An Introduction to Law and Economics: The Coase Theorem and Behavioral Economics

1. An Introduction to Law and Economics: The Coase Theorem and Behavioral Economics Thomas S. Ulen University of Illinois College of Law University of Colorado Law School June 11, 2008

2. Introduction • Why all the fuss? • A practical and useful innovation or one that is confined to the academy? • A stalking horse for a particular political ideology? • A (scientific) method of evaluating the impact of law? CU – NIE Seminar June 11, 2008

3. Assumptions and premises • “People respond to incentives.” • Law is a method of ordering society to further social goals. • Law creates incentives for people to behave in certain ways. • Law can help people by facilitating their achievement of their legitimate goals. • Economics provides both theoretical and empirical techniques for examining law’s likely and actual effects in the world. CU – NIE Seminar June 11, 2008

4. Assumptions and premises 2 • So, to discourage a particular activity, law should increase the “price” for engaging in that activity. • E.g., by increasing the sanction for engaging in undesirable behavior. • Or by increasing monitoring and enforcement of the undesirable activity. • If legal sanctions increase or become more likely, people will “consume” less of the sanction-triggering activity. CU – NIE Seminar June 11, 2008

5. Coase Theorem • Ronald A. Coase, “The Problem of Social Cost,” 3 J.L. & Econ. 1 (1960). • If transaction costs are zero, bargaining will lead to an efficient allocation of resources, regardless of the law. • Law is only necessary to induce efficient behavior when transaction costs are positive. • An implication: assign legal entitlements to the party who would have ended up with the entitlement (that is, to the person who values it the most). CU – NIE Seminar June 11, 2008

6. The Economics of Contract Law • Law should seek to reduce the costs of concluding and enforcing consensual agreements. • Law does so by providing a set of default and mandatory rules that contracting parties can use as a template for concluding an agreement. • Default rules. • Mandatory rules. CU – NIE Seminar June 11, 2008

7. Contract Law 2 • Why do private parties need help in forming, relying upon, and completing consensual agreements? • Time-intensive transactions—i.e., those that take time to complete. • Coordination, commitment, and cooperation. • Risk allocation. • Information exchange. CU – NIE Seminar June 11, 2008

8. The Economics of Tort Law • Minimize the social costs of accidents. • Precaution costs. • Accident losses. • Administrative costs. • Continue to assume that potential victims and injurers are rational decisionmakers. CU – NIE Seminar June 11, 2008

9. Economics of Tort Law II • Tort law holds out the prospect of liability for accident losses so as to • create incentives for parties to choose levels of precaution and activities in which to participate in order to minimize their liability, • And thereby to minimize the social costs of accidents. CU – NIE Seminar June 11, 2008

10. Precaution costs • How does a rational potential injurer decide how much precaution to purchase? • Assume provisionally that the injurer will be liable for the victim’s losses if there is an accident. • But recognize that most parties are acting “behind a veil of ignorance”—they do not know if they will be a victim or an injurer. • A rational potential injurer takes all cost-justified precaution—i.e., precaution for which the cost of the last unit of precaution taken is just equal to the benefit provided by that precaution. CU – NIE Seminar June 11, 2008

11. Precaution costs 2 • The expected benefit of a unit of precaution equals the probability of an accident’s occurring times the anticipated accident losses. • Suppose that one more unit of care will reduce the probability of an accident’s occurring by 0.005 and that if an accident occurs, given that amount of precaution, the losses are likely to be $100,000. • The expected benefit of that unit of precaution is (0.005) x $100,000 = $500. • So, if that unit of precaution costs less than $500, society would like a potential injurer to purchase the precaution because the cost is less than the expected benefit. CU – NIE Seminar June 11, 2008

12. Additional topics in the economics of tort liability • Different tort liability standards. • The relationship between administrative agency safety regulation and tort liability. • Should regulatory compliance be a defense in a private tort action? • “Who are these rational people you’re talking about?” • If injurers and victims are not fully rational, then a situation that might seem to be one of bilateral precaution may be, instead, one of unilateral precaution. CU – NIE Seminar June 11, 2008

13. The Economics of Crime and Punishment • Recall the assumption of rational decisionmakers. • Gary Becker, Nobel Laureate in Economics, 1992. CU – NIE Seminar June 11, 2008

14. Crime and Punishment 2 • Becker’s rational-choice theory of the decision to commit a crime: • Criminal compares the expected costs and expected benefits of a crime. • Expected costs include the probability of detection, arrest, and conviction times the value of the sanction imposed. • Expected benefits include the monetary value of the crime plus any non-monetary satisfaction the criminal receives. CU – NIE Seminar June 11, 2008

15. Crime and Punishment 3 • A rational potential criminal commits the crime if EB > EC and refrains if EB < EC. • Society can reduce crime by raising the expected costs of crime. • Raise the probability of detection, arrest, and conviction or, • Increase the criminal sanction or, • Do both. CU – NIE Seminar June 11, 2008

16. Recent U.S. Statistics on Crime • Since the mid- and late 1980s a decline in non-violent crime. There is now less auto theft in the U.S. than in much of Western Europe. • Property crimes down 30 percent in the 1990s. • Since 1991 a precipitous decline in violent crime, with homicide at the lowest level since the 1930s. • Homicide rates down 40 percent in the 1990s. CU – NIE Seminar June 11, 2008

17. Why the Decline in Crime? • “Deterrence works.” • Increasing incarceration rates. • More police and improved policing strategies. • Decline in crack cocaine. • A robust economy. • Increased victim precaution. • Alarms and security procedures. • Faster and more effective trauma treatment. • The legalization of abortion? CU – NIE Seminar June 11, 2008

18. Donohue & Levitt, “The Impact of Legalized Abortion on Crime” • 116 Q. J. Econ. 379 (2001). • Donohue and Levitt attribute half of the decline in crime since 1991 to the legalization of abortion in 1973. • Roe v. Wade led to a significant increase in the number of abortions. (1.6 million per year by 1980; 1 abortion per 2 live births.) Therefore, relatively fewer 18 year-olds in the population beginning in 1991. • All the other factors together account for the other half of the decline. CU – NIE Seminar June 11, 2008

19. Donohue & Levitt 2 • What’s the evidence for legalized abortion’s effect on crime? • (1) Broad consistency with the prevailing pattern—namely, most crime is committed by 18-24 year-old males; because of legalized abortion, there are fewer 18 year-olds exactly 18 years after Roe, and that’s when the downturn in crime began. • (2) Five states legalized abortion in 1970 (before Roe v. Wade), and they experienced a decline in crime before the rest of the country did. CU – NIE Seminar June 11, 2008

20. Donohue & Levitt 3 • (3) “[H]igher rates of abortion in a state in the late 1970s and early 1980s are strongly linked to lower crime [in that state] for the period from 1985 to 1997.” • (4) “There is no relationship between abortion rates in the mid-1970s and crime changes between 1972 and 1985.” • (5) Almost all of the decline in crime in the 1990s can be “attributed to reduction in crime among the cohorts born after abortion legislation[;] [t]here is little change in crime among older cohorts [over the last 30 years].” CU – NIE Seminar June 11, 2008

21. Donohue & Levitt 4 • The other hypotheses are unlikely to explain the drop in crime in the 1990s. • The greater use of imprisonment, more police, and changes in police strategies have been going on for a long time. It’s unlikely that they could cause a sudden and sharp drop in crime just in the 1990s. And the drop occurred in places, such as Los Angeles, where there was no particular improvement in the police force. • Similarly for the decline in the crack cocaine trade. That was largely a phenomenon of major urban areas. But the crime drop occurred not just in major urban areas but everywhere. • The robust economy has been with us since the early 1980s, not just in the 1990s. And, moreover, there is a relatively weak correlation between macroeconomic activity and crime levels. Indeed, there is some evidence that much crime is anti-cyclical, increasing when the economy is doing well and declining when it is doing poorly. CU – NIE Seminar June 11, 2008

22. Donohue & Levitt 5 • Donohue and Levitt identify two components that make up the total effect that legalized abortion had on crime: • The “cohort size” effect. • When the cohort reaches the late teens—the prime years for committing crimes, there are fewer of them and, therefore, less crime. • The “cohort quality” effect. • “[C]hildren born after abortion legalization may on average have lower subsequent rates of criminality.” • (1) “[W]omen who have abortions are those most at risk to give birth to children who would engage in criminal activity.” Teenagers, unmarried women, and the economically disadvantaged. • (2) “[W]omen may use abortion to optimize the timing of childbearing.” Through abortion women may delay childbearing till later if their current conditions are suboptimal. Children tend to be born into better environments. CU – NIE Seminar June 11, 2008

23. Donohue & Levitt 6 • Of the half of the drop in crime in the 1990s that Donohue & Levitt attribute to the legalization of abortion, • about half of that total effect is attributable to the “cohort size” effect and • about half to the “cohort quality” effