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  • pg 1
									               Agenda for 16th Class
• Cleaner Skies (continued)
• Information

                     Assignment for Next Class
• Next class is Thursday 11/10. Classes next week are canceled
• ## 61-66, 69-70. Rights and Ordinary Understanding
• Writing Assignment. Group 3
       • P. 281 Qs 2, 3, 9, 13
       • Pp. 289 Qs 2, 5
       • Kull thinks legal rules should establish liability even when they only
         provide compensation for harm, but do not "change the world for the
         better … by reducing the incidence of losses." That is, he believes
         that a legal system should incur costs (the costs of litigation and
         adjudication) even when, in economic terms, all litigation will do is
         transfer money from one party to another, with no beneficial ex ante
         effects. That is, he believes that legal systems should make
         decisions which would fail cost-benefit analysis. Why does Kull think
         it worthwhile for the legal system to decide such disputes? Do you  1
Cleaner Skies

• Efficiency of competition assumes perfect information
• Imperfect information is a transactions cost
   – Efficient allocation of resources may be impaired by imperfect
• Imperfect information (like externalities) is ubiquitous
   – When law school and student choose each other
        • Law school doesn’t know how smart or hardworking students are
        • Students don’t know how good school is
        • Law school tries to gather info – admissions process
        • Students try to gather info – US News, campus visits, blogs
        • But information gathering is expensive and imperfect
   – When promisor breaches
        • May not know how much harm will cause promisee
        • May not know whether judge will find breach or not
        • Judge or jury may not know whether breach intentional or accidental
        • Judge or jury may not know whether promisee could have mitigated
        • Discovery and trial try to get answers to these questions, but
          expensive and not completely accurate
          The Market & Information
• Market corrects or mitigates some informational
  – Product markets
     • Consumer Reports, Angie’s List, Amazon consumer
       reviews, EBay ratings, etc.
  – Insurance
     • Medical exam before life insurance
  – Loan markets
     • Credit ratings, loan applications
  – Schools (see previous slide)

               Information & the Law
• Much of law is concerned with information
  – Litigation is principally about production of information
  – Much consumer regulation is forced disclosure of
     • Nutritional labeling
     • Securities Law
         – Prospectus before initial offering
         – Quarterly reporting of profits
     • MPG for cars
     • APR for loans and savings instruments
  – Contract law
     • Limitation of damages to those which are “forseeable” forces
       promisee with high damages to disclose (Hadley v Baxendale)
  – Product liability law makes price of product reflect producer’s
    estimate of expected liability
     • Expected liability likely (otherwise) unknown to consumer
  – Title recordation in Property law                                 5
                            Moral Hazard
• Insurance context
   – Insured has suboptimal incentive to take precautions
       • If insured against fire, may not install sprinklers or be as careful with fireplace
       • If have health insurance, may not be as careful to eat right or exercise
       • If have health insurance, may request treatments that unlikely to be effective
   – Tort law is form of insurance
       • Product liability may make consumers less careful
       • Duty to rescue may make parents (and others) less careful
   – Government programs are a form of insurance
       • Welfare may dull incentive to work
       • Income tax may dull incentives to work
• Contracts generally
   – After contract entered into, party may have incentive to act in way that is
     detrimental to other party
       • Employee may not work hard
       • Lawyer paid by hour may spend too much time on project
       • Renter may not take good care of apartment
             Responses to Moral Hazard
•   Gather information
     – Moral hazard is result of fact that insurer does not know how insured is behaving
          • If insurer knew, then could condition insurance on insured behaving properly
     – Insurer’s “monitor” insured
          • Fire insurer may inspect home for smoke detectors, brush clearance, roof
            materials, etc
          • Government monitors welfare recipients, requires job search, etc.
