imprisonment Rate:

• Legislators responded to the increase in crime by increasing the severity of

punishment especially imprisonment
• Imprisonment rate has been rising

C. Causes of Crimes:

• First most large cities in the US have violent crime rates that are much higher than
those in their suburbs

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• Second a disproportionate amount of criminals are young males, changes in crime

rates often follow changes in the distribution of people by age
• The increase in the amount of crime b/w 60s and 80s, however, was so large that
the increase in the population of young males explains only a fraction of it
• Third violent criminals and their victims in the US are disproportionately African
Americans. One side blames discrimination as the cause and the other side locates
the problem in black society
• Fourth a small number of people commit a large proportion of violent crimes.
Sociological factors attributed to these individuals suggest a connection between
crime and the economy. This connection however is weak because economic
booms have occurred in times of crime booms, and recessions have occurred
without increases in crime
• A possible for the increased crime rates, at least through the early 1990s, one that
is in keeping with the economic theory of the previous chapter, is that the
expected punishment for committing a serious crime has fallen

B. Social Cost of Crime:

• The easiest costs to document are state expenditures on preventing crime and
punishing criminals
• 1/3 police protection, 1/3 prison systems, courts and criminal justice
administration is the other 1/3
• Individual prevention of crime is harder to estimate
• the value of lost property and the losses to individual victims of crime are the
most difficult elements of the social costs of crime to estimate
• Many indirect costs such as medical (amount has not changed much)

II. Does Punishment Deter Crime?

• The detterence hypothesis holds that crime decreases significantly – the supply of
crime is elastic with respect to punishment
• Another hypothesis is that certainty and severity do not significantly deter
• This alternative hypothesis claims that the appropriate way to minimize the social
costs of crime is to attack socio-economic root causes of crime with social
programs and welfare

A. Deterrence

• Issac Ehrlich – holding all other variables constant, the higher the probability of
conviction for robbery, the lower the robbery rate
• Alfred Blumstein – a higher probability of conviction and a higher level of penaly
caused a lower rate of draft evasion
• Other studies also found a significant deterrence effect

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• Professor Ann Witte – she concluded that the higher the probability of conviction
and imprisonment, the lower the number of subsequent arrests per money out of
prison
• There is mixed evidence on the effect of deterrence

B. Economic conditions and crime rates:

• An increase in the opportunities for earning income leally should cause a decrease
in criminality
• But this is not true because, when economy prospers, more oppurtunities for
crime and when its worse, less opportunity

C. Does crime pay:

• Wilson and abrahamse conclude that career criminals are tempermentally

disposed to overvalue the benefits of crime and to undervalue its costs because
they are inordinately impulsive or present oriented. In economic terms these
people discount punishments for uncertainity and futurity highly than other people
do

D. Abortion and Crime:

• Donohue and Levitt divide legalized abotions effect on the decline in crime in two
effects
• (1) the cohort size effect points to the reduction in the number of 18-year old
males as an important explanation of the decline in crime
• (2) Cohort quality effect says that the young men who were not born because of
abortion, was such that they would have been even more likely to commit crime
and other anti social acts
• their research however falters under intense scrutiny

III. Efficient Punishment

A. Imprisonment

• Social benefits of incarceration

1. Deterrence
2. Retribution – varying lengths
3. Rehabilitation – do not commit more crimes
4. Incapacitation – cannot commit crimes on society
• Two conditions must be met for incarceration to reduce crime rates
1. Criminals incapacitated by imprisonment must not be replaced immediately
by new criminals – when supply of criminals is inelastic
2. In order for incarceration to reduce crime, imprisonment must reduce the total
number of crimes committed by repeat offender over their criminal careers

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- Incapacitation may reduce crime caused by youthfulness

• Social costs of imprisonment
• Direct costs – the cost of the criminal justice system
• Opportunity cost
- “factories with fences” – invite private industry to hire prisoners to produce
marketable goods, in place where this is implements prisoners compete for the
jobs with signs of good behavior
• Sentencing Reform:
• Two reforms in the sentencing of prisoner may have caused the sharp increase in
the number of prisoners
1. indefinite sentencing (a range) replaced with mandatory sentencing with less
Judge discretion
2. Three strikes policy

B. Fines:

• US crimes are more violent thus more severe punishment is needed then just fines
• US offenders tend to be repeat where prison is a better sanction and Europeans
tend to be first time offenders that fines may be preferred
• A third possible difference is that Europeans are more responsive to punishment
then US
• Europeans use the day fine that helps spreading the payment and this overcomes
the problem that fines can be large relative to income or wealth

IV The Death Penalty:

