Law and Economics
Exam One
Friday, January 31
Winter 2014
Friedman Text:
Chapters 1-8
A. Law as a Framework for Markets
1. contracts
2. property
3. liability
4. prevent fraud or violence
B. Economics as a tool to analyze Law
1. incentives
a. rationality
b. judge laws by the incentives they create
2. efficiency
II. Economic Concepts
A. Markets
1. Demand
a.
willingness to pay
b. marginal benefit
2. Supply
a.
willingness to accept payment
b. marginal
cost
3. Efficiency
a. optimal
quantity
b. consumer
and producer surplus
c.
deadweight loss: measure of inefficiency
4. Allocation
a. put
resources to highest valued use
b. pareto efficiency
i. meaning
ii. limits to usefulness
c. Laissez
Faire
i. private property and freedom of exchange
ii. problems
- external effects
- transactions costs
III. Externalities
A. External effects lead to inefficient outcomes
B. Pollution (a negative externality)
1. price of
product is too low
2. quantity
of product is too high
3. deadweight
loss
4. too much
pollution
C. Optimal level of pollution
1. balance
marginal cost and marginal benefits
2. regulate
3. Pigouvian
tax
D. Coase
1. reciprocal
nature of externalities
2. efficiency:
solve problem at lowest cost
3. property
rights
4. Coase
Theorem
a. private
bargaining
b. no
transactions cost
c.
assignment of rights doesn't change outcome (only income changes)
E. Transactions Costs
1. assignment
of rights matters in the presence of transactions costs
2. negotiations
between large numbers of individuals are likely to fail due to transactions
costs
a. free
rider problem
b. holdout
problem
3. no
general rule always leads to efficient outcomes
4. liability
rules
a. less
protection than a property right
b. other
party can impose cost & then pay damages
c. can lower
transactions costs
IV. Risk
A. Uncertainty
1. probability
2. expected
value
3. fair bet
4. risk
averse
B. Insurance
1. offsets
risk
2. pooling
eliminates uncertainty
3. real
social value
C. Insurance problems
1. moral
hazard
a.
incentives to take precautions
b. too few
precautions
c. too much
damage
d. insurer's
responses
i. require precautions, inspections
ii. co-insurance
iii. higher premiums
2. asymmetric
information
a.
individuals know their own risks better than insurer
b. insurance
premiums based on average risk
i. better than fair, for high risk individuals
ii. worse than fair, for low risk individuals
c. adverse
selection
i. riskier individuals buy insurance
ii. more insurance claims
iii. cost of insurance increases
iv. low risk individuals can not buy fair insurance
D. Dangerous behavior
1. causes
damages sometimes (with some probability)
2. weigh
benefits of behavior with expected value of damages
3. restrict
behavior where expected costs exceed benefits
a. ex ante
rule
i. restriction/ punishment for behavior
ii. provides incentive to avoid behavior
b. ex post
rule
i. fine/punishment for damages
ii. also provides incentive to avoid behavior
4. ex ante,
ex post information problems
a. some
dangerous behavior is not observable to outsiders
b. some
individuals may misjudge the probabilities
c. law
makers may have better information
5. inability
to pay may reduce effectiveness of ex post punishment
V. Strategic Behavior
A. Strategy
1. interdependence
2. action, reaction,
re-reaction, and anticipation
3. individual
incentives and group incentives may be incompatible
4. many different strategies
exist and one may dominate in certain situations but not others
a. intransigence
b. first mover advantage
c. second mover advantage
d. randomized strategy
B. Game theory
1. formal
treatment
2. simple games
may have clear solutions
3. more complex
games may have multiple (or zero) solutions
C. Bilateral monopoly
1. bargaining
2. pre-commitment
3. costly
break-downs