•   Deny insurance if precautions not taken
     – Comparative/contributory negligence in tort
     – Insurance exclusion for arson
     – Fire employees if shirk
•   Build incentive into contract
     – Insurance seldom covers full cost of hazard
          • So insured has some incentive to take precaution
     – Employer can make pay proportional to output
•   Government regulation seldom helpful
     – Government doesn’t usually have superior information
     – But sometimes can help
          • By using information gathering of criminal law
          • By threatening larger penalties (e.g. imprisonment)
          • E.g. imprisonment for securities fraud
 Moral Hazard, Coase Theorem, & Externalities
• Cost of obtaining relevant information is
  transactions cost
  – If info could be obtained costlessly, moral hazard
    wouldn’t exist
  – Since info is expensive, inefficiency may result
• Moral Hazard is kind of externality
  – Insured imposes costs on insurer
  – Employee imposes costs (or less benefit) on
  – Sometimes not considered an externality, because
     • Insured and insurer are in contractual relationship
     • Employer and employee in contractual relationship     8
           Principal-Agent Problem
• Many situations where one person (agent)
  works for another (principal)
  – Lawyer works for client
  – Employee works for employer
  – Promisee works for promisor
• Problem
  – How get agent to act in interest of principal
  – Problem is often moral hazard
     • Agent can take actions which adversely affect prinicipal
       (not work sufficiently hard (shirking), damage equipment,
Responses to Principal-Agent Problem
• Monitoring
   – Terminate contract if agent shirks
• Performance-based contract
   – Pay agent in accordance with some measure of performance
       • Contingent fee for lawyer
           – Plaintiff’s lawyer gets 1/3rd of damages, if prevails
       • Piece work
       • Pay CEO in stock or option
       • Bonuses for good performance evaluations
• Input-based contacts
   – Hourly fee or wage
   – Cost-plus construction contracts
• Fixed fee contracts
   – Salary
• Best contract depends on circumstances
   – Incentive contract -- if performance easy to measure
   – Fixed fee – if repeated interactions or agent is very concerned about
   – Input based – if cost unpredictable, agent is risk averse, and efficiency
     can be monitored
                   Adverse Selection I
• Markets may fail where one side lacks information and thus sets prices
  based on average
   – Thus inducing those who are above average to leave the market (but
     price not attractive to them
• Classic example: Insurance
   – If insurer has imperfect information
       • Insurance priced at average risk
       • But person who knows low risk may then decide not to insurer
       • But that raises average risk of those still buying insurance
       • Thus raising prices
       • Causing more people to drop out of insurance market
   – Examples
       • Health insurance
       • Product liability/warranty, if voluntary
            – Those who are careful may opt not to purchase warraty
            – Thus raising average risk and cost…
     Adverse Selection Example I
• Suppose 2 people want life insurance
  – A is smoker, 10% probability that will die next year
     • $10,000 expected cost to insurer for $100,000 policy
     • A is willing to pay $11,000 for insurance
  – B is non-smoking marathon-runner
     • 1% probability that will die next year
     • $1,000 expected cost to insurer for $100,000 policy
     • B is willing to pay $2000 for insurance
• If insurer can’t get credible information on smoking
  and exercise habits
  – Price for insurance, if both A and B are both buying
    insurance must be at least, $5500 (average of $10,000 and
  – But then insurance is not worthwhile to B
                  Adverse Selection II
• Lemons problem
   – Used car purchaser has imperfect information
   – Willing to pay price that reflects average used car quality
   – But person who has above average quality used car doesn’t want to sell
     at average price, so doesn’t sell
   – But that lowers average quality and thus price, leading more used car
     owners not to sell
   – Other examples
      • Loans for new businesses
    Responses to Adverse Selection
• Ex ante information gathering
  – So can price product in accordance with individual
    characteristics, rather than market average
  – Life insurance – blood pressure and cholestoral
    screenings, different rates for smokers, etc.
  – Health insurance – exclusion of preexisting
  – Inspection and certification of used cars
• Warranties
• Reputation
• Mandatory insurance
  – So no one can drop out of market
  – Health insurance “mandates” / universal coverage
  Questions on Information II (p. 244)
• Here is how the difference between moral
  hazard and adverse selection is sometimes
  – Problem A occurs when a party has an opportunity
    to do a hidden action once the contract is in effect.
