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					ECONOMIC ANALYSIS OF LAW
    September 12, 2006
ECONOMIC ANALYSIS OF LAW
    ECONOMIC ANALYSIS OF LAW
•   ECO320Y5Y
•   LEC6001P1
•   TUESDAY - 19:00 - 21:00
•   SE 1104
ECONOMIC ANALYSIS OF LAW
 ECONOMIC ANALYSIS OF LAW
• Posted at:
• http://www.utm.utoronto.ca/~w3eco320/
    • PDF
ECONOMIC ANALYSIS OF LAW
 ECONOMIC ANALYSIS OF LAW
• Two Formats at:
• http://www.utm.utoronto.ca/~w3eco320/


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ECONOMIC ANALYSIS OF LAW
 ECONOMIC ANALYSIS OF LAW

• Standard Microeconomics
   • No Legal System
       (Or A Legal System that is completely dysfunctional)

  • Parties will still make contracts, but the focus is on
  strategy, not design or enforcement
  • Contracts are instantaneous
  • No Property Rights
  • No Enforcement
  • No Legal Hierarchy
ECONOMIC ANALYSIS OF LAW


• Where do “laws” come from?
 • Custom
 • Judicial Precedent (Common Law)
 • Statutory Legislation
 • Executive Decision – Making
 ECONOMIC ANALYSIS OF LAW
• Courts
     • Beverley McLachlin,
       P.C. – Chief Justice of
       Canada
 ECONOMIC ANALYSIS OF LAW

• In each category, the following
 questions arise?

• Does a law (rule), over time, become
    » More Efficient?
    » More Competitive?
    » More Optimal?
 ECONOMIC ANALYSIS OF LAW

• The “interesting” or most “visible”
 legal issues arise in non-market
 situations
• What does one mean by a non-market
  situation?
    » No pricing mechanism or the pricing
      mechanism has broken down
    » Imperfect information
    » Power, not resources, is paramount
 ECONOMIC ANALYSIS OF LAW

• Bilateral Agency

    » Bilateral monopoly is an example of a
      bilateral agency
    » Examples: One union represents the entire
                  workforce of a monopolist
                  Brand loyalty or brand
                  exclusivity
 ECONOMIC ANALYSIS OF LAW

• Bilateral Agency
    » Almost all of the legal problems discussed
      in this course will involve some form of
      bilateral agency
    » Examples: Landlord and tenant
                  Spouses in a marriage
                  Firm and shareholders
                  Criminal and victim
                  Tribunal and parties before it
 ECONOMIC ANALYSIS OF LAW

• Bilateral Agency
    » Two broad types of “bilateral” agency
    » Implicit – relationship is exclusively
              strategic
    » Examples: Duopoly – substitutes or
                          complements
    » Explicit – relationship is both
              strategic and has some legal
              significance
    » Examples: See previous slide
 ECONOMIC ANALYSIS OF LAW

• Bilateral Agency
    » Two types of “explicit” agency
    » Imposed – A law “imposes” a relationship onto
                parties
    » Examples: Parent – child
                Car owner – accident victim
    » Voluntary – The parties “choose” their relationship
    » Examples: Contracts
                Some marriages
 ECONOMIC ANALYSIS OF LAW

• Horizontal Agency
    » A further way of classifying agency
    » Horizontal – Two parties are similar and enter into
                 some form of legal venture
    » Examples: Two partners in a firm
                Two joint property owners
                Spouses in some marriages
 ECONOMIC ANALYSIS OF LAW

• Horizontal Agency



     AGENT 1          AGENT 2
 ECONOMIC ANALYSIS OF LAW

• The following relationships predominate
  here
     » Prisoners Dilemna
     » Battle of the Sexes
 ECONOMIC ANALYSIS OF LAW
• Divorce
 ECONOMIC ANALYSIS OF LAW

• Vertical Agency
    » Vertical – Two parties agree on a ranking and
               order of conduct
               Principal – first mover
               Agent – second mover
    » Examples: Landlord and tenant – (especially
                                          residential)
                Employer - employee
                Buyer – seller
                Client - lawyer
 ECONOMIC ANALYSIS OF LAW

• Vertical Agency



           AGENT 1




           AGENT 2
 ECONOMIC ANALYSIS OF LAW

• Vertical Agency



           PRINCIPAL




            AGENT
 ECONOMIC ANALYSIS OF LAW

• Agency
   » No pricing mechanism or the pricing
     mechanism has broken down
   » The focus is on information acquisition in
     order to maximize surplus (perfect
     discrimination = optimal surplus)
   » Power determines who or what sets the
     price
 ECONOMIC ANALYSIS OF LAW

• Agency
   » The focus is on information acquisition
     in order to maximize surplus (perfect
     discrimination = optimal surplus)

   » Moral Hazard – non-verifiability of agent’s action
   » Pooling – treating different agents the same
   » Discrimination – treating the same agents
                      differently
 ECONOMIC ANALYSIS OF LAW

• Two “non-market” phenomena that
  predominate law and economics
    » Moral Hazard
    » Adverse Selection
 ECONOMIC ANALYSIS OF LAW

• Moral Hazard
    » The possibility all or part of a contract
    might not be performed
    » Accidents
 ECONOMIC ANALYSIS OF LAW

• Adverse Selection
      » Where discrimination is optimal, prohibit it
          (Banning pitbulls)
      » Where discrimination is sub-optimal, allow
 it
            (Asking new Canadians to re-qualify
            their work credentials)
 ECONOMIC ANALYSIS OF LAW

• Cost of Going To Court
  • Delay
 • Lawyers
 • Legal Aid
ECONOMIC ANALYSIS OF LAW
How does the legal system resolve
 conflict ?
    » Negotiation - Settlements
    » Courts – Lawsuits
ECONOMIC ANALYSIS OF LAW
            BACKGROUND
• 1776 – Adam Smith –
  Legal rules can
  impact economic
  growth
            BACKGROUND


• England had poorer climate and less
  arable land than France in 1700’s

• Why did productivity in England outstrip
  France?
            BACKGROUND
• Common law – long lease – the tenant
  farmer could keep the profits of innovation
          »Better breeds
          »Better crop cycles
          »Successful enclosure system
          »Crop specialization


• Common law – not perfect – why? – law of
  primogeniture
           BACKGROUND
• Law of primogeniture – On the one hand it
  kept good farms intact and continued
  economies of scale where present
             BACKGROUND
• On the other hand the
  eldest son might end
  up being useless –
  Smith regarded this
  as a major problem
  and recommended
  repeal
            BACKGROUND
• Recall that on
  September 11, 2001,
  in New York, there
  were acute shortages
  of water
• What happened?
             BACKGROUND
• Opportunistic types
  took advantage of the
  need and would sell a
  bottle for $200.00 or
  more!
           BACKGROUND
• In England, in Adam Smith’s day, there
  were penalties against such opportunistic
  behaviour
• What did Smith recommend – get rid of
  these laws! Let the market rule. Okay to
  make a dollar (or pound) off someone’s
  suffering – as long as the conduct is not
  fraudulent
             BACKGROUND
• What was Smith’s
  answer for people
  caught stealing or
  lying in business?
             BACKGROUND


• Death penalty?
• Do not want these
  types around
• They pervert and
  corrupt the market
  system which serves
  to give ammunition to
  critics of capitalism
            BACKGROUND
• Who were the critics of capitalism?
• Not the NDP. It was not around in those
  days
• Not the Green party. Not necessary.
  Courts had tough rules against polluters
  (as we will see) and with which Smith
  agreed.
           BACKGROUND
• Who were the critics?
• The Church. Protestant and Catholic
• Smith and his academic colleagues were
  regarded as heretics.
• Why?
           BACKGROUND
• Smith said greed was usually good
  provided liars and cheaters were
  eliminated
• The Church said greed was always bad,
  but one should show mercy and
  compassion to the wrongdoers
            BACKGROUND
• Smith said courts and Parliament should
  make rules that make society better off
  economically – basic model for this course

• The Church said courts and Parliament
  should make rules that are morally correct
  even if this makes people poorer – a lot of
  people including many judges and lawyers
  believe this still
 ECONOMIC ANALYSIS OF LAW

• The “central problem” in the
 economic analysis of law:
 Recall that the “problem” for consumers was to maximize
 utility:
 Outcome: Demand

 Recall that the “problem” for producers was to maximize
 profits:
 Outcome: Supply
 ECONOMIC ANALYSIS OF LAW

• The “central problem” in the
 economic analysis of law:
 The “problem” for “lawmakers” is to
 maximize social surplus:
 Outcome: A law or a rule
            BACKGROUND
• Smith said courts in England basically got
  it right
• Why?
• Competition – courts competed for the
  business of lawsuits and judges were paid
  by the case – not by a salary
• Smith believed this encouraged good
  outcomes over time
             BACKGROUND
• Justice Richard
  Posner – major
  contemporary scholar
  in this field – argues
  that even if lawyers
  and judges do not
  “believe” this – over
  time it is the
  economically efficient
  precedent – that
  prevails
            BACKGROUND
• So what happened after Adam Smith?
• Courts in England and Canada were
  suspicious of economics and were
  opposed to allow economists to testify as
  experts until 1976 (in Canada)
            BACKGROUND
• United States – different story
• Economic argument encouraged on
  constitutional and antitrust briefs as early
  as the 1890’s
• This encouraged the formation of a “law
  and economics” specialization in
  economics
• The centre of this specialization is the
  University of Chicago
            BACKGROUND
• By the early 1900’s – economics
  professors focused policy research on the
  legislators (not the courts) – use taxes or
  subsidies – stay clear of legal problems
             BACKGROUND
• A.C. Pigou – wrote a
  leading text on taxes
  and subsidies – The
  Economics of
  Welfare” in 1920
  followed by many
  governments until
  1960
            BACKGROUND
• For example, Pigou did not believe the
  strictness of common law rules against
  pollution did much good
• Why?
• Most firms were monopolistic in some
  way. Such firms could pass on, at leadt in
  part, the “expected” costs of lawsuits and
  other anticipated liabilities in the price
  charged to the consumers
           BACKGROUND
• Solution?
• Put a tax on the product – the producer
  cuts back and thereby reduces pollution
• What is wrong with this argument?
             BACKGROUND
• Challenged by Ronald
  Coase – in 1960, in
  an article - “The
  Problem of Social
  Cost” (featured on the
  syllabus) – Coase
  restored Smith’s view
  that legal rules do
  matter and we will
  study his arguments
  in considerable detail