• Public support is high for it but is declining

A. The Deterrent Effect of Capital Punishment:

• Thorten Sellin 4 Tests
• No difference in adjacent states that did and did not have the death penalty
• Found no significant in those states depending on the legal status of the death
penalty (Penalty -> Abolished -> reinstated)
• Third, where execution was publicized, there was difference in homicide rates
before or after the execution
• Rates at which police officers were killed were the same b/w states with or
without the death penalty
• In conclusion death penalty does not deter homicides
• Other results like Enrich found that per execution resulted in 7 less homicides but
there were empirical shortcoming to this
• Furthermore, greater use of execution as the punishment, homicides might lead to
fewer convictions because juries don’t want to sentence to death. This would lead
to a loss of any deterrent effect of convictions
• Its mixed but not a compelling argument for its deterrent effects

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B. The Social Costs of Capital Punishment:

• High admin cost

• Expensive trials due to higher effort and split of trial to determine guilt and then
to determine penalty
• The post conviction legal proceedings in death cases have become elaborate and
expensive
• Even including the appeals process, the costs of the death penality t the state are
high. Imprisonment on death row is twice as expensive as imprisonment among
the normal prison population

C. Conclusion on Deterrence and Capital Punishment

• Statistical evidence does not support the firm conviction that executions deter
homicides
• Plus wrongful convictions in death row is disturbing

V. The Economics of Addictive Drugs and Crime:

• Drug addicts need to commit crimes to generate incomes

• Drugs, like alcohol, may cause people to commit crimes by undermining the their
inhibitions and increasing the volatility of their moods
• Drug dealing is a lucrative business, and, therefore, a business worth protecting
against competition (violent crimes on competetors)

A. Punishing Drug Sales:

• One means of reducing the supply and lessening the use of illegal drugs is to
increase the expected punishment for selling or using them
• Suppliers will leave, and higher price f drugs may cause less people to purchase
• Critics argue that the addiction makes the demand for the drugs inelastic.
Therefore, a restriction in supply and the resulting increase in price will not cause
a reduction in consumption significantly and will instead cause him to increase
the amount of crime he commits to produce the greater revenue required to
support his habit
• Raising the price of durgs has a little effect on frug use by addicts and a large
effect on nonaddicts
• An increase in price leads to a large increase in expenditures on drugs by addicts
because they buy a similar quantity for a much higher price
• The best way then is to somehow raise the price for nonaddicts while keeping it
the same for addicts

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• One way is for addicts to get licences to buy their drugs legally for a low price,
while people with no addiction cannot get a license and thus must pay a much
higher price that deters them
• Its different from companies who try to maximize profits by selling at a higher
price to inelastic consumers, here we sell at a lower price

B. Suppressing and Interdicting:

• Suppression has usually met with failure because for drugs such as opium and
heroin the world market is too large. Production is too flexible and can move
around. Thus if suppressed in one place it rises in another.
• The attempt to restrict the import of illegal drugs has failed due to the inability to
effectively monitor all trafficking

C. Legalization:

• Legalization would increase tax revenue by almost the amount we are spending to
eradicate thus legalization would save 88 billion per year in the US
• All the social costs of illegal drugs are only a fraction of the social costs imposed
by alcohol and tobacco
• The prohibition proves that while alcohol causes crime, its prohibition caused
more crime because during the prohibition the murder rate rose to that of drug
dealers in the 80s
• Tax on legal good could cause a greater reduction in output and increase in price
than would optimal enforcement, even with a rise of black market
• The conclusion is we should decriminalize, regulate, and tax, using tax revenue to
finance advertising against the use of drugs and helping addicts

VI. The Economics of Handgun Control:

• Does gun ownership cause crime or does crime causes gun ownership
• Guns makes criminals more dangerous and crimes easier
• Guns make victimization harder and crime more risky

B. Gun Control:

• The effort to break the connection b/w handgun and crime has focused on two
methods. (1) Restrict production and possession (2) more severe punishment for
the use of guns for the commission of crimes
• The latest federal attempt is the Brady act -> wait 5 days and undergo a
background check (its goal is to limit crimes done by legally bought guns)
• Besides restrictions on production and possession, the punishment for violating
handgun possession regulations or for committing a crime with a handgun has
increased (more severe and certain)

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• Although regulations have had some effect on crime rates its little effect on crime
rates
• If guns deter criminals due to risk, limiting them may increase crime
• Evidence of countries and history show some countries and times where the gun
per capita is high, has low crime, while some countries with strong regulation has
high crime
• If guns scared criminals, one ought to observe fewer hot burglaries in jurisdictions
that allow homeowners to keep handguns and this is what one finds when
comparing countries like US and Canada.
• Regulations should be about reducing violent crimes not just limiting possession
(less dangerous guns for example)

VIII. Explaining the decline in crime in the United States (if time)

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