Law & Econ Midterm 1

What is law and economics?

It studies how rational people respond to incentives created by legal rules.

What are the three uses of economics in studying law?

Predict the effects of legal rules; identify efficient rules; and predict what rules will exist through public choice theory.

What is the Posner Thesis?

Posner conjectured that judge-made common-law rules tend to be economically efficient.

What is public choice theory?

It explains laws as partly shaped by special-interest politics, where a small group may benefit at the expense of a larger group. Example: California dairy farmers benefit from a higher milk price floor while taxpayers help fund the surplus.

How can a traffic ticket be understood economically?

It can raise revenue, but it also creates a financial disincentive for speeding.

What is a negative externality example from fuel use?

Each household may rationally burn cheap coal because most pollution costs fall on other people, even though everyone would be better off with less pollution.

What does economic efficiency mean?

Choose the outcome that maximizes total benefits minus total costs for society.

What is Pareto efficiency?

No one can become better off without making someone else worse off.

What is a Pareto improvement?

At least one person becomes better off and nobody becomes worse off.

What is the Hicks compensation principle?

Winners could hypothetically compensate losers and still have a net benefit left over. Actual compensation is not required.

How does Marshall define individual value?

By revealed preference: what a person would be willing to pay for an outcome.

How does Marshall aggregate value?

By adding individual dollar values or willingness to pay.

What are criticisms of willingness-to-pay efficiency?

It treats willingness to pay as value even for goods such as heroin; it treats a dollar to a rich person like a dollar to a poor person; and the perfect all-knowing decision-maker does not exist.

What is the private decision rule?

Act until marginal private benefit equals marginal private cost.

What is the social decision rule?

Act until marginal social benefit equals marginal social cost.

When do competitive markets tend to be efficient?

When decision-makers receive all benefits and bear all costs, and there are no major market imperfections or externalities.

How can individual rationality differ from group rationality?

An individually rational choice can make the group worse off. Example: soldiers may run away to protect themselves even though the army would be better off if everyone stayed.

What are the three branches of government?

The legislature makes laws; the executive enforces laws and creates administrative rules; the judiciary interprets and applies law.

What happens in a federal district court?

It is the trial court where evidence and witness testimony are presented and the factual record is created.

What do Courts of Appeals do?

They review lower courts for legal error and generally do not retry the facts.

What is a reversible error?

A significant mistake in applying or handling the law that justifies changing the lower court's decision.

What can a Court of Appeals do?

Affirm, reverse, or remand the case to the lower court.

What is a circuit split?

Different Courts of Appeals reach conflicting decisions on similar legal questions.

How does a case usually reach the Supreme Court?

After an appeal, a party files a petition for certiorari. Supreme Court review is usually discretionary.

What makes the Supreme Court more likely to hear a case?

A constitutional conflict, a circuit split, or an important unresolved federal question.

What is an en banc hearing?

A rehearing by the entire court or a larger group of appellate judges instead of the usual three-judge panel. Parties may request it but are not entitled to it.

What is judicial review?

The power of courts to determine whether government actions or laws violate the Constitution.

What did Marbury v. Madison establish?

Judicial review. It held that Congress cannot pass laws contradicting the Constitution.

What is the Supremacy Clause?

Federal law generally takes priority over conflicting state law: federal law trumps state law.

What is stare decisis?

The principle that courts should follow legal precedents from earlier cases.

Is stare decisis absolute?

No. Courts may distinguish, limit, or overrule precedent in appropriate circumstances.

What is deference?

Giving weight to the decisions of higher courts or institutions with authority or expertise. Lower courts generally defer to controlling higher-court precedent.

What is recusal?

Removing a judge from a case because of a conflict of interest or possible bias.

What does Lawrence v. Texas illustrate?

A law treating same-sex and opposite-sex conduct differently raised a constitutional equal-protection problem.

What is private property?

An identifiable owner has rights to control, use, exclude others from, and transfer a resource.

What are the advantages of private property?

It encourages production, maintenance, investment, and exchange, while helping prevent overuse.

What is a commons?

A shared or unowned resource available for collective use.

What are the advantages of a commons?

It avoids the cost of creating and enforcing private boundaries. It can work when exclusion is difficult or expensive.

What is the main disadvantage of a commons?

Users may overuse or deplete the resource because each person ignores some costs imposed on others.

When might a commons be more efficient than private property?

When boundaries are difficult to define, exclusion is expensive, or individual transactions cost more than the harm from overuse.

Why is private property useful for agricultural land?

Farmers receive the benefits of planting, maintaining, and harvesting, so they have incentives to work and invest.

What is the hunting-land example?

Hunting land may remain common because stopping at every property boundary to request permission would make hunting inefficient. The animal may instead become the hunter's property when first spotted.

What is the bionic burglar alarm example?

Dogs made it cheaper to defend property boundaries, helping make private ownership of agricultural land practical.

How can technology change property rights?

Technology can make it cheaper to define or enforce boundaries. Examples include barbed wire, security cameras, GPS, drones, and motion-sensitive lights.

What is the oil-pool problem?

Multiple owners may drill too early and pump too quickly because each fears others will extract the shared underground oil first.

What is unitization?

Converting an underground oil pool into joint property so owners coordinate extraction and share income.

What is an externality?

An effect of an action on people who are not part of the transaction.

What is a negative externality?

An outside cost, such as pollution, secondhand smoke, traffic congestion, or accident risk.

What is a positive externality?

An outside benefit, such as education, vaccination, or pollination from a neighboring orchard.

Why do negative externalities cause overproduction?

The producer ignores part of the social cost, so the market price is too low and too much is produced.

What is the least-cost avoider?

The party who can prevent or reduce the harm at the lowest cost.

What is the Pigouvian solution?

Impose a tax or fee equal to the external damage caused by the activity.

How does a Pigouvian tax create efficiency?

It forces the decision-maker to internalize the externality so private costs reflect social costs.

When does Pigou work best?

When the government can measure the harm accurately and the taxed party is the least-cost avoider.

What is Coase's joint-causation insight?

Externalities are often jointly caused by both the person creating the harm and the person exposed to it.

What is the Los Angeles pollution example?

Pollution would not harm residents if nobody lived in Los Angeles. The factory and the residents' location jointly create the problem.

What is the bombing-range example?

Moving campers away from a bombing range may be cheaper than stopping valuable military testing.

What is the roommate loud-music example?

Music bothers the sleeping roommate, but a rule banning music while the roommate sleeps also imposes a cost on the person who wants to play music.

What is the Martin's Tavern example?

A student paid someone $20 not to smoke at the table. The agreement showed that private bargaining can solve an externality when transaction costs are low.

What is the airport-noise example?

Possible solutions include quieter planes, soundproofing homes, changing flight patterns, paying homeowners, or using nearby land for nonresidential purposes.

What is the factory-recording-studio example?

If the factory existed first and a studio locates next to it, moving or soundproofing the studio may be cheaper than closing the factory.

What is the Coase Theorem?

If rights are clearly defined and transaction costs are zero or low, parties can bargain toward an efficient outcome regardless of the initial assignment of rights.

What does the initial assignment of rights affect under Coase?

It affects wealth distribution by determining who pays whom, even if the final allocation is efficient.

Why does Coase fail with many affected parties?

Negotiation becomes difficult because of public-good, free-rider, holdout, and enforcement problems.

What is the public-good problem in pollution negotiations?

Each victim may refuse to contribute because everyone benefits if pollution is reduced, even noncontributors.

What is a holdout problem?

One party refuses to agree in hopes of receiving a larger payment, potentially blocking an efficient deal.

What is the central-planning solution?

A court or government assigns the right to the party it believes values it most or directly regulates the activity.

What is the main problem with central planning?

The government may lack information about who values the resource most or who can prevent the harm most cheaply.

What is a property rule?

An entitlement cannot be taken or interfered with without the owner's consent. The parties must negotiate.

What is a liability rule?

Someone may interfere without advance consent but must pay damages determined by a court afterward.

Who sets the price under each rule?

Under a property rule, the owner sets the price. Under a liability rule, the legal system sets the price.

When is a property rule preferable?

When private bargaining and voluntary exchange are relatively easy, such as selling a car or obtaining a land easement.

When is a liability rule preferable?

When bargaining is impractical but courts can measure damages reasonably well, such as auto accidents or widespread pollution.

Why are auto accidents usually governed by liability rules?

Drivers cannot obtain advance permission from every driver and pedestrian who might be affected.

Why might a lost hunter breaking into a cabin be a liability-rule situation?

The owner cannot be located in time, making advance bargaining extremely costly. Paying for damage afterward is more practical.

What is the railroad-and-farmers example?

Railroad sparks may burn wheat. Farmers might plant clover, the railroad might install spark arresters, or the railroad might compensate farmers.

What determines the efficient outcome in the railroad example?

The option with the lowest total cost: accepting fires, changing crops, or installing spark arresters.

What is the difference between an absolute right and an injunctive right?

An absolute right permits the holder to act without paying damages. An injunctive right lets the holder prevent another party from acting without permission.

Why does the court's ability to measure damages matter?

If damages are difficult to calculate, a property rule may be better even when transaction costs are significant.

What is the Kelo economic issue?

Central planning asks a government or court to decide who values property most, which requires difficult information and creates litigation incentives.

Why do people buy insurance?

Risk-averse people prefer a predictable premium to the possibility of a much larger uncertain loss.

What is risk aversion?

Preferring a certain outcome over an uncertain outcome with the same expected monetary value.

What is diminishing marginal utility of income?

Each additional dollar provides less additional utility than the previous dollar, so losses hurt more when income is low.

What is the $10,000/$110,000 risk-aversion example?

A person facing a 50 percent chance of $10,000 and a 50 percent chance of $110,000 may prefer to pay for certainty at $60,000 in both states.

Does insurance eliminate risk?

No. It transfers risk. Pooling many risks makes total losses more predictable.

What is the law of large numbers?

As the number of independent trials increases, the average result approaches the expected value.

What conditions help an insurance pool work?

Many participants, estimable probabilities, diversified or independent risks, accurate pricing, and controls against fraud and excessive risk-taking.

How do insurance companies make money?

Premiums plus investment income must exceed expected claims plus administrative costs.

Do insurers accept only low-risk customers?

No. They can insure high-risk customers if they can identify the risk and charge an appropriately higher premium.

What is moral hazard?

After obtaining insurance, a person takes fewer precautions because someone else bears part of the cost.

What is the rental-car example of moral hazard?

A person with rental-car coverage may drive less carefully because the insurer will pay for damage.

What is the Double Indemnity example?

A life-insurance policy may create an incentive for someone to cause the insured person's death to collect the payout.

How do insurers reduce moral hazard?

Deductibles, co-insurance, coverage limits, safety requirements, inspections, and exclusions.

What is co-insurance?

The insurer covers only part of the loss, leaving the insured with a financial stake in preventing it.

What is the factory sprinkler example?

An insurer may require a factory to install and maintain sprinklers before providing fire insurance.

When can moral hazard be a feature rather than a problem?

When the insurer is better positioned than the insured to prevent the loss. The insurer may know more about fire prevention and conduct inspections.

What is the Leisure World example?

A small doctor-visit co-payment eliminated long lines more cheaply than hiring many additional doctors.

What is adverse selection?

Before insurance is purchased, high-risk customers are more likely to seek coverage because they know more about their own risk.

Why does adverse selection raise insurance prices?

High-risk customers enter the pool disproportionately, raising the insurer's average expected claims.

How can insurers reduce adverse selection?

Medical exams, risk-based pricing, disclosures, exclusions, group insurance, and compulsory participation.