  – Problem B is the result of hidden information prior to
    entering into a contract
• Is Problem A moral hazard or adverse
  selection? Which is Problem B
             Gilson, Role of Lawyers
• Functions of Lawyer
  – Litigate
  – Advise
  – Draft & negotiate contracts (transactional lawyer)
• Role of Transactional Lawyer
  – Transaction Cost Engineer
     • Reduce transactions costs for benefit of both parties
     • Solve informational problems
     • Lawyers often cynically viewed just transactions costs
         – But Gilson suggests that function of (good) lawyer is to reduce
           transactions costs
  – Value Creation
     • Function of (good) lawyer is to “create value”
         – i.e. increase the pie
         – Not just bargaining to get greater share of surplus for client
  – Other roles
     • Regulatory compliance
     • Getting most for client
   Gilson, Corporate Acquisition Agreement
• Lawyer as transactions cost engineer
   – Lawyer create value (increases pie) by reducing transaction costs,
     especially informational problems
• Representations and Warranties
   – Detailed statements of facts concerning the relevant business
       • Including accuracy of financial statements, absence of particular
         liabilities, ownership and condition of key assets, pending litigation.
   – Seller liable if turn out to be false
   – Purpose. Provide credible information that is key to transaction and its
• Earn out provisions
   – Part of price depends on performance of business
       • Part of payment delayed and contingent on how well business does
   – Helps parties to agree on deal, even if disagree on profitability of
   – Also gives former owners an incentive to help
Gilson, Corporate Acquisition Agreement II
• Covenants and Conditions
  – Covenants. Agreement on how owner will
    conduct business in period between signing
    of contract and transfer of ownership
  – Conditions, if not satisfied, relieve buyer of
    obligation to purchase
             Question on pp. 263ff
• 1. Would you characterize the informational problem
  in a typical corporate acquisition agreement as
  primarily an adverse selection, moral hazard, or
  principal-agent problem?
• 2. Gilson mentions “Convenants and Conditions” as
  one of the four main components of an acquisition
  agreement (see p. 258), but he doesn’t say much
  about them. What kind of informational problem do
  you think they address? Adverse selection? Moral
  hazard? Principal-agent?
• 3. Gilson focuses on private, contractual solutions to
  the informational problems posed by corporate
  acquisitions. Is there a role for courts, legal rules,
  and/or legislation?
                   Question on p. 263ff
• 4. Consider an employment decision. A law firm is considering whether to
  offer an associate position to a 2L, and the 2L is deciding whether to accept
  the offer.
•        a) What are the information asymmetries in this potential transaction?
  What relevant information does the 2L know which the firm does not? What
  relevant information does the firm know which the 2L does not?
•        b) What has the firm probably done to (partially) overcome the
  information asymmetry?
•        c) What has the 2L probably done to (partially) overcome the
  information asymmetry?
•        d) Are there any aspects of the typical contract between the 2L and law
  firm which help overcome the informational asymmetries? Note that many
  law firms and lawyers have no written contracts. In such cases, the law
  provides default rules. One of those default rules is “employment at will,”
  which means that the employee can quit at any time, and the employer can
  fire the employee at any time.
•        e) Are there any legal rules which help overcome the informational
                 Question on pp. 263ff
• 5. Consider the way home mortgages are often sold. A bank contracts with
  a mortgage broker. A mortgage broker is an independent businessperson,
  not an employee of the bank. The mortgage broker solicits customers and,
  when a customer wants a loan, helps the customer fill out the relevant
  paperwork and sends the paperwork to the bank for approval of the loan.
•       a) The contract with the mortgage broker might specify that the
  mortgage broker gets a fixed salary – perhaps $3000 per month. What
  problems might occur under such a contract? Would the bank be wise to
  offer such a contract?
•       b) The contract with the mortgage broker might specify that the
  mortgage broker gets a percentage of the value of all loans approved. For
  example, the mortgage broker might get 0.5% of the value of each loan,
  which would be $2500 on a $500,000 loan. What problems might occur
  under such a contract? Would the bank be wise to offer such a contract?
•       c) What macro-economic problems might occur if most loans were
  negotiated through contacts such as those described in (b)?
•       d) Can you think of a better contract between the bank and the
  mortgage broker?
•       e) The relationship between a bank and a mortgage broker presents all
  three types of asymmetric information problems discussed in readings ##50-
  51, supra – adverse selection, moral hazard, and principal-agent. Identify
  which aspects of the relationship present which kinds of problems.

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