Law and Economics Exam 1 Rutgers Gilgenbach

3 Main Applications of Economics to Law

1. Efficiency: efficiency is always relevant in policy making because public officials never advocate for wasting money
2.The Distribution of Income: among the earliest of applications of economics to public policy
-Who really bears the burden of alternate taxes
3. Profits: lawyers aim to increase profits by helping make deals, avoid litigation and obey regulations

Efficiency of Distribution, Why?

By making a rule, the division of the stakes in a legal dispute affects all similarly situated people, this can affect consumers or investors. And consumers can be rich people while investors can be relatively poor people.

-Most proponents of income redistribution have something else in mind; they usually target social groups such as the poor, minorities, women, race (for the sake of social justice)

2 Ways to Redistribute Income

1. Private Law:
The book rejects this approach because it is inefficient.
A) Redistribution by private legal rights relies on crude averages.
-Example: assume that a court interprets a law to favor consumers over corporations in order to redistribute income from rich to poor. "Consumers" and "Investors: imperfectly correspond to "poor" and "rich". But consumers of Ferraris and skiing vacations tend to be relatively rich and union workers with good pension plans own stocks of large companies.
B) Hard to predict because courts can't be certain that holding a corporation liable to its consumers will decrease the wealth of it stock holders. The corporation can just pass on its higher costs to the consumer via higher prices
C)The transaction costs of redistribution through legal rights are typically high
D)Redistribution through private law distorts the economy more than progressive taxation.
-Example: Law to benefit consumers of tomatoes negatively affects the investors of tomatoes farms, so they withdraw their money from the farms, thus decreasing supply and increasing the price

2. Progressive Taxation and Social Welfare Programs. Also called the tax and transfer system. The income tax precisely targets inequalities.

Rational Preferences have to be:

Transitive: Preferences follow a logical order to one another

Complete: Preferences are able to be ranked

Reflexive: I like a good/bundle as much as itself?

Pareto Improvement

Is any change to the economy which leaves:
-Everyone at least as well off as they were AND someone strictly better off

If something is a Pareto improvement, the new situation is Pareto superior to the old situation, or Pareto dominates it.

These are win-win situations

What does it mean when preferences are continuous?

If you prefer $3000 to a car, but a car to $2000, then there must be a value in which you are indifferent

Kaldor-Hicks Improvement

Any change which increases the total value achieved by everyone in society.

Suppose your car is worth $3000 to you and $4000 to me, and the government seizes your car and gives it to me. I'm better off and you're worse off, but since I valued the car more than you it's a Kaldor-Hicks improvement. (Net gain of $1000 in economy)

Creates winners and losers

We call a change to the economy efficient if it is a Kaldor-Hicks Improvement. Law A is more efficient that law B if it is a Kaldor-Hicks Improvement. An efficient situation is when there's no way to make some people better off, without making some others worse off by more.

What's efficient is what creates the most value

4 Causes of Inefficiencies

1.Externalities: 2 Kinds:
A) Negative Externalities: typically do more than the efficient amount (overgrazing, overfishing, etc)
B) Positive Externalities: typically do less than the efficient amount (writing free software, public murals, etc)

2. Barriers to Entry: anything that prevents me from buying something I want can be a source of inefficiencies

3. Taxes:
-Example: I value my time at &40/hour, working at a factory and I get $50/hour(efficient, net gain of $10), but let's say there is a 25% income tax. So that $50/hour is now $37.50/hour, so I'd rather stay home and not have a job than get a job. Very inefficient.

4. Monopolies: It's not that there's a monopoly that's inefficient it's that there is private information
-When a consumer walks into a monopolist's store, the monopolist cannot tell if the consumer would be willing to pay $90 for the product or $50, so the monopolist is forced to charge the same amount to everyone
-Some people are getting it for less than what they value it or they can't buy it because of limited demand

Ex-Ante Consent

Stems from Richard Posner's argument for why efficiency is good for the law.

Starts with the observation: if you buy a lottery ticket and lose, you can't complain.

Now imagine before we all started driving, everyone in the world got together and discuss a liability rule for traffic accidents. The people wouldn't know whether they will be the victims or injurers, so if one rule is more efficient than all the rest we'd all vote for that rule ex-ante

Posner's basic argument: If we choose the most efficient legal system, everyone is compensated ex-ante for their choice, and should willingly accept the outcome they got.
-Back to the lottery example: if you buy a ticket and lose you were compensated ahead of time for that loss by the possibility of winning

Limitations to Posner's argument: The lottery example requires risk neutrality, meaning: 50% chance at $1,000,000 is just as good as a 50% chance at $900,000, which is just as good as a 50% chance at $100,000. Which isn't true because $100,000 is worth more to a poor person than someone who already has $900,000

3 Things Efficiency Is Not

1. Equity: efficiency is only about how much wealth exists, not how it's divided up

2.Fairness: efficiency only considers outcomes, not the processes to get to that outcome
-A law might be efficient but violate our notions of what's right or wrong

3.Maximize Happiness: by equating value with willingness to pay, efficiencies ignore the possibility an incremental dollar might mean more to someone poor than it does to someone rich and it ignores the possibility of "really really really wanting something" but not being able to afford it, like a heart.

4 Reasons the Tax System is a Better Way to Redistribute Wealth than the Legal System

1.Taxes can target "rich" and "poor" more precisely than the legal system can.
-taxes are based on income and assets, which are directly tied to wealth

2.Distribution effects of the legal changes are harder to predict
-Like in tenants v. landlords, passing laws that favor tenants can increase the rental prices as compensation for the landlord, leaving the tenants worse off

3. Lawyers are more expensive than accountants.
-transaction costs are higher when we try to redistribute via the legal system vs. taxes

4. More narrowly-targeted taxes cause greater distortion than broad-based taxes
-laws designed to redistribute wealth would be more narrowly-targeted: liability laws that are unfavorable to lambo drivers and plastic surgeons, but instead use an income tax that'll cover both there people.
-the point: narrowly-targeted taxes cause greater distortion -> greater dead weight loss\
-Example: if you impose a tax on bagels people will just buy more donuts, making the bagel producers suffer, but if you just taxed everything a little more, and people just consume a little less of everything

A Static Game is Completely Described by 3 Things:

1. Who the players are
2.What actions are available to each player
3.What payoff will each player get, as a function of:
-His own actions and
-The actions of the other player

Nash Equilibrium

We solve a game by looking for a Nash Equilibrium.

Nash Equilibrium is a strategy profile (for each player) such that:
-No player can improve his payoff by switching to a different action given what his opponent is doing
-Best move will sometimes depend on what the other player is doing
-So in Prisoner's Dilemma playing mum is never an option in Nash Equilibrium, whatever your opponent is doing you could improve your outcome by switching to rat

If any player can improve his payoff by changing his action, given his opponent's action, then it is not a Nash Equilibrium

Steps to Find the Nash Equilibrium:

1.Circle payoff from player 1s best response to EACH action his opponent could do
2.Do the same for player 2
3.Any box with both options circled is an equilibrium

Why do we need property law?

One reason is the tragedy of the commons.

Another reason is: example: Imagine we have 2 neighboring farmers and each had 2 choices:
-Farm his own land
-Steal crops from
Stealing might be less efficient but I avoid the costs of watering and planting my own crops. With no legal system the Nash Equilibrium would be for both farmers to steal, but with a legal system in place that has property laws, the Nash equilibrium would be for them both to farm.

The Idea is, anarchy is inefficient, I spend my time stealing from you and you spend your time & money defending your property instead of doing productive work

Coase Theorem

Created by Ronald Coase (1960), "The Problem of Social Costs"

In the absence of transaction costs, if property rights are clearly defined and tradable, voluntary transactions will lead to efficiency
-It doesn't matter how the rights are allocated initially because if they're allocated inefficiently at first, they can be traded/sold