Spring 2001, Economic Analysis of Law, Wachter 1
INTRODUCTION .................................................................................................................................................................. 2
METHODOLOGY OF LAW AND ECONOMICS ............................................................................................................ 2
EFFICIENCY AND EQUITY ............................................................................................................................................... 3
THE COASE THEOREM ..................................................................................................................................................... 4
THE CALABRESI FRAMEWORK ..................................................................................................................................... 6
APPLICATION: COASE THM AND NUISANCE LAW .................................................................................................. 7
PUBLIC V. PRIVATE NUISANCE ............................................................................................................................................. 8
ESTABLISHING PROPERTY RIGHTS AND PUBLIC GOODS.................................................................................. 10
CALCULATING DAMAGES ............................................................................................................................................. 12
LOSS OF EARNINGS CASES ................................................................................................................................................. 13
TAKINGS AND LAND USE REGULATION ................................................................................................................... 14
EFFICIENCY OF THE LAW: COMMON LAW & STATUTORY LAW .................................................................... 17
VOTING AND RENT-SEEKING....................................................................................................................................... 18
BENEVOLENT DICTATOR MODEL ....................................................................................................................................... 19
VOTING MODEL – VOTERS AS DECISION MAKERS ............................................................................................................. 19
HOW TO DO STATUTORY INTERPRETATION ......................................................................................................................... 21
ECONOMIC ANALYSIS OF TORTS ............................................................................................................................... 21
TORTS AND THE INSURANCE QUESTION ............................................................................................................................. 23
DEFENSES AND ALTERNATIVE LIABILITY RULES ............................................................................................... 24
GRAPHICAL REPRESENTATION OF TORT LIABILITY ............................................................................................................ 24
TORT LAW STARTS WITH NEGLIGENCE .............................................................................................................................. 25
TORT DEFENSES ................................................................................................................................................................. 25
PRODUCT LIABILITY ...................................................................................................................................................... 26
PRODUCTS LIABILITY EXAMPLE: BOTTLES V. CANS .......................................................................................................... 26
ESCOLA COCA COLA CASE................................................................................................................................................. 29
COMPLAINTS OF STRICT LIABILITY .................................................................................................................................... 29
GAME THEORY AND TORTS ......................................................................................................................................... 29
COMPARATIVE NEGLIGENCE .............................................................................................................................................. 30
COMPARATIVE NEGLIGENCE IN S/L WORLD ...................................................................................................................... 31
COMPARATIVE NEGLIGENCE FORMULA: ............................................................................................................................ 31
JOINT AND SEVERAL LIABILITY ................................................................................................................................ 32
EXPRESSED GRAPHICALLY ................................................................................................................................................. 32
INTENTIONAL TORTS ..................................................................................................................................................... 33
CONTRACTS ....................................................................................................................................................................... 34
INTRODUCTION AND FORMATION DEFENSES ...................................................................................................................... 34
UNCONSCIONABILITY ......................................... ERROR! BOOKMARK NOT DEFINED.ERROR! BOOKMARK NOT DEFINED.
Spring 2001, Economic Analysis of Law, Wachter 2
Digesting law & economics cases:
1. Proceedings Below
a. Relationship of parties – 1st-2d (contractual) or 3d party relationship
b. Setting of transaction costs – who is low transaction cost party?
c. K-H calculation facts (wealth-max numbers)
i. What are plaintiff’s lossess it if loses?
ii. What are defendant’s losses if it loses?
d. Forward or backward looking dispute/harm
e. Ability to avoid accident – who’s better able to insure?
3. Issue – identify if it’s market failure or the source of the problem
4. Holding (Calabresi Framework) – “who won” & “how protected – liab or prop rule”
5. Reasoning – the K-H calculations apply
a. Explanation for holding based on K-H
i. Discussion of the costs borne by plaintiff and defendant
ii. And why decision is efficient or inefficient
b. Review of other rules – why they were not chosen and what outcome would have been if they
had been chosen
c. Issues of fairness or distribution. Court may have used different decision rule for deciding “who
won or how protected.”
d. Long-run concerns
i. Includes import of decisions on alter cases
ii. Any 3d parties not presented in the plaintiff or defendant class?
iii. Whether this is optimal legal institution for settling claim
6. Discussion of dissent, including it’s K-H
Methodology of Law and Economics
1. unity of common law
2. develop notion of economic damages, separate from issues of liability
3. jurisprudential – explain debate btw/of law and economics
Legal Reasoning Economic Reasoning
(inductive bottom-up thinking, very fact-specific) (deductive top-down thinking)
facts precedents assumption hypotheses
In law and economics (L/E), holding and conclusion reach the same result.
1. largely descriptive of what law is.
a. Examine legal structure
b. Understand how they develop
c. AND look at what incentives are created for the parties
2. is L/E inherently conservative?
a. No but more easily used by conservatives
b. Looks at cost and benefits
Spring 2001, Economic Analysis of Law, Wachter 3
i. Largely adopted by liberal govts in 1960s as way to justify greater govt intrusion on
c. It’s a tool more than a set of conclusions.
Efficiency and Equity
Efficiency – the relationship btw the aggregate benefits of a situation and the aggregate costs of the situation
Pareto efficiency/Pareto optimality
Equity – the distribution of income among individuals
Is there a conflict btw the pursuit of efficiency and the pursuit of equity?
This is where you make a POLICY choice!
Depends on how important efficiency is relative to equity
Conflict may exist IF income can’t be costlessly redistributed
If income CAN be costlessly redistributed, goal is to MAXIMIZE the size of the pie b/c the pie can be
sliced in any way desired.
Assumptions made to discuss legal system:
Costless redistribution of income (no transaction costs)
Common denominator – all benefits and costs to be measured in dollars
Consumer sovereignty – individuals themselves determine the dollar values to place on their benefits
Exogenous preferences – values that individuals place on their benefits and costs are “stable”
Utility maximization – indiv (and firms) maximize their benefits less costs
First fundamental theorem of welfare economics – In a world of perfect competition, society would produce
as much wealth as it could.
All points along WPF are allocatively efficient
(i.e. society is as wealth as it can be)
WPF = welfare possibility frontier
Pareto superiority (P-S) – a point is P-S to D if and only if
A at least ONE of the parties is made better off WITHOUT
1 = 150 - making the other worse off.
ex. A is P-S to D (100,100) v. (75,75)
C is not P-S to D (200,0) v. (75,75)
C Pareto superior points are all points within the right angle
coming out of point D (shaded area).
All points in shaded area = domain of contract law
(what parties would agree to
if bargaining in good faith. Anything
outside is nonconsensual.)
Pareto optimality (P-O) – every point on WPF is pareto optimal.
If you’re on P-O point, then there are no pareto superior moves or improvements to make.
Conversely, if you’re NOT on P-O point, there is a P-S point which will improve your situation.
Welfare economics – govt should not be limited to pareto moves.
1950s/60s economists K-H benefit-cost analysis
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o any policy that moves you from point D such that the winners could compensate the losers is a
o All P-S points are K-H points, but not all K-H moves are P-S moves. (More K-H than P-S pts.)
o All points above line 1 are K-H points.
o Focus on making societal wealth higher – make pie as big as possible regardless of income
distribution. (Note: could compensate people made worse off, not have to.)
Thinking of the Chicago school (Scalia, Easterbrook, Posner).
Normative Posner (what law OUGHT to do) – ct should give entitlement to party that values it most.
Positive Posner (DESCRIPTIVE) – what courts do DO in area of property and torts
Second fundamental theorem of welfare economics – If a govt can costlessly redistribute income, then govt
policy should be bifurcated into 2 parts:
Make pie bigger – Govt should do everything it can to improve size of the pie. (all K-H improvments)
Restribute income to point that society favors
o Govt (legislature) should have responsibility to redistribute through taxes, soc security, welfare
Question: When is fairness consistent with K-H points and when not?
1. Courts should make pie as big as possible and then let legislature redistribute.
2. Court are passive. Cases are brought before them.
Criticisms of Posner school:
1. Right-wing (wt minimal govt; libertarians) Posnerians are much more interventionist than desired.
What’s desirable is only pareto points.
2. Left-wing wealth isn’t everything. Need more fairness/equity.
3. The incentives for buying and selling does not necessarily lead to what we think of. Doesn’t always lead
to good results. (Grumby who hates rap music and doesn’t wt his daughter to listen to rap music so
spends the money to listen to it himself v. Sharpy who loves rap music)
4. Circularity in some very important cases
a. Fundamental property rights
b. Entitlements are large or fundamental
c. Scitovsky Paradox – In a world where neither party will sell the entitlement, then K-H doesn’t
give the answer.
i. For K-H, think in terms of “would the loser sell the entitlement?”
ii. Tends to occur when entitlement is a large component of the parties’ wealth OR in
The Coase Theorem
Coase’s theorem (for ZTC and PTC):
Zero Transaction Costs – If ZTC, the EFFICIENT outcome will occur rgdless of the choice of the
o The legal rule affects the REDISTRIBUTION of income. Best choice is to redistribute income
by the amount of the least-cost solution to the conflict.
Positive Transaction Costs – If there are PTC, the efficient outcome may not occur under every legal
rule. In these circumstances, the preferred legal rule is the rule that MINIMIZES the effects of
transaction costs. These effects include actually incurring transaction costs as well as the inefficient
choices induced by a desire to avoid transaction costs.
Five pillars of Coase:
Spring 2001, Economic Analysis of Law, Wachter 5
1. Coase’s theorem – in a zero transaction cost, it doesn’t matter who the court decides to give the
entitlement to as long as the two parties can freely bargain w/ each other.
2. Harm is reciprocal – goes both ways.
3. Legal rules embody a lot of economic theory law does efficiency! Party who bears lower cost!
4. In real world, transaction costs do matter so legal regimes matter.
5. Court ought to do efficiency. (normative Coase)
What’s the role of legal regulation if we have economically efficient results?
1. Coase’s them only works where ZTC.
2. Defines who has the initial right (sets boundaries) which in turn makes bargaining easier and parties
are more likely to reach agreement.
3. If there are transaction costs, parties may not trade. In this case, initial entitlements do matter.
4. Need to decide what’s the appropriate legal remedy for negative externalities.
Question: Is the economically efficient result also the just result?
Sturges v. Bridgman (Supp. 8) – “coming to the nuisance” 1879 English case. Candymaker in area for long time.
Area becoming more residential. Doc moves in, builds extension and sues Candymaker b/f of too much
vibrations. Property right given to the doctor courts effectively are “zoning” the area. Forward-looking harm.
Coase says it’ doesn’t matter what the legal resolution is b/c the parties can bargain for entitlement.
Doc CM Tot Wealth If doc wins, he’ll sell entitlement if he can get $150 or
If doc wins 150 0 150 more for it. CM won’t buy b/c the max he gets is $125.
If CM wins 20 125 145 (wealth maximing party pretty much never sells
Doc CM Tot Wealth Here, CM is wealth maximing party. If CM wins, will sell
If doc wins 100 0 100 entitlement at 130 (min price where he won’t be worse
If CM wins 20 130 150 off) or more. Doc won’t buy b/c can only pay 100 max.
o If Doc gets entitlement, max price CM will pay is $130 – point where CM is no worse off whether the buys or not.
(indifferent!) Min price CM can buy entitlement is $100-20 = $80.
o If Doc gets damages and CM wins, he gets 100 – 20 = $80 (loss the doc suffers.)
Damages gives plaintiff the minimum price for the entitlement.
o When people bargain, they often split the gains from trade. So if P(max) = 130 and P(min) = 80, then P(avg) = 105.
Doc gets entitlement:
CM gets = max – P(avg) = 130 – 105 = $25
Doc gets = min + P(avg) = 20 + 105 = $125
Still end up w/ total wealth = 25 + 125 = 150 (wealth max result!)
CM = 130 won’t sell b/c he can’t be made better off
Doc = 20
Cooke v. Forbes (Supp. 10) – hypersensitive weaver using unusual manufacturing process. Sues ammonia
factory for damages to fabric. Weaver prone to damages b/c of the process. Held for D (mfr of ammonia) ct’s
decision affects the initial distribution of wealth.
Here, jmt for D is the economically efficient and just result. P is hypersensitive so he can best guard
against the offenses to himself.
Note that another option is for the firms to merge, i.e. for P to buy-out D so loser now has control to do
what he wants.
Bryant v. Lefever (Supp. 11) – smoke nuisance. P and D are neighbors. D rebuilt wall that blocks P’s chimney.
Held for D nuisance is always two way street. P, by lighting fire, is causing the nuisance that harms himself.
Ct really saying that D had legal right to build a bigger house and it’s P who’s causing his own
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Bass v. Gregory (Supp. 14) – P is bar that cust shaft thru cellar for air circulation. Air is vented onto D’s
property and smells bad. D covers up well to stop ventilation. Held for P adverse possession; air venting
happened for a long time w/o D complaining.
By deciding who has the legal right first, court then determines who creates the nuisance.
The Calabresi Framework
Differentiates between property and liability rules
o Property rules – entitlement determined by state but value is determined by the seller. any
transaction is consensual.
o Liability rules – both entitlement and value are determined by the state. Drawback is that
liability rules only approximates seller’s value of entitlement and it involves greater govt role.
Two questions must be asked:
o Who gets the entitlement – P or D?
o How to protect the entitlement – injunction or damages?
Property rule Rule 1: injunction Rule 3: no liability/no nuisance
Δ can buy @ $ Π sets (injunction is denied)
Π can buy the right @ $ set by Δ
Liability Rule Rule 2: damages Rule 4: buy an injunction
Δ can buy right to activity @ $ ( pays ’s damages equiv.
set by court to buying an injunction since
gets $ and is enjoined.)
Π can buy @ $ set by court
Inalienability rule Something that cannot be sold gen have public law take care
Rule 1 and 3 are consensual. Bargaining can occur with any of the rules????
Rule 4 – can’t refuse the injunction.
Example (from Polinsky Ch. 4):
Factory Profits Change in Damages to Change in Total Wealth =
Output profits Residents damages profits – damages
0 0 – 0 – 0
1 10,000 10,000 1,000 1,000 9,000
2 14,000 4,000 16,000 15,000 -2,000
3 16,000 2,000 36,000 20,000 -20,000
The efficient outcome in ZTC world is for Q = 1, where total wealth = 9,000
Under property rule 1, wins injunction (entitlement) so can sell injunction to factory such that we
end up at Q = 1.
P(min) = min damages to residents = 1,000
P(max) = min profits of factory = 10,000
P(avg) = price where R and F split the profits = = 4,500 therefore,
Factory gets P(max) – P(avg) = min profits – P(avg) = 10,000 – 4,500 = 5,500
Residents get P(avg) – P(min) = P(avg) – min damages = 4,500 – 1,000 = 3,500
total wealth = 5,500 + 3,500 = $9,000, Q = 1 (which is the efficient outcome!)
Under property rule 3, factory wins entitlement, no liability/injunction denied to residents. So factory
can produce as much as it wants to max of Q = 3. But residents will try to bargain with the factory to get
to Q = 1.
P(min) = max profits – min profits of factory = 16,000 – 10,000 = 6,000
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P(max) = max damages – min damages to residents = 36,000 – 1,000 = 35,000
P(avg) = P(min) – P(max) / 2 = (35,000 – 6,000)/2 = 14,500 therefore,
Since we want to get to Q = 1:
Factory gets profits(q = 1) + P(avg) = 10,000 + 14,5000 = 24,500
Residents get damages(q = 1) – P(avg) = -1,000 – 14,500 = -15,500
total wealth = 24,500 – 15,500 = 9,000, Q = 1 (still efficient outcome!)
Note: in ZTC world, both R and F want to maximize their wealth which is at Q = 1.
Under rules 1 and 3, bargaining occurs. But since we don’t live in a zero (or very low) transaction cost
world, bargaining may not always succeed so court will sometimes use the damage remedy (liability
rules) instead. Transaction costs include:
o Bargaining costs
o Monetary costs – Discovery of underlying facts; Compliance costs
o Strategic costs
Hold-out problem – “tough bargaining” where 1 pty tries to get to its max soln
Free-rider problem – 1 pty in group doesn’t wt to pay and hopes to benefit from others’
Under liability rule 2, wins entitlement of damages.
(damages) = actual damage suffered by depends on what factory produces
note, factory will end up at Q = 1 (where it’s most efficient!)
(damages) = minimal victory under property rule 1
Under liability rule 4, wins so gets damages, i.e. buys an injunction factory retains right to
continue production; residents can try to pay F to produce less by paying loss profits for production.
(damages) = loss profits from output of 3 to output of 1 = 16,000 – 10,000 = 6,000
(damages) = minimum victory under property rule 3
Another problem is imperfect information. (If court had perfect information, that can serve as a
substitute for a ZTC world.) W/ imperfect information, depending on whether court overestimates or
underestimates some numbers, the result will change.
o Here, if court thought profit at Q = 3 is 50,000, then Q = 3 becomes wealth maximing outcome
since 50,000 – 36,000 = 14,000. But court gets it wrong! So in this case, injunction may be the
better solution allows parties to bargain to get efficient outcome.
When we want property rules: When we want liability rules:
Property rules harm is forward-looking Liability rules harm has already occurred
Can get to pareto superior condition Parties can’t bargain
Settle property disputes to encourage investment in Opposite situations of propery rules
In civil disputes, favor group whose civil rights are
Idiosyncratic violation of land/relative valuation of
Irreparable harm so injuncction
Court doesn’t know administrative cost
Damages are inadequate b/c loser is jmt proof (ex.
can’t pay or immunity)
When might transaction costs themselves dictate who wins?
Multiple and one , and not a class suit high TC amongst plaintiffs.
o Injunctions won’t work b/c s can’t settle on a price among themselves no property rule
o Rule 4 susceptible to free-rider problem
o So court will use rule 2 (damages)
One and multiple ,, and wins end up at rule 4????
Application: Coase Thm and Nuisance Law
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Nuisance cases – incompatible land usage, usu involving small number of indiv bargaining with each other.
Resolution is a two-step process:
o Entitlement must be chosen determination must be made re: who is entitled to prevail
o Decide how to protect the entitlement injunction or damages
Nuisance is a legal conclusion! Depends on your K-H balancing.
PUBLIC V. PRIVATE NUISANCE
Public nuisance – unreasonable interference with a right common to the general public. Public rights!
o Factors: Significant interference w/ public health, safety, peace, comfort, or convenience?
Proscribed by statute or ordinance? Continuing nature or produced permanent/long-lasting effect?
o Any member of the affected public can sue but usually only if the person bringing suit can show
“special injury” – injury/damage of a kind different from that suffered by other members of public.
Private nuisance – protects rights in the use and enjoyment of land.
o Only owners of interests in land can bring a suit.
BOTH require a substantial harm caused by intentional and unreasonable conduct OR by conduct that is
negligent, reckless, or abnormally dangerous.
Issue: Can the efficiency criterion determine which entitlement to choose and which remedy to use to protect it?
1. Zero Transaction Cost World – If ZTC (the parties bargain cooperatively), then every choice of
entitlement and remedy will be efficient.
2. Strategic Behavior – If the parties are likely to act strategically, then the efficient outcome still can be
achieved under both remedies if the court has adequate information.
a. Injunction – can overcome strategic behavior by choosing the entitlement that corresponds to
the efficient outcome, which can be determined only if the court knows the injurer’s benefits
from engaging in the harmful activity and the victim’s damages.
b. Damages – can overcome strategic behavior by giving an absolute entitlement to the victim and
setting liability equal to actual damages, which requires knowledge of the victim’s damages.
3. Imperfect Information
a. Court only knows victim’s damages
i. Injunctive remedy generally will fail b/c the court cannot accurately set the entitlement
equal to the efficient outcome.
ii. Damage remedy can still guarantee the efficient outcome.
b. Court underestimates victim’s damages
i. Damage remedy generally leads to excessive output and may be less desirable than the
4. Even where there is some uncertainty about which entitlement and remedy to choose in the real world,
efficiency analysis of nuisance law is still helpful.
wins wins property rules are
Property rule Rule 1: injunction Rule 3: no liability better than liability
Sturges v. Bridgeman (CM/doc) (injunction is denied)
Liability Rule Rule 2: damages Rule 4: buy an injunction Liability rule = take & pay
option to loser; better where
Boomer v. Atlantic Cement ( pays ’s damages.) high TC may prevent pties
Spur v. Del Webb (cattle feed) from barg w/ prop rules
Boomer v. Atlantic Cement (Supp. 32) – cement factory pollution. wants injunction b/c factory decreases
property value s.t. it became total loss. doesn’t wt to be found liable. Factory was brought to area for jobs.
Residents were there first.
Held: temporary injunction for that will be vacated when (factory) pays damages. Essentially, wins
based on the liability rule. (Rule 2)
o Changed existing precedent of permanent injunction.
o Damages = value of house (total loss)
Spring 2001, Economic Analysis of Law, Wachter 9
Note that if pays full damages, essentially bought the house from . So the factory can
now go into the real estate business and rent out the homes to people who won’t complain.
B/c it has to rent, it won’t overly pollute, otherwise, people won’t come.
Can still get to efficient result. Factory would make decisions that’s wealth-maximizing,
even if it means polluting more.
Rule: balance the equities between compensating the residents and the needs of jobs for the community.
o Trade-off btw level of pollution and amounts of jobs produced so, in implementing
regulations, EPA essentially does CBA.
o Situation of higher transaction costs – 1 factory v. multiple , so here, rules may matter
o KH calculation facts:
house $185,000 (intangibles like loss of community? N/A)
factory worth a lot more, also provides jobs
so factory would lost most by closing down only gets damages (minimum value of
injunction) and not an injunction.
o This case didn’t focus on third-party harm.
o The more you can quantify the damages suffered by the parties, the more you can win on liability,
based on damages. So, size of damages determines liability.
o Posnerian result (what courts ought to do) is rule 3 (no liability, wins) no transaction cost so
most efficient. Considers property rule to be default rule! Only reason we are using rule 2 is to
Spur Industries v. Del Webb Development (1972) (Supp. 39) – Spur () is cattle feed ranch, emitting foul
odors.Got to area first. Del Webb () developed community near Spur’s ranch. Sues Spur for nuisance. Got
injunction and Spur now appeals. (Coming to the nuisance case)
Held: for but has to pay Spur damages for shutting it down. Equivalent to rule 4 ( buying the
injunction, since has to pay damages, and stops the nuisance activity.)
o 1 relatively low transaction costs (1 who oversees lots of individuals)
o KH calculation facts:
Look for profits loss if Spur closed down OR Del Webb closed down value of homes &
Key: can either one be moved and at what cost?
If Spur had enormous moving costs, even though Del Webb gets injunction & pays
damages cheaper for residents to move so Del Webb won’t exercise option to
buy out Spur.
o Court said that Spur was to be permanently enjoined BUT notes also that Spur was there first. Spur
originally developed in a remote area and that area eventually became a populous center. Since
Webb’s development brought people near the nuisance, Webb must indemnify Spur for the cost of
moving or shutting down.
o Land-use pattern changes. Spur required to move b/c of the overriding public interest; did nothing
wrong. Court seems to favor the newcomer and compensates the old guy to stop.
Similar to Sturges – doctor came to candymaker.
Property cases tend to be forward-looking!
Fontainebleau Hotel () v. Forty-Five Twent-Five () (1959) (Supp. 55) – P wts D to stop building a 14-story
addition to the hotel. Says it blocks sunlight so seeks injunction.
Held: for D. There is no legal right to the free-flow of light and air from adjoining land. (Rule 3 – property
rule with D winning)
o Costs – P’s loss profits from blocked view v. cost of construction & D’s profits.
Note: Even if P got entitlement, would not sell to D they hated each other and both wanted to be the most
successful hotel in Miami. So neither one would sell!
Spring 2001, Economic Analysis of Law, Wachter 10
o Scitvosky Paradox! Neither party would sell the entitlement. Entitlement is large component of
parties’ wealth. So K-H analysis doesn’t resolve dispute. No single predictive winner that’s the
wealth maximizing party.
Union Oil Co v.Oppen (1974) (Supp. 60) – commercial fisherman & oil spill. Whether the commercial fishing
fleet or the oil company should bear the cost of oil spill damage to the fish in the Santa Barbara area.
Held: Court assigns loss to the oil company (D) – rule 2: D has to pay damages, P wins.
o Ct looked at which party was in the best position to minimize the combined costs of damage to fish
if drilling continued, or lost oil production if drilling were halted to prevent another oil spill.
Who can correct the entitlement if given incorrectly?
If Union Oil is low cost avoider, make them liable. Doing so would make them clean up
their act. Union Oil is wealth max party & damages to fishers not that high. D will buy
the entitlement, i.e. D pays damages.
Making low cost briber liable gets it right.
o Low cost briber/low transaction cost party principle: damages seen as an option and exercising
that option = bribing the party you buy the entitlement from.
Low cost accident avoider rule (BPL!!!!) – if you can avoid an accident cheaply, you are liable. Look at costs
of avoiding! Why not always use LCA rule?
Accidents can’t always be prevented
Court may not who LCA is and getting that knowledge is too expensive.
Doc CM Tot Wealth
If doc wins 150 0 150
If CM wins 20 120 140
o Sps doc can prevent vibrations at cost of 50. Doc’s net is 150 – 50 = 100.
o But total value becomes (150 – 50) + 120 = 220 b/c since doc can prevent, CM can also produce!
So the efficient result is to give entitlement to CM. Giving CM entitlement allows him to
produce at full force (120) and doc can prevent at 50 and still rake in 150, with a net of 100 (still
better than 20). Both parties end up producing.
Doc is still the wealth-maximizing party, but even if spending 50 to prevent, he’s still better off
at 100 than at 20.
If you chip away at property rights, party becomes less likely to make efficient use of his or her property.
Note that a rules re: wealth-maximizing party and low cost avoider are DIFFERENT!
Establishing Property Rights and Public Goods
Demsetz article: Toward a Theory of Property Rights (1967) (Supp 64)
Thesis: Emergence of new property rights takes place in response to the desires of the interacting persons
for adjustment to new benefit-cost possibilities. Property rights develop to internalize externalities when
the gains of internalization > costs of internalization.
o When there are no property rights, there will be over-usage and inefficient land use. Ownership will
emerge when the costs of building an ownership structure is low AND costs of internalizing the
externalities are also low.
Example: Historically, didn’t have strict land boundaries. Canada fur trade becomes very valuable;
demand of beavers. Beavers don’t roam around. So if you can fence their area, then you own the beavers.
o led to development of land claims by Native American tribes against each other.
o Doesn’t happen on Great Plains b/c those animals – buffaloes, horses – roam around and it’s impractical
to build fences.
Types of property rights:
o Communal ownership – right that can be exercised by all members of the community. Community
denies to the state or to individual citizens the right to interfere w/ any person’s exercise of
Spring 2001, Economic Analysis of Law, Wachter 11
o Private ownership – community recognizes the right of the owner to exclude others from exercising the
owner’s private rights.
Much internalization accomplished here – partial concentration of benefits and costs. Cost of
negotiating over remaining externalities will be reduced greatly.
o State ownership – state may exclude anyone from the use of a right as long as the state follows accepted
political procedures for determining who may not use state-owned property.
Same idea as Boomer. Both essentially asking “who has the right to pollute if they choose to pollute?”
Boats Total Marg Ben of Avg Catch Total Marginal Net Benefit =
Value Catching Fish (Equal # Fish) Cost Cost Value - Cost
0 0 - - 0 - 0
1 20 20 20 8 8 20 – 8 = 12
2 35 15 17.5 16 8 19
3 45 10 15 24 8 21
4 50 5 12.5 32 8 18
5 55 5 11 40 8 15
If the ocean is not owned:
o 5 boats will go out. With the 5th boat, avg catch – marg cost = 11 – 8 = 3
o So you’ll get overfishing. The last boat will only compare the avg catch v. marg cost, and since AC
> MC, he’ll still go out and fish.
If ocean is owned:
o 3 boats will go out efficient result!
o Each boat will go out IFF marginal benefit marginal cost 10 > 8
o Most efficient result is where MB = MC, or as close as possible.
If cost of restocking the ocean is included:
o Where demand is high, common ownership is inefficient “tragedy of the commons”
Over-usage of land
Now, cost of internalizing ownership structure (for private ownership) > cost of common
ownership, so we still have overfishing in the ocean. (???)
Perhaps, it’s cost of internalizing ownership struct for ocean > gains from the
Same principle applies to global warming. When we reach the point where cost of
internalizing ownership struct to help prevent global warming < cost of common ownership
(what we have now, no ownership), then we’ll have real results in prevention.
Benefit of Cost of creating Ownership structure
Ownership and enforcing (property rights) is
Structure ownership structure created.
Emergence of Civil Society: Why Hobbes Ruled for a Long Time Prisoner’s Dilemma
“Life is short and brutish,” a.k.a. it stinks!
(A , B)
Civil Steal # = value in crops
50 , 150 40 , 155 assume when A steals, steals 40
Civil = 200 (Coase) = 195 but destroys 10 (net of 30)
A B is not a good thief
Steal 80 , 110 70 , 115
= 190 = 185 (Hobbes)
If both steal, wealth destruction = 200 – 185 = 15
Best scenario is having both civil maximize joint wealth (200)
But both will end up stealing stealing is their dominant strategy, regardless of what the other does
o Ex. for A: If B steals, A gets 70 if A steals, 40 if civil 70 > 40 so A steals
Spring 2001, Economic Analysis of Law, Wachter 12
If B civil, A gets 80 if steal, 50 if civil 80 > 50 so A steals
A doesn’t care about total wealth, just her own wealth. A is better off if they both steal.
If both civil, A is worse off – gets 50.
o Ex. for B: If A steals, 115 (B steal) > 110 (B civil) so B steals
If A civil, 155 (B steal) > 150 (B civil) so B steals
Will B pay A off? (i.e. will the parties trade?) Assume A steals.
o A wants to get to 80 B can pay A 30 to be civil. B will end up at 150 – 30 = 120. Still better than when
A steals, B civil. Now, A & B are both civil, net gain of 200, and each gets (80,120).
Coase-ian society: gains from not stealing = 200 – 185 = 15
o If split gains so they’re both civil, get:
A = 70 + 7.5 = 77.5
B = 115 + 7.5 = 122/5
A is better off moving from (steal, steal) to (civil, civil)
o This leads to emergence of feudal society trade specialization!
Investment, Time, and Capital Markets (Supp)
How do we really know what the wealth max value of Atlantic Cement is?
o Stock – asset value (for Atlantic Cement, stock = homes)
o Flow – income produced by the asset (flow = rental value of homes)
When is subjective value considered?
o Courts skeptical of subjective value hard to verify and people tend to have a reason to
overestimate subjective value courts prefer market value.
o But subjective value does exist and can be very important. Courts will try to get to give a number
for the subjective value. Ct will ask if the stated value is observable and/or verifiable.
Best way to value any asset is the free cash flow it produces, i.e. the profits (excluding costs, re-
investments) close to profit-flow.
To get the present discounted value of $M in year n at fixed interest rate r, PDV
(1 r ) n
So the discount factor is
(1 r) n
For variable interest rates, PDV
(1 r1 )(1 r2 )...(1 rn )
VALUING PAYMENT STREAMS
Which payment stream do you prefer?
o Will depend on the interest rate!
Year 0 Year 1 Year 2
Stream A $100 100 0
Stream B 20 100 100
o Sps r = 10%:
PDVA = 100 1
100 90.91 $191.91
(1.10) (1.10) 2
PDVB = 20 20 90.91 82.64 193.55 , so w/ r = 10%, PDVB is better!
(1.10)1 (1.10) 2
o Sps r = 15%:
DF1 = 0.8696 PDVA 100 (0.8696)(100) 100 86.96 186.96
(1 r ) 1.15
Spring 2001, Economic Analysis of Law, Wachter 13
DF2 = 0.7561 PDVB 20 86.96 75.61 182.57 , so w/ r = 15%, PDVA better!
In general, as r , $ in future worth less today.
Bonds – contract in which a borrow agrees to pay the bondholder (the lender) a stream of money.
The higher the interest rate, the lower the value of the bond.
Example: corporate bond makes coupon payments of $100 per year for the next 10 years, and then a
principal payment of $1000 at the end of ten years. To find out how much the coupon is worth, calculate the
PDV of the payment stream:
(1000)(c) (1000)(c) (1000)(c) (1000)(c) 1000
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) n (1 r ) n
where c coupon rate, r interest rate, n # years
o Here, r = 10%, n = 10 years, coupon = $100 so c = 10%. So PDV = $1000.
See 2/7 If r = c, then bond = $1000 (principal)
handout o If r = 8%, coupon rate = 10%, PDV = $1134.20. So, if r < coupon rate, bond worth > $1000.
o If r = 12%, c = 10$, PDV = $887.00. So, if r > coupon rate bond worth less than $1000.
Anything that pays you a constant amount and gives you your money back at the end is like a bond.
o For Electric Motor Factory, same PDV formula except last number, “principal,” is its salvage value if
the factory shuts down after 10 years.
Perpetuity – a bond that pays out a fixed amount of money each year forever! Never get principal back!
$ paid each year
perpetuity: PDV , where r interest rate
Spread – indicator of market liquidity. Illiquid markets have big spreads. from a legal standpoint, hard to
use market value as representative of true value. Less trustworthy.
Ex. IBM 93/8 of 04 (maturity date)
Ask 100.625 (price to buy) Difference = “bid-ask” spread
Bid 99.875 (price to sell)
LOSS OF EARNINGS CASES
W0 (1 g ) W0 (1 g ) 2 W0 (1 g ) 3 W (1 g ) n
Basic formula: PDV ... 0 ,
(1 r ) (1 r ) 2 (1 r ) 3 (1 r ) n
where W0 = salary,
g = growth rate of salary, (1+g) = growth factor
r = discount rate, (1+r) = discount factor
Example: years = 40
Salary = W = $100,000
Growth rate of salary = g = 5%
Discount rate = r = 7%
PDV = $2,714,516.00 (see 2/9/01 hand-out for caculations)
Note, if g = r, PDV = $4,000,000 (which is also the gross $)
If perpetuity (you live forever), PDV $5,000,000 , so you make
r g 0.07 0.05
over half of your gross in the first 40 years.
Kaczkowski v. Bolubasz (1980) (Supp. 91) – PA case. Car accident, victim is deceased. Case centers around
how to calculate loss of earnings of deceased to get damages.
o Held: Simplify calculations by using total offset method set r = g damages = (annual loss)(# yrs)
AND then, can add back in the productivity increases. Essentially, offsets effect of inflation.
So, PDV = W0(1 + g) + W0(1 + g)2 + . . . + W0(1 + g)n , where g = productivity for PA only
In other states, g based on both productivity and inflation.
Spring 2001, Economic Analysis of Law, Wachter 14
Most of the time, r g. More likely that r < g.
Calculation method is thus very pro-plaintiff.
Also, growth rate for earnings (g) tend to flatten, or even decrease, as you get older.
Wachter: Best type of rule for jury-calculated damages have regular decisions for r & g for generic
types of cases, and then give these results for jury to look at and work from there. So, right formula should
W 0 (1 g ) W 0 (1 g ) 2 W 0 (1 g ) 3 W (1 g ) n
look like: PDV ... 0 .
(1 r ) (1 r ) 2 (1 r ) 3 (1 r ) n
Only time when r & g tend to move together is in a high inflation environment.
In tort cases where the person dies, the estate still does NOT get the total earnings. Need to take away
what deceased would have spent on himself – i.e. maintenance items such as food and clothing.
Estate really gets back “profits” = earnings – maintenance.
CALCULATING PROPERTY DAMAGES
(1 g ) 0 (1 g ) 2 0 (1 g ) 3 (1 g ) n
Basic Formula: PDV 0 ... 0
(1 r ) 2
(1 r ) 3
(1 r ) n
(1 r )
This is the same exact formula used in tort damages, except = profits!!!!
For Electric Motor Factory, what would damage remedy be if it had to close and you had to pay them?
.96 .96 .96 .96 1
PDV 10 ... , last equation is salvage value. (All
(1 R) (1 R) 2
(1 R) 3
(1 R) 20
(1 R) 20
numbers taken from Supp. 83.)
o Note: we are assuming real rather than nominal values, so g = 0.
o Real values already cancel out inflation.
Nominal r = real r + inflation
o What matters is the factory’s profits! Damages will be different whether based on profit or
revenue. We look only at profits.
If we shut down factory today, factory gets original sunk cost + annual profits – discounted salvage
value = $10 mil + $3.50 mil – [1/(1 + r)20) = $13.05 mil. So the scrap value is essentially deducted and
discounted b/c factory recovers that when it sells the scrap.
Note that 0.96 functions like an annuity.
o NPV (annuity) = c/r if it goes on forever assume r = 4%
o Here, annuity goes for 20 years so solve by taking:
NPV (annuity forever) – NPV (annuity beginning at year 21)
c c 1
c 1 c 1
r (1 r ) 20
r r r (1 r ) 20
c annuity th pays for 20 years c 1 1
r r (1 r ) 20 r (1 r ) t
.04 (.04)(1.04) 20
How do you get the appropriate interest rate?
Level of damages often determines liability!
Takings and Land Use Regulation
Public goods v. Private goods
Most goods are private goods.
Public good – has problems either with excludability or rivalry.
o Essentially a good that has less/no rivalry and problems of excludability.
Spring 2001, Economic Analysis of Law, Wachter 15
o Constitution – govt shall provide public goods. BUT, 5th Amendment prohibits federal govt
takings w/o just compensation. 14th Amendment applies to states.
(A can exclude others at low cost)
(When A uses it, Private good Ocean
no one else can) Yes - hot dog Clean air
- 99% of goods in world
Museum Ultimate public good
No Toll Road - national defense
Takings & Regulatory Takings in the Calabresi Framework
(government) wins (property owner) wins Whenever possible,
Property rule Rule 1: govt wins and doesn’t have Rule 3: property is not condemned. property rules are
to pay for the taking shows govt’s taking is not for better than liability
(unconstitutional!) public purpose. rules!
Liability Rule Rule 2: Inverse condemnation. Prop Rule 4: takings! State takes the
“Take & pay owner says govt took land & wts to land but has to compensate the
option” be compensated. can buy land by owner. (Compensated takings) Just compensation =
giving govt $. (Unimportant!)
Also too much like bribery.
Takings = govt takes land for public or private use. Litigation in takings re: “what’s a just compensation.”
(government) wins (property owner) wins
Property rule Rule 1: unconstitutional Rule 3: property not condemned.
shows taking not for public purpose.
Liability Rule Rule 2: unimportant Rule 4: compensated taking
Regulatory takings = govt leaves landowner to occupy land but regulates how that land is to be used.
(government) wins (property owner) wins
Property rule Rule 1: govt wants this box! Rule 3: Property not condemned.
Injunction based on nuisance Not liable in sense of creating
Liability Rule Rule 2: unimportant Rule 4: NOT what govt wants, b/c
govt has to take and pay here
K-H arguments & takings
Taking is KH mvt Taking is not consensual but at least you’re paid for it. Std for taking in a
Pigouvian govt: look at costs and benefits of takings and take where benefits > costs (Efficiency!)
Just compensation may not be adequate:
o People won’t invest in land b/c they fear it might be taken away.
o Idiosyncratic valuations of land not accurately reflected.
Govt, in reality, is not Pigouvian. Won’t do a cost-benefit analysis.
Is the govt taking to provide a public good?
Govt takings are nonconsensual they are K-H but they are not Pareto.
Poletown Neighborhood v. City of Detroit (1981) (Supp. 97) – private property to be taken for GM’s use.
Question is use by GM private or property?
Held: Court says it’s public use allows taking w/ just compensation Rule 4!
Spring 2001, Economic Analysis of Law, Wachter 16
Is GM providing a public good?
o Public benefit must be clear & significant in order for land to be taken through eminent domain.
o Not a traditional public good – more like public benefit no excludability, no rivalry
o What happens is that a business will provide a public good locally but on balance, doesn’t
provide a national public good. Localities end up competing against each other.
(GM/govt) wins (residents) wins Whenever possible,
Property rule Rule 1: unconstitutional Rule 3: property is not property rules are
condemned. better than liability
Liability Rule Rule 2: unimportant. Rule 4: takings! GM wins in rules!
court. Takes the land but has to
Just compensation =
compensate the residents. economic damages!
Rule today – as long as you can define it as a public good, then you can exercise a taking. No CBA.
Govt doesn’t have to be Pigouvian at all.
o Where exercise of eminent domain power is rationally related to a conceivable public
purpose, court has not proscribed such takings. After Poletown, govt generally wins in an
eminent domain case.
Pennsylvania Coal v. Mahon (1922) (Supp 101) – regulatory takings. = homeowner; = PA Coal Co. wts
to dig for coal under ’s house. PA Coal sold surface rights only and homeowners knew they were only buying
surface rights. Coal Co preserved digging rights. sued to get enjoinment against PA Coal.
Held: for (PA Coal Co). Homeowner knew about the surface rights and took the risk of acquiring
only those surface rights.
(homeowner) wins (PA Coal Co) wins prop rules better
than liability rules!
Property rule Rule 1: what wtd stop PA Rule 3: what we got! PA Coal
Coal Co. Injunction. wins & doesn’t have to pay .
Liability Rule Rule 2: PA Coal Co would’ve Rule 4: paying PA Coal Co to Here, w/ rule 3, can
bargain w/ .
had to pay . (Boomer) stop (Spur case)
If rule 4, $ award is
set by court.
What the court did, was it efficient?
o Probably YES under the circumstances, given that property rules are better than liability rules.
Since parties can now bargain, better chance to reach a mutually agreeable result than where
court sets the $ award.
Keystone Biluminous Coal v. DeBenedictis (1987) (Supp 107) – Regulatory takings. Replaced PA Coal case.
Held: for (Rule 1). If taking is not 100%, then PA Coal does not apply.
o Test for taking requires court to compare value that has been taken from the property with the
value that remains in the property.
Lucas v. South Carolina Coastal Council (1992) (Xerox II) – Lucas paid $975,000 for lots to build single family
homes in 1986. In 1988, state legislature bars structures to be built on lots. Lucas claims a takings (probably
regulatory takings, since he can no longer use the land for his intended purpose) and files suit.
Held: for Lucas.
o Scalia 2 situations where regulatory action is compensable:
Physical invasion – traditional takings case
Regulation denies all economically beneficial or productive use of land. (PA Coal)
o Scalia wants South Carolina to state more specifically why Lucas’ houses are public nuisances,
rather than just saying it’s a nuisance.
o Court is mediating dispute btw private party & govt on basic principle fight over the use of
police power to declare nuisance.
Spring 2001, Economic Analysis of Law, Wachter 17
Up to this point, believed that nuisance is executive decision with support of legislative.
Lucas suggests that judiciary is ultimate decision-maker of what’s a nuisance.
When there is 100% taking, you must compensate unless there is a nuisance.
Not a “taking” if laws had pre-prescribed use of land as nuisance. Can’t now run a
balancing test and decide it is a nuisance.
Paradox of Compensation
If regime is “take & pay,” developers will over-develop.
o Govt must either overpay or overregulate early on.
o Developer has no risk.
If regime is “take and don’t pay,” developer will under-develop.
o Govt will over-regulate.
o Govt faces no cost.
No rule handles both problems.
Issues in balancing equities
o Talk of amt party would lose if unable to use land.
o Presupposes party can create that amount of wealth.
o Presupposes party would lose that amount of wealth.
o Assume loss cannot be mitigated.
Efficiency of the Law: Common Law & Statutory Law
Priest article: Common Law Process and the Selection of Efficient Rules (1977) (Xerox)
Thesis: Common law is efficient! does K-H results/wealth max/economic efficiency.
o Efficient laws will be re-litigated less often.
o Inefficient decisions:
Re-litigated more often b/c both sides can still benefit. Some inefficent laws may give
bigger payoffs so more parties are willing to bear the cost of litigating them.
Costs more $.
Distributional argument (ct ends up re-distributing) + efficiency element:
More is at stake more litigation!
Efficient laws only have the redistributive element.
o As long as private parties bring suit more frequently when the law is inefficient, the more likely
that exisint precedents will be based on efficient results.
Interest groups generally don’t go to the Courts. It’s more effective for them to go to the govt courts
are reactive, not pro-active.
Historical argument for CL’s tendency towards efficiency:
o Evolution of English CL – competition among courts (cts of equity, King’s court, CL courts)
strive to do well by being efficient. Need to make court system more attractive to litigants to get
them to litigate within that system. So courts end up trying to maximize the wealth of the
litigants before them.
What matters is YOUR welfare v. the other party’s! (narrow argument)
Macey article: Promoting Public-Regarding Legislation through Statutory Interpretation (1986) (Supp 109)
Thesis: statutory law is generally NOT efficient. There is no principle that pushes statutory law to be
Interest groups exist for the common good.
o To be an effective interest group, you want to be narrowly focused and it’s easier to do that
when you’re a smaller group.
o (Tullock) Interest groups generate inefficiencies b/c groups compete with each other. Ex.
militant pro-choice grp leads to a militant pro-life group. So then end up competing and
spending $ against each other. Once there is competition, there is a lot of petitioning for laws
that only benefit a single person or a small group.
Spring 2001, Economic Analysis of Law, Wachter 18
(Olsen/Tullock Theory) Demand & Supply Model for Legislation
o Public groups have demand curve for legislation analoguous to normal economic dd curve.
$ Supply (legis)
As # of legis items (Q), $ spent per
issue becoming less effective.
Look only at the demand curve!
Macey addresses the supply of legislation and says that legislation falls into categories:
o Public purpose legislation
o Special interest legislation - Open special interest legislation v. Closed & hidden
The more stuff you want, the more costly it is. This is what democracy is all about. Historically, govt
viewed as being helpful to people with particular needs.
o Interest grps can be effective re: poor people issues b/c poor can deliver votes as a bloc and
what they wt tends to be popular.
o Young pp tend to have broad political causes so are not as effective!
Whole thrust of Macey article deals w/ statutory interpretation.
2 irreconcilable components of Constitution:
o legislature is Supreme – House is set up to serve constituents.
o Checks & balances – does judiciary serve as a check and balance, or yield to legislature and
allow legislature to make law?
Three types of statutes
1. Public purpose (Pigouvian) – most expensive to pass
2. Special interest (open & explicit) – 2d most expensive
3. Special interest (hidden & implicit) – cheapest to pass
Given Macey’s 2 irreconcilable components, there are threes view on how to read a statute:
1. Easterbrook model – legislation should be read as contracts btw interest groups and legislators.
Courts should just enforce the contract. Look at the Congressional record mostly to see what the
contract is trying to do. Distribution of resources if legislature’s job.
2. Activist View – Courts should be Pigouvian in doing what they think is best for the country.
a. Legislative supremacy won’t be so strict in favoring special interest groups. Favors checks &
balances i.e. courts should strike down special interest bargains.
b. High point was in 1930s when Court sturck down lots of New Deal legislation.
3. Public Regarding Middle Ground (prevailing view!) – Sees special interest groups to be particularly
important in statutes.
a. Strict interpretation of legislation itself. Won’t look at Congressional record. Otherwise, hidden
implicit legislation won’t get to be interpreted by the judiciary.
b. Legislation gets supremacy but it has to be CLEAR about what it means. So forces interst
groups to pay more attention to being clear about what they mean. (clear intent open and
c. Enforce open deals! Imposes higher costs on hidden and implicit legislation b/c there is a lower
chance that such legislation will be enforced. Court doesn’t search for hidden deal.
Question: How to reconcile ourselves with special interest groups and what they do.
Voting and Rent-Seeking
How do we know what’s in the public interest?
Spring 2001, Economic Analysis of Law, Wachter 19
Look at various models of government. Katz & Rosen Government (Supp 133)
Govts play a central role in nations’ economies.
Supplies and demands both commodities and inputs. Households and firms can obtain govt svcs by
direct purchase and also by paying taxes.
Has coercive power can control and regulate market exchanges in which it is not directly involved.
Defines and enforces individuals’ property rights.
In democratic societies, “social contract” btw govt and the people pp give govt a monopoly in the use
of coercive power in return for govt’s agreement to use this power to protect pp’s lives and property,
and to enforce contracts.
Various models of government vary on what’s being maximized.
BENEVOLENT DICTATOR MODEL
Govt as a benign and neutral dictator whose only goal is to maximize social welfare thru
redistribution of income.
Simple utiliatarian view:
o Add up people’s utility functions – additive social welfare function
W = U1 + U2 + U3 + . . . + Un
Equal weight gn to the utility of each person in society.
So keep redistributing income until complete equality is obtained. As long as
consumption levels are unequal, marginal utilities will be unequal and the sum of
utilities can be increased by distributing C to the poorer individual.
Utility fcns not easily measured nor additive. Looks more like:
W = f(u1, u2, u3, . . . , un)
Taxes and subsidies enacted to redistribute Y will generally change people’s work
deicsions and diminish total income.
o Society’s goal is to maximize the utility of the worst-off person.
W = Minimum (U1, U2, . . . U3)
o Rawls says imagine ZTC precondition, ceteris paribus, everyone would probably agree to adopt
this social welfare function. provides insurance against disastrous outcomes.
But moral hazard problem. Also, are people so risk-adverse?
Pareto-Efficient Income Redistribution:
o Redistribution is never a Pareto improvement - that allowed all individuals to be at least as
well as under the status quo.
Redistrib IS Pareto improvement where rich people are so altruistic that their utilities
depend not only on their own incomes but also on those of the poor.
Pushed to limit, becomes externatlity problem.
Income distrib rgd-ed as public good b/c everyone’s utility is affected by the
degree of inequality. So by coercing ALL rich pp to give to poor, benevolent
dictator can the utilities of both rich and poor pp.
Income redistribution policy is a bit like a publicly provided insurance policy.
VOTING MODEL – VOTERS AS DECISION MAKERS
o No proposal is approved unless every single person votes for it.
o Adv – guarantees no one will be exploited. BUT, does not lead to efficient outcomes.
Unanimity rule is an invitation to blackmail. Due to strategic behavior, costs of reaching a
decision are likely to be very high so that no decisions whatsoever are made.
Spring 2001, Economic Analysis of Law, Wachter 20
o Voting paradox:
Want voters’ preferences to be transitive A > B > C A > C. Stable outcomes.
Want vote to reflect the preference of the median voter. (public regarding)
But, although each individual’s preferences are transitive, community’s preferences are
Single-peaked v. double-peaked preferences
Single-peaked preferences – as you move away from preferred outcome in all
directions, utility falls. no voting paradox
Double-peaked preferences – as you move away from preferred outcome,
utility goes down but then goes back up again. voting paradox! matters
in which order things are introduced for voting legislation.
o Issue: Can the judiciary take more action b/c it knows what the median voter wants (public
regarding) or can it take more of a backseat b/c it doesn’t know?
And how do we know what is public regarding?
Ken Arrow no perfect way of defining public regarding. So there’s no way to
mathematically define public regarding.
One way is K-H model but K-H doesn’t deal w/ non-transactional issues such
as moral values.
o Ken Arrow: democracy works well only if people have single peak preferences and not so well
with double-peak preferences. So, where preferences are not transitive, there is no median
outcome that every single voter wants.
US govt works well b/c by and large, Americans have single peak preferences AND
there are only two main political parties.
In a democratic society, a collective DM rule should satisfy the following:
Rank all possible outcomes
Must be consistent must satisfy transitivity
Must produce a decision, whatever the configuration of voters’ preferences
must respect Pareto efficiency
Independence of irrelevant alternatives
Dictatorship is ruled out
Arrow’s Impossibility Theorem – In general, it is impossible to find a voting rule that
satisfies: completeness, transitivity, Pareto effiency, the independence of irrelevant
alternatives, and nondictatorship for all configurations of voters’ preferences.
But can construct a DM rule that satisfies 5 of the 6 criteria.
o Logrolling (“vote trading”)
W/o Arrow Impossibility Thm, can say logrolling bad b/c doesn’t reflect voter median.
BUT voting model does not include the INTENSITY w/ which pp have preferences.
Logrolling can both and efficiency can lead to K-H or Pareto Superior outcomes.
Improves welfare by allowing pp to act upon the intensity of their preferences.
Allows for 2 of 3 projects to be built, instead of 1 or none.
Introduces mrkt mechanism into voting & this is what pp are rebelling against.
Simple majority rule w/o vote trading can lead to inefficient results.
Majority of voters can form a coalition to vote for projects that serve their
interests, but whose costs are borne to a large extent by the minority.
o Rent-seeking – trying to get a benefit that is REDISTRIBUTIVE in favor of the stuff you want.
actions aimed at obtaining or preserving economic profits (“rents”).
Problem: everyone engages in rent-seeking and the activity itself is costly!
Rent seeking is the driving force behind the demand for political favors, b/c incumbents
in an industry w/ existing entry restrictions typically are willing to spend money to
maintain their favored position.
Rent-seeking model focuses attention on the potential size of the waste generated by the
govt’s power to create rents.
Spring 2001, Economic Analysis of Law, Wachter 21
HOW TO DO STATUTORY INTERPRETATION
(A More Detailed Classification of Types of Legislation)
Types of legislation in world of special interest groups/advocacy groups:
o Public regarding
o Open-special interest
o Closed-special interest
Healthy skepticism abt whether we really know what’s public regarding.
Assuming the courts know what is public regarding, how should they interpret different types of statutes
if forced to apply them to a case?
o Depends on the distribution of benefits and costs.
o Assumes that when benefits & costs are widely distributed, interest/advocacy groups will have
less influcence since it is the narrowly focused groups that tend to have the most influence.
Distributed Benefits & Distributed Benefits & Concentrated Benefits & Concentrated Benefits &
Distributed Costs Concentrated Costs Distributed Costs Concentrated Costs
Public view of political More regulatory – caputre Purest rent-seeking model. Ex. NLRA, unionized firms
issues – grand issues such as theory. Benefits to large # of Classic case of interest representing workers.
global warming, arms race pp w/ =ed costs. Ex. Ind groups! Ex. subsidizing
that affects everyone a little. regulation ranging from tobacco farming.
electric utilities, ins co.
Danger: legislature’s failure Danger: Regulated groups’ Danger: Rent-seeking by Danger: The statutory
to update the law as society evasion of duties, as special interest groups at the “deal” often grows
and the underlying problem agencies are captured by expense of the general unexpectedly lopsided over
change. grps. Regulation becomes a public. time.
means to exclude
Response: Courts can help Response: Cts can monitor Response: Cts can narrowly Response: Cts can fine-tune
maintain a statute’s agency enforcement and construe the statute to the statutory arrangement to
usefulness by expanding it private compliance & can minimize the benefits. Cts reflect new circumstances.
to new situations and by open up procedures to allow should err in favor of
developing the statute in excluded grps to be heard. stinginess w/ public
common law fashion. Cts should seek to make the largesse.
original public goal work.
Caveat: Cts should still be Caveat: In the case of Caveat: Rule of stinginess Caveat: Err against very
aleart to the influence of industry regulation, not applicable if statute much judicial updating,
organized groups & not companies often have more really serves a public unless affected groups are
create special benefits or knowledge than the agency purpose. systematically unable to get
reduced costs for them. and do have incentives to legislative attention.
Economic Analysis of Torts
Strictly speaking, bargaining doesn’t work in tort liability cases since accidents happen instantaneously. But
Coase Theorem may still be helpful. (Polinsky §6)
Efficient legal rules for dealing w/ driver-pedestrian accidents still can be derived by imagining what
rules a driver and a pedestrian would have chosen if they could have costlessly (ZTC) gotten together
before the accident.
If ONLY goal is to create incentives for the parties to take appropriate care, strict liability w/
defense of contributory negligence (SLWCN) and negligence – w/ or w/o a defense of contributory
negligence – are efficient.
If wt to create incentives to take care AND participate in activity at appropriate level:
o Strict liability is efficient.
o Negligent is also efficient IF std of care covers BOTH injurer’s care and his level of
participation in the activity.
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o IF std of care does NOT include injurer’s activity level, then negligence rule will lead to
excessive participation in the activity. (why negligence is ineffective in practice!)
Policy decision if it’s not feasible to include either party’s activity level in the std of care, the
preferred liability rule depends on whether it is more important to control the injurer’s or the victim’s
Administrative costs Effect of each rule on administrative costs of resolving accident disputes
depends both on # of cases litigated and cost of resolving each case.
o Negl rule expected to generate less litigation than SL rule. But cost of resolving each negl case
may be higher under the SL rule.
o On balance, admin costs do not clearly favor either rule.
ALL contracts are BOTH K-H and Pareto Superior!
Example1: flax farmer and railroad tracks – only look at RR’s level of care (injurer)
Benefits Exp Costs K-H result Doesn’t matter Assume risk-
(B) E(C) B – E(C) how close to the averseness!
Drive rapidly 120 100 20 tracks flax is.
Drive medium 80 40 40
Drive slow 50 20 30
Best for RR to DM. Both negl & SL get efficient results!
In torts, K-H rule applies to low cost accident avoider. Here, RR is LCA only RR’s behavior matters.
o SL – train always liable rgdless of how fast it drives. Last column = RR’s profits, and since rR wts to max
profits, will go moderately.
o Negl – if RR goes slowly or moderately, not liable for damage. RR only liable if drive fast.
So if DR, RR gets 20. If DM gets 80 (no damages) and DS gets 50. So will DM.
No liability world K-H not efficient. RR will drive rapidly since it’s never liable!
Example 2: flax farmer & RR tracks – both speed of train and how far flax is from tracks matters. Look at both
parties level of care. (Assume third party torts, i.e. they are strangers.)
Benefits Exp Costs K-H result Matters how Assume risk-
(B) E(C) B – E(C) close to the tracks averseness!
Drive rapidly 120 Far: 100 20 flax is.
Near: 110 10
Drive medium 80 F: 40 40
N: 50 30
Drive slow 50 F: 20 30
N: 30 20
Negligence – EFFICIENT!
o Train drives moderately. (RR gets 80)
o Farmer puts flax far away since it knows train will not be negl F also has to take care.
o leads to efficient result.
Strict Liability – NOT efficient!
o Flax near tracks since F won’t care b/c RR is strictly liable.
o So train will only look at results of when flax is near and most profitable is to DM but not efficient result
b/c RR gets 30.
Strict Liability w/ Contributory Negligence – EFFICIENT!
o SLWCN – injurer (RR) is strictly liable unless victim (F) is contributorily negligent. Results in desired
behavior of both parties.
Difference is who gets left in the loss.
If is negligent, gets residual accident cost.
If (RR) is negligent, gets residual accident cost.
o If flax is far, then Farmer not negligent, so he will put flax far away. Knowing that flax is far and RR
will be strictly liable, RR will look at B – E(C) and pick DM, where profits max at 40.
Spring 2001, Economic Analysis of Law, Wachter 23
Example 3: car accident – driver’s care AND activity level matters.
Activity level = how often you drive or # of trains that pass by the tracks
Generally, activity level is NOT taken into account in a negligence world.
Where both parties standard of care matters AND only the activity level of matters, SLWCN is
efficient, and negligence is not.
Conversely, where both parties’ std of care matters AND only activity level of matters, Negligence
is efficient but SLWCN is not.
KEY: NEGL AND SLWCN ARE DUALS OF EACH OTHER.
o Negligence takes care of ’s activity.
o SLWCN takes care of ’s activity.
Benefits to Exp Costs to K-H result Driver’s care &
Driver (B) Ped E(C) B – E(C) activity level
(depending on how (depending on how (Depending on how matter!
(behavior of driver) much driver drives) much driver drives) much driver drivers)
Drive rapidly Little: 120 Little: 100 20
A Lot: 140 Lot: 130 10
Drive moderately Little: 80 Little: 40 40 Assume risk-
A lot: 100 Lot: 70 30
Drive slow Little: 50 Little: 20 30
A lot: 70 Lot: 50 20
Negligence Rule – NOT efficient!
o Driver negligent only if drives rapidly.
o driver DM but this is not efficient b/c: driver will end up driving a lot, gets $100. But farmer loses 30
more (from 40 to 70).
o Negligence doesn’t account for activity level.
SLWCN – EFFICIENT!
o Driver faces all costs (his own harm and pedestrian’s harm) so he DM and a little!
TORTS AND THE INSURANCE QUESTION
No insurance available:
o Negligence = insurance policy for defendant; risk of activity borne by pedestrian
o SL and SLWCN = insurance policy for
Perfect insurance available:
o Perfect insurance = insurance company can perfectly monitor behavior of insured party and set
premiums ($) or adjust coverage accordingly.
o Both negligence and SL are efficient with respect to care exercised and the removal of risk from
o Because insurance company can’t perfectly monitor insured party’s behavior, have the problem
of moral hazard – insured pty acts in a hazardous manner.
Moral hazard – party that buys insurance, negatively affects expected loss by increasing
probabily of adverse event or magnitude of the loss.
If moral hazard exists, then we don’t get to efficient result.
o If moral hazard affects defendant (injurer), use negligence to be efficient. Another alternative is
deductibles and co-insurance this will set level efficient but will bear some risk.
o If MH affects , SLWCN gets it right.
Warehouse example: (insurance & moral hazard problem)
Warehouse worth $100,000
Fire Prevention Program $50
P(fire w/ program) = .005 = Expected loss = (100,000)(.005) = $500
P(fire w/o program) = .01 = Expected loss = (100,000)(.01) = $1000
Spring 2001, Economic Analysis of Law, Wachter 24
Cost of monitoring by insurance company = 100
No insurance, should company run FPP? YES! FPP costs $50, W saves 1000 – 500.
W/ perfect insurance: cost of insurance policy is expected loss ($500) plus cost of
W/ imperfect insurance: insurance company assumes W will act w/ moral hazard and
charges $1000 (max expected loss) to cover everything. Here, W won’t run FPP since it
doesn’t save anything by doing it.
o Monitoring is antidote to moral hazard problem up to point where incremental cost
incremental expected loss. (Just restatement of Demsetz’ article on emerge of property rights.)
o Risk to insurance company declines with number of policies.
o Solution to moral hazard is deductibles.
Deductible part the owner is not insured for.
If deductible is $10,000, cost of insurance is (100,000 – 10,000) * 0.005 = $450. So
If run FPP, cost to warehouse = - 50 – 450 – (10,000*0.005) = $-550
If don’t run FPP, cost = - 450 – (10,000*0.01) = $-550
This is the margin.
Deductible is amount that makes owner indifferent to risk reduction and solves moral
hazard. It lowers premiums and makes warehouse better off.
Adverse selection – high risk people buy insurance.
Defenses and Alternative Liability Rules
GRAPHICAL REPRESENTATION OF TORT LIABILITY
Y = victim’s () care or effort
X = injurer’s () care or effort shaded area = where pays
No Liability Strict Liability
NL and SL are duals.
SL efficient where ’s std
of care matters. Trial abt
damages only b/c harm
NL eff where ’s std of
Negl – pays when it doesn’t meet
std of care. What does is
y irrelevant. Look at harm & std of
care (x v. x*) y*
SLWCN - pays only when
exercised appropriate level of care.
Harm occurred. Look at ’s care.
x* x x
NWCN NWCN – liable only if did not SL w/ Dual Contrib Negl
y exercise care AND used care. (1) y
did meet std of care? (2) if not, did
meet std of care? SLWDCN could come
SLWDCN – NOT liable where up in product liability
used care and did not use care. (1)
y* cases where misuses
look at first if careful, pays. product and ’s
product also defective.
(2) if not careful, look at ’s
behavior. If not careful, pays.
x* x x* x
Spring 2001, Economic Analysis of Law, Wachter 25
Comparative Negl – jury determines how negligent
parties are in relation to each other. Box of the graph
where BOTH parties are negligent. (area of litigation)
y* How is this better than Negl or SL? Prevents game
playing – each party will look to the behavior of
other. Appeals to sense of equity. Reduces uncertainty
due to deviation in loss when crossing x*.
***If you ask who pays under what circumstances, you will know what standard is being applied.***
What standard is applied in LeRoy Fibre?
o Negligence looks at whether train acted in way that was negligent.
o SL is strictly liable. Don’t care whether met std of care as long as you can show
caused accident. (look at x*)
o SLWCN look at y*; did exercise appropriate level of care?
Trial court says this is a negligence case and found RR to be negligent.
On appeal, majority (McKenna) says negligence but sets x* so far out it is like SL. Focus on prop right.
o Concurrence (Holmes) – says it’s NWCN. Need some level of reasonableness. Don’t have to
pay for accidents where was not careful.
TORT LAW STARTS WITH NEGLIGENCE
In negligence, owes a DUTY OF CARE to .
Key question: whether has met the “reasonable standard of care” (x*)?
o Reasonable Learned Hand’s formula. If B < PL, liability!
The Reasonable Person Standard
o Is the rational person = reasonable person?
Rational person wts to maximize utility.
Given liability (law creating incentives for rational actors), rational person will act
reasonably will set x = x*.
Standard doesn’t vary w/ respect to individual characterisitcs. Since std doesn’t vary, it
is absolute reasonable person.
o Generally, once ct sets x*, rational person sets x = x*.
o Learned Hand’s formula makes reasonable person into rational person. So reasonable rational
person will act at x*.
What’s wrong w/ BPL?
o Doesn’t account for tansaction costs.
o Learned Hand actually wants to look at MARGINAL costs and MARGINAL benefits. So
should really be:
B(cost of avoiding accident) > PL(expected loss) economic standard
(Ct acts efficiently if it follows x* created by BPL)
o L&E doesn’t worry about causation.
Pillars of Coase – all harm is joint issue of causation not as clearly defined as a
purely legal regime.
Negligence w/ defense of contributory negligence (affirmative defense)
o Both parties fail to meet std of care, i.e. both parties negligent.
Spring 2001, Economic Analysis of Law, Wachter 26
o Where believes will be careless, will be able to recover no matter what standard it set
since x < x*. So will take no care. But if have the affirmative defense, this will induce to
take some care so will set behavior at y y*.
Assumption of risk
o Affirmative defense to ’s own negligence.
o knew this was dangerous and was willing to do it. (Moral hazard problem)
o Contractual implicity or explicitly. (Ex. higher wages for more dangerous jobs.)
o Typically 1st and 2nd party cases.
Custom (Never argue Custom in a 3rd party negligent tort case!)
o Generally, custom relevant but not determinative.
o TJ Hooper (Cooter-Uten 375) – (Learned Hand) Tugboat found negligent b/c it didn’t carry
radios. Cost of radio so low that party hadn’t met its std of care.
Looked at custom to determine what standard (x*) should be.
Acts as demarcation line – in some sense, it’s a contract case that migrated into torts.
There is an efficient level of care that parties will agree to themselves. Parties
interact w/ each other – 1st&2nd party torts. Suppliers don’t wt to lose customers
so will take some level of care.
Where x* = 0 exists only in 3d party accidents (no biz relationship w/ each
Posner feels Learned Hand blew it. How?
Tort is akin to contract.
o Nuisance torts involve 3d parties.
o Contracts involve 1st and 2nd parties.
o This involves 1st and 2nd parties, a dissatisfied customer is suing so
really more like a breach of contract.
o case should be dealt w/ as a contract.
o Custom from L&E should be element in defense. Judges should let market find efficient
standard of care.
o Custom plays a big part in medical malpractice.
Competitive Markets – market where there are many firms producing the same commodity and many
consumers purchasing it. (Polinsky, §11)
Neither buyer nor seller has control over the price of the commodity.
Assume, also, free entry and exit When all firms that wt to leave the industry have done so and when
all firms that want to enter have done so, the industry is said to be in long-run equilibrium.
In competitive markets, the price of a product = its cost of production.
o Mgrs’ compensation and owners’ returns already are included as part of the cost of production.
If firms take “all relevant costs” into account in setting their price, a competitive market will lead to the
PRODUCTS LIABILITY EXAMPLE: BOTTLES V. CANS
Production Exp Accident Total Cost Assume:
Cost Cost Consumers indifferent btw bottles and
cans so will choose the least costly option.
Bottles .40 .10 .50
Cans .43 .02 .45
Example 1: Perfect Information Case. Bottles and Cans have same consumer satisfaction. Consumer level of
care doesn’t matter. Low transaction costs. Risk neutral. (Analoguous to ZTC)
Spring 2001, Economic Analysis of Law, Wachter 27
SL, Negligence, and No Liability rules are all efficient! Application of Coase Theorem w/ perfect
information, liability rule is irrelevant. Every rule will be efficient in terms of the care exercised
by producers and the output of the industry.
Under Strict Liability – gets it right!
o Manufacturer is liable for all accident costs.
o Accident costs are costs of doing business.
o To cover costs, bottles will be sold at 0.50 and cans at 0.45
Under Negligence – gets it right!
o Firm negligent for accidents involving bottles only.
Bottles will sell in store at 0.50.
Bottles don’t add any satisfaction over cans, so fail B < PL.
o Firm is not liable for accidents involving cans
Cans sell at 0.43.
But consumer w/ full information adds in the 0.02 cents to self-insure and thinks 0.45
cost – effective price.
Under No Liability – gets it right!
o Consumer liable for all accident costs.
o Bottles sell for 0.40 and cans for 0.43.
o But consumers w/ full information will add accident cost to sell insure so think bottles cost 0.50
and cans cost 0.45.
Consumers would prefer a 0.45 can w/ the risk of accident to a 0.46 can w/o risk of accident in a risk
netural world where damages fully compensate.
Example 2: Consumers underestimate product risk. Think risk is zero.
Under Strict Liability – gets it right!
o Manufacturer liable for all accident costs. Does not depend on consumer knowledge –
consumers know they are covered and can recover from the company.
o Bottles sell at 0.50 and cans at 0.45 – same results as perfect information.
Under Negligence – inefficient consumers buy too much; firm care efficient.
o Firms negligenct for accidents involving bottles only.
o So firms sell bottles at 0.50 and cans at 0.43.
o Level of care of firm is efficient.
o But consumers no longer know to factor in the 0.02 to self-insure so buy too much. So they end
up buying too much activity level too high (in the short run).
In the long run, firms will adopt risks and be efficient.
Under No Liability – inefficient wrong activity level; wrong standard of care.
o Consumer liable for all accident costs.
o Bottles sell for 0.40 and cans for 0.43.
o Underestimate product risks, consumers will buy bottles b/c they don’t account for the 0.10
accident cost. Also will end up buying too much.
If consumers overestimate product risk and drink too litte, Firms will assume lability.
Analytically, this is a contract world and parties will act to joint profit maximize.
Consumers underestimate strict liability is efficient! Negligence can only induce producer to take care but
consumers will purchase too much of the good; no liability is deficient both with respect to care and output.
Example 3: Consumers overestimates risk.
KEY: what changes is what consumer thinks the expected accident cost is. So essentially play with
STEPS FOR changes in those numbers and see what happens.
ANALYSIS! o Assume risk-neutrality and do analysis (no insurance world)
o Assume insurance world (risk-aversion)
For example, if consumer’s perception is:
Spring 2001, Economic Analysis of Law, Wachter 28
Negl too little consumption since consumer sees cost as
Production Exp Acc Total
.48 and .53. So mfr may end up assuming SL to sales. Can
Cost Cost Cost
do this by giving warranty, which is price of insurance.
Bottles .40 .13 .53
Dwelve into contract law.
Cans .43 .05 .48
Product liability comes from contract law. Liablity in contract law is strict – default rule seller is
liable for any defect. Reasoning: seller knows better than buyer about risks so seller becomes low cost
In general, in first-second party cases, seller knows more than buyer about product risks. So if seller
Prod Liab wants to attract buyer, seller will make itself strictly liable REGARDLESS of legal rule for the
Contracts performance of product.
o The areas of SL as legal rule are the areas where SL is more efficient, i.e. product liability,
o First-second party cases – people know each other. “contract disputes.” Product liability cases
tend to be 1st-2nd party relationships.
Example 4: Risk Adverse World (both parties). Perfect Info.
If there is perfect insurance, then no moral hazard nor adverse selection.
o Adverse selection – If insurance sold at cost to everyone, only pp who buy are the sicket. So
insurance companies will price differently to diff pp. Perfect info is antidote.
o Moral hazard – actual behavior changes. probability that event triggering insurance will occur.
Monitoring is antidote.
o Ideal insurance is antidote to risk aversion.
o In SL, consumer insured by firm. Firm will thus buy own insurance at 0.10 for bottles and 0.02 for
cans. Insurance cost = expected loss + (admin cost + profit margin)
o In Negl, firm selling cans faces no liability so consumer buys 1st party accident insurance.
For there to be perfect insurance, insurance has to be able to charge price = expected accident cost.
Insurance company nees to know activity level for ideal insurance.
o Not possible for individual consumers.
o May be possible for firms.
o There will be moral hazard.
o Activity level hard to measure generally not incorporated.
o Insurance company won’t sell full insurance no full coverage.
o End up looking at relative risk-averseness. Ex. If consumers more risk-averse, SL better.
Consumers insured by liability payments and mfrs bear some risk.
o SL w/ imperfect insurance
Firm will pay monitoring costs to cut premiums.
Provide incomplete insurance – don’t insure bottles.
Insurance will include deductibles and co-insurance for cans.
When customer’s level of care matters, need SLWCN.
Example 5: Consumers can take care.
SLWCN is efficient. (derived from fact that SL generally better for product liability cases) Defense of
contributory negligence is required to get consumer to take appropriate precautions.
If consumer can take care but doesn’t, then SL w/ DCN
y consumer’s care y < y*. Allows firm to escape y
liability when it was efficient.
However, most firms don’t want to harm clients y*
since they want repeat business. So may want to
x x* x
Spring 2001, Economic Analysis of Law, Wachter 29
With third parties, only SL gets it right!
o Externalities created by product.
o Activity level causes externality.
o We want to cover non-negligent accidents (risk-spreading)
ESCOLA COCA COLA CASE
Used res ipsa loquitor – if bottle exploded, can take it that it’s negligent in some way. Movt towards SL.
(J. Traynor) Mfr is absolutely liable b/c mfr in best position to prevent such accidents.
o Abs liability insures the consumer. More impt to insure the injured rather than injurer. Also
lower admin costs.
o Firm can pool over all accidents. Firm is perfect insurer.
o Setting x* is too complex. Set y* w/ SLWCN.
o Getting toward fact that in contracts, performing party is strictly liable.
In some cases, std of care decisions left to jury – usu apply reasonable person std what reas person would do
under the same circumstances.
COMPLAINTS OF STRICT LIABILITY
For SL to be efficient, need to allow defenses of A/R where relevant OR ’s product misuse. Often the
courts just apply rule that firms always liable and forget about the defenses.
Game Theory and Torts
Game Theory – another way to illustrate which liability regime is best.
Parties interacting w/ each other 1 party’s action influences the other.
How much do the parties know?
o Perfect information world re: strategies and payoffs. So strategies & payoffs are known.
Only thing you don’t know is which strategy the other party will choose.
To what extent do we assume rationality?
o Rationality = wealth maximization if player has a dominant strategy, player should play it.
o Rationality also means that a party will assume that the party with the dominant strategy will
play it. (i.e. believes the other party is similarly rational!)
Game – consists of three parts:
Players – at least two
Strategies – also at least two; hardest thing to do
Payoffs for strategies
Basic idea (as it relates to torts) – probability of an accident as investment in care , and the efficacy of one
party’s investment in care turns on whether the other party invests in care as well. But we want to create a
system incentivizing both parties to take care which liability regime will do this?
No Liability World: (assume cost of taking care = -10)
Motorist Motorist’s dominant strategy is to take No Care. (if
ped takes NC, mot better off taking no care; AND if
(Ped, Mot) No Care Due Care ped takes care, mot still better off taking NC)
No Care -100, 0 -100, -10 Ped has no dominant strategy. But since Ped knows
Due Care -110, 0 -20, - 10 Mot takes NC, P better off also taking NC.
Motorist has no incentive to take care
Strict Liability World
Spring 2001, Economic Analysis of Law, Wachter 30
Ped – dominant strategy is to take NC.
(Ped, Mot) No Care Due Care Mot – no dominant strategy; but since it knows
No Care 0, -100 0, -110 motorist will take no care, also ends up taking no care.
Due Care -10, -100 -10, -20
Motorist liable for all accident costs.
Strict Liability w/ Contributory Negligence: EFFICIENT!
Motorist Shaded area in chart =
(Ped, Mot) No Care Due Care patterned area in graph
Ped dominant strategy is y*
No Care -100, 0 -100, -10 DC Mot also DC.
Due Care -10, -100 -10, -20
Incentives for BOTH parties to take care.
Negligence w/ Contributory Negligence: EFFICIENT! NWCN
(Ped, Mot) No Care Due Care
No Care -100, 0 -100, -10 y*
Due Care -10, -100 -20, -10
Incentives for BOTH parties to take care.
Question: What would regime of simple NELIGENCE look like?
Makes sense where game theory assumptions fall apart (not rational in game theory sense) usual
sharing rule works! Efficient!
Nash Equilibrium – there is a NE combination of strategies where no player can do better by choosing
a different strategy, given the strategy the other player chooses. The strategy of each player must be a
best response to the strategies of the other.
o “What’s best for me now depends on what you do.”
o Dominant strategy thinking: “I will do what’s best for me, regardless of what you do.”
Example: Skewed sharing rule
Assume DC = $3; SC = $1; Accident costs $100; P(accident) = 1/50 if both show due care
Motorist Shaded area = Nash equilibrium neither
(Ped, Mot) No Care Some Care Due Care pty can do better by moving elsewhere; does
No Care -50, -50 -99, -2 -100, -3 not depend on sharing rule!
Pedestrian Some Care -2, -99 -51, -51 -101, -3 Neither party has a dominant strategy.
Due Care -3, -100 -3, -101 -5, -3 Do analysis starting from (NC, NC) and see
where you end up.
Comp negl makes sense from efficiency viewpoint if Motorist believes Ped won’t take due care.
What happens if one party assumes other party is not rational? (i.e. why do we have so many negligent
accidents? Why are there so many torts cases where comparative negligence is applied?)
Spring 2001, Economic Analysis of Law, Wachter 31
Hardest part about comparative negligence is figuring out x* and y*. But intuitive sense that it’s fairer.
o As y to y*, injurer’s share of fault increases.
o Once y* is reached, victim no longer at fault. All burden goes to injurer.
Where both parties are negligent, comparative negligent can create the right incentives!
Example: Assume extreme sharing rule gives the following results:
DC accident cost by $20; SC accident cost by $10
No Care Some Care Due Care
Pedestrian No Care -50, -50 -89, -2 -80, -3
Some care is best choice for motorist but societal optimum is Due Care.
So extreme sharing rule gets it wrong! Ped gets stuck w/ most of the costs.
Society wts rule that gets motorist to show DC.
Here, Comp Negl not better than NWCN does not set the right incentives for Mot to take DC.
Instead of extreme sharing rule, try most common comparative negligence sharing rule:
it's share of negligence
TOTALshare of negligence
So if DC = 0%, SC = 50%, NC = 100% Injurer pays ; had some care; had no care.
50% 100% 3
So we get:
No Care Some Care Due Care
Pedestrian No Care -50, -50 -60, -31 -80, -3
Here, motorist will now exercise DC, which is exactly what we want! Societal optimal!
So, with usual sharing rule, even if believes will not be careful, comparative negligence gets it
right! (whereas NWCN & SLWCN will get it wrong.)
o To get this result, either party’s share of accident cost has to more than cost of taking
o Like BPL analysis where you’re liable only if B < PL
Generally, extreme sharing rule gets it right where accident costs >> due care costs
COMPARATIVE NEGLIGENCE IN S/L WORLD
Movement towards comp negl break presumption that is at fault. More like SL w/ dual CN.
SLWCN SLWDCN Comp Negl in SL World
y y y
So we get:
y* y* y*
x x* x x
Key: who bears cost when neither party is liable?
COMPARATIVE NEGLIGENCE FORMULA:
% paid by in SL world = , where y = and x =
( x x*) ( y y*)
Spring 2001, Economic Analysis of Law, Wachter 32
% paid by defendant in negligence world =
( x x*) ( y y*)
Joint and Several Liability
Two types of joint torts:
All parties contributed to accident and accident required all of them to be careful. Harm indivisible. (Ex.
2 cars speeding, hit at same time.) more traditional types of cases
Alternate care cares: only one party needed to be careful for the accident to be avoided. (Ex. Muth
case – indemnification case w/ general contractor and sub who built fautly foundation.)
o Indemnification shifts costs and liabilities of the parties!
Common Law said no contribution for joint torts. (Similar to SLWCN)
Since all parties needed to be careful, it’s efficient for any of the parties to pay the entire bill.
Typical where harm is indivisible.
With contribution, more similar to comparative negligence who contributes to what part of the accident?
Contribution v. Indemnification
Contribution from joint care cases
Indemnification – liability shifts; person who has to pay entire amt also shifts
put each on an axis x1 and x2 are defendants; y = plaintiff/victim
Traditional CL contribution not allowed!
x1 y could choose who to go after
x2 pays cannot x1 could not pursue x2
collect incentive to be found non-negligent
Modern Day – allow contribution
x1* prevents level of care
chooses prevents game playing by
who pays x1 pays from doctrine of COMPARATIVE
(jt torts!) NEGLIGENCE
allows to recover even if one is
Indemnification is not true Joint and Several Liability. In Joint cases, both parties must have exercised care
to avoid the harm (can only collect percentage of accident from that )!
Alternate Care Case: Muth v. Urricelqui (1967) (Xerox III)
Buyer buys house. Wall cracks right after moving in. Buyer hires general contractor to fix it. Sub builts
faulty foundation for now faulty house. Buyer sues GC and GC seeeks to indemnify sub.
o Subcontractors – independent; not employees
o Buyer can sue any of the parties. But if buyer sues GC and sub is the least cost avoider, GC can
seek indemnifaction against sub. Indemnfication shifts liability and costs of the parties.
Only ONE person needed to exercise care.
Inefficient for law to require both parties to meet standard of care.
Similar to contract rule if parties could have anticipated, then who would they have made
o LOW-COST AVOIDER!!!!!
will collect regardless of whether successfully indemnifies third party or not.
An alternative care case in which a homeowner brought suit against the GC.
GC in turn brought suit against SC for indemnification. Harm is divisible.
Spring 2001, Economic Analysis of Law, Wachter 33
In alternative care case, it would be inefficient to have more than one party exercising care.
Alternative care case triggers indemnification. Similar to contract rule. If parties could have anticipated, then
who would they have made responsible?
EMERGENCE OF NEGLIGENCE
Arose during the 19th century as a result of constant interaction (replaced strict liability).
Based on fact that anybody could be a or at any moment in Coasian world, would like to think
ahead and ask ex ante how to minimize the cost of the accident (minimize administrative costs).
Negligence is less costly than SL since if neither party is liable case does not get into court. (more K-
Areas for alternate care to apply:
General contract/subcontractor with harm to . Which party is low cost avoider?
Employer/employee. Employee will try to shift liability to employer (ex. in sexual harassment case) or
Principal/agent. Principal hires Agent to act in P’s interest (i.e. maximize P’s profits.) If A causes
accident, can sue agent who will then try to seek indemnification from P as long as A acted within the
authority given to him by P.
Where did negligence as a standard come from?
Traditional view 19th century; negligence replaced SL world to protect the emerging industrial class.
Negligence focuses on standard of care. SL looks at whether harm was done or not.
L&E negligence system arose in world where we’re in constant interaction w/ each other. So any of
us can be either plaintiff or defendant at any one moment.
o World in a COASIAN state prospective; don’t know who is injurer/injuree so decide to
minimize cost of the entire accident system. Negligence less costly than SL world.
o L&E predicts society to adopt negl std efficient in sense that most cases don’t go to court.
Stand prior to negligence was as much no liability as strict liability.
o Laws of distress (Old English) – rule by which can use self-help against . Suggests no
liability world b/c potential from self-help to cure harm < world w/ established ct system.
Probability of accident occuring is close to or equal to ONE.
B 0 B << PL liable
Not dealing w/ conflicting land use cases.
Generally, defendant can avoid liability at virtually no cost!
So effectively, no standard of care for (x* = 0). Defendant almost always negligent.
o more like SL since almost always ends up paying.
Punitive damages more regularly assigned.
o Efficient number of accidents is ZERO so punitive damages won’t deter wrongdoer excessively.
o Why no punitive damages in unintentional torts?
Punitive damages is to punish.
Inefficient will increase total cost of accident system.
Creates more incentives for litigation
There is already an efficient number of accidents. Punitive damages will just
end up encouraging inefficient precautions. So the result ends up being fewer
accidents but society less wealthy.
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Coerced transfers of wealth/utility.
o Battery, rape, murder
o Can be dealt with Hand formula.
o Coerced transfer violates idea that property should be protected by the property rule. So want to
penalize/over-deter thru punitive damages.
Criminal law – leaves world of economics. Have to account for moral judgments. (L&E has a lot to say
about deterrence but doesn’t explain the way the law IS.)
One goal of Law & Economics is to connect property, contracts, and torts. The legal rules in the three areas are
reasonably similar. All do K-H but apply different versions of the K-H principle.
Property – default rule is either 1 or 3. Give entitlement to wealth maximizing party.
Torts – default rule more like 2 & 3, OR 3 & 4. Accident already occurred. Least cost accident avoider
should be liable.
Contracts – liability to lowest cost insurer.
INTRODUCTION AND FORMATION DEFENSES
All contract transactions are pareto superior. (voluntary transactions can be beneficial to both parties)
Must have consideration
Contracts law – sets up default rules that tell parties what to do, if not specified otherwise. Can contract
around it if parties desire.
o Made world less costly – std form/set of defaults cost of contracting
o Provided mechanism for dealing w/ contract breach and contract interpretation (Note: a
complete contract that deals with every contingency cannot be breached)
o Deters opportunistic behavior/rent-seeking.
A COMPLETE CONTRACT DEALS WITH EVERY CONTINGENCY AND CANNOT BE BREACHED.
THINGS TO THINK ABOUT:
1. Contract is between 1st and 2nd parties. But watch for 3rd parties not in contract but are harmed in the
enforcement of the contract. area of Liquidated Damages
2. Low transaction costs
3. Formation or Performance case?
4. Read the Contract!
5. Mistake Case what type of information & who can obtain the information
Contract Formation Defenses
MISTAKE – information is antidote to mistake. Who is the low cost information gatherer?
o Two types of mistakes
Mutual mistake – makes void b/c no meeting of the minds. Transaction not pareto
o Symmetric v. Asymmetric info
Symmetric – both parties can get information at about the same cost
Asymmetric – one party has clear advantage over the other party to get the information
o Sherwood v. Walker (Barren Cow Case) Asymmetric info. Seller (owner) should know more
about cow’s fertility. If Rose fertile product turns out better than thought so B should benefit.
Efficient result: Buyer gets to keep cow. B guaranteed either the product he thought he
bought or a positive surprise. Seller is the low cost info gatherer.
Held: for D – mutual mistake occurred that went to the SUBSTANCE of agreement.
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Both parties must have made a mistake of material fact – subject-matter of sale, price,
or some collateral fact materially inducing the agreement. Parties would not have
made of sale except upon understanding and belief that R was incapable of breeding,
and of no use as a cow. Barren cow substantially different from breeding one. Thus,
Rose was not the animal, or the kind of animal, intended to sell or intended to buy.
Dissent: (Sherwood) Sees no mistake. Interprets the facts as -seller saying that his Angus cattle
are probably barren and buyer still believed that the cow could be made to breed. The parties
were not mistaken in a legal sense, but merely ignorant or uncertain, and each took his chances
business in making the deal. They were dealing in probabilities, not mistake. prediction
Rescission is bad for POLICY. Buyer can thus use mistake doctrine to get free
warranty. If let B return cow b/c of difference in expected quality, then sayting sale
price implicitly includes warranty. BUT a warranty is valuable signifies belief in
quality so seller would want $ for warranty.
o Laidlaw v. Organ – first insider trading case to reach S.Ct. Buyer had inside info on when War
of 1812 ended so bought tobacco at low price, under Seller’s assumption that War will continue.
Seller asked if there were any special circumstances to be aware of. Unclear how B responded.
Held: B did not have to disclose the information.
Information was symmetrically available ex ante. As long as B did not affirmatively
misrepresent information, then his nondisclosure was okay.
Key: Investing in information-gathering is useful and costly so have to make it
profitable for people to go out and get the information. You have the right to trade on
the information you have.
o Why not force Organ to disclose the information?
If you want to have information in the market, best way is to allow pp to trade and
profit on it. Otherwise, no one would go get the information.
When pp trade on incorrect prices not efficient. As soon as pp who know start
trading, they put the correct info in the market. If you didn’t let them benefit, then
won’t trade and price won’t move in the correct direction.
o Market information v. information based on prior ownership
Own product/based on prior ownership asymmetric
Market prices symmetric b/c any # of factors can affect the price.
o With symmetric information, unless parties contract otherwise, either party can trade on it. How
to contract otherwise?
Can have saying nondisclosure = misrepresentation
Principal-agent Laidlaw (seller of tobacco) hires someone to an his agent to gather
info. So if hire Organ to be info gatherer, Organ can’t benefit from trading to Laidlaw.
As agent, Organ has to maximize principal’s wealth. BUT, hiring agents is costly.
a. Will not be discharged (if based on symmetric information).
b. May be discharged if due to asymmetric information
a. Contract will be discharged no longer Pareto Superior.
Information is the antidote for mistake.
o Symmetrically – cost of gathering information is the same
o Asymmetrically – information where one party has a clear advantage of collecting information
Want to know who is the low cost information gatherer.
Mistake may occur after performance. Issues of mistake involve facts at the time of formation.
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Mistake cases always involve asymmetric information, ex post. But is it really asymmetric?
a. Market information is virtually always equally available.
b. Party needs to invest in the information.
Symmetric market information parties each bear own risks and bargain with one another.
a. No duty to inform.
b. No duty to disclose, but cannot misrepresent.
c. Ex ante, parties would not agree to a regime that allowed affirmative misrepresentation.
d. Fraud would increase information gathering costs.
Sherwood v. Walker (Supp. III) – Infertile cow case. Sherwood bought a cow with calf. Walker refused to
deliver when he realizes cow no longer infertile.
Held: A mutual mistake. A fertile cow is not the same infertile cow.
o Owner/Walker had asymmetrical information about the cow (ability to inspect over long-run).
Seller is the low-cost information gatherer.
o Barren cow price includes risk the cow is not barren.
o Sherwood paid something for the risk the cow is not barren.
o Should have had specific performance.
o Wrong contract law does not effect efficiency since both parties can contract around the default
Mistake must be DETRIMENTAL and information INCORRECT at time of TRANSACTION!
Laidlaw v. Orgon (Supp. III “Mistake”) [first “inside trading” case] – Orgon obtains information about the
ending of the War of 1812 and enters into a contract for the purchase of tobacco from Laidlaw. Laidlaw agents
asks if Orgon had any “news” that would enhance the price or value of tobacco (Orgon did not answer).
Tobacco prices shoot up.
Held: Court awarded Orgon for his investment in the information (contract upheld).
Reasoning: Both parties had equal power to invest and gather information.
o Was this information really symmetrical? Ex post, yes. But ex ante, probably.
1st and 2nd party; low transaction costs; equal gathering power.
o A way to reward individuals with information is to assign a property right in the information
o Only way to assign property rights in short-lived market is to allow people to contract freely
Distinguishing between Sherwood and Laidlaw…
prior information vs. market information
1. Are parties experiences?
2. Was there equal access to the information?
3. Is there evidence of hidden clauses, duress, incapacity, distress?
4. Was there dickering over specific terms?
5. Long term contracting relationships don’t lend themselves to procedural unfairness.
1. Are there similar clauses used elsewhere in the industry?
2. Contract must be judged in its totality, not simply because of one harsh clause.
3. Is there perfect competition?
Method of Determining Unconscionability
1. Are other people doing it? If yes, then it is not unconscionable.
2. Was this harsh given the regular market outcomes?
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3. What of situational monopolies?
Unconscionability as collection of Formation Defense
Deals with market at the time of contract.
May be seen as hidden clause, because it was so harsh that no one would voluntarily agree to it.
Presumption is then that the party did not mean to enter the contract.
State is a 3rd party that does not want clauses enforced that would force people onto welfare.
William v. Walker Thomas Furniture (Supp. III) – Substantive unconscionability cross-collateral clause.
Held (by Wachter): This case was situationally unconscionable.
o If the add-on clause was harsh, parties could of bargained around it.
o Intransient clauses will limit access of poor to furniture.
o Society/State (as 3rd party) has an interest in protecting the poor from becoming bankrupt. State
does not want to pay welfare.
Difference between hidden and harsh clause:
o Hidden clause suggests an attempt to deceive.
o Harsh clause suggest a detriment to one party.
Not a Defense except in three areas:
1. After signing of contract, performance is illegal
2. Cause of nonperformance is death of the performing party
3. Item needed for performance is destroyed
Posner Contract is SL thus
1. Cannot win impossibility through mere balancing
2. The rule is that when performance has become unprofitable, performing party breaches and pays
3. Discharge is an exception.
Would Parties had agreed to the exception ex ante?
1. If they had, expectations damages would include the exception.
2. Most contracts have damages in case of non-performance not a breach.
3. Economic analysis turns on question of risk allocation.
Performing Risk Allocation analysis:
1. Who is the low cost insurer?
2. Which party accepted the risk?
3. If risk not allocated determine which party could best make risk appraisal
a. Risk of probability of loss
b. Risk of size of loss
c. Transaction costs – which party could best buy insurance
Effects of Supervening Illegality
Phelps v. School District (Supp. III) – state board of health ordered school closed for two months because of flu
epidemic and board laid off the teachers.
Held: Court refused discharge.
o Although neither party could prevent the epidemic, the school district was the superior risk
o School district could spread the risk among all of its schools and among the teachers.
o One impossibility factor is not dispositive.
Spring 2001, Economic Analysis of Law, Wachter 38
Stratford v. Seattle Brewing & Malting Co. (Supp. III) – party leased premises to be used “for saloon purposes.”
Contract was discharged when a referendum disallowed liquor licenses.
Reasoning: Assigned the risk of the law change to the lessor.
Loss in value was = to the difference b/t the original rental value and the rental value after the
Lessor was a brewer probably as competent as the lessee to estimate the likelihood of the loss of the
liquor license. (low cost insurer)
Transatlantic Financing Corp. v. United States (Supp. III) – contract to transport should be discharge b/c of the
closing of the Suez Canal.
Held: The owner-operators of vessels low cost insurer against the hazards of war.
Hadley v. Baxendale (Supp. III) – consequential damages not relevant to discharge questions places liability
of damages (in the absence of express agreement to the contrary) on the shipper rather than the carrier.
If a risk of loss is known to only one party to the contract, the other party is not liable for the loss if it
This will induce the party with knowledge of the risk either to take appropriate precautions himself or, if
he believes that the other party might be the more efficient preventer or insurer of the loss, to reveal the
risk to that party and pay him to assume it.
Incentives are created to allocate the risk in the most efficient manner.
Arising due to the narrow confines of impossibility (near impossible performance)
1. Contingency Unforeseen
2. Risk of failure not assumed
3. Breaching party did not cause event that lead to impracticability
4. Server shortage
ALCOA v. Essex Group (Supp. III) – Mutual mistake. Also included an impracticability element (unforeseen
time bomb waiting to go off).
Both parties contracted around the default rules and split the share of loss.
Usually, long term contracts can be reformulated. A panel may fill in the gaps the way the parties
would of filled them in ex ante.
Cases like ALCOA usually go into private arbitration.
1. If prevention is not possible…
2. Allocate the Risk
a. If risk is either explicitly or implicitly allocated enforce the terms
b. If not, the court determines ex post what the parties would have done ex ante
3. Low Cost Insurer
a. Risk Appraisal (or measurement)
a. Estimate the P (probability) of event occurring
b. Estimate the L (loss) should the event materialize
b. Transaction Cost
a. Self-insurance, best able to pool risks.
b. Buy market insurance at lowest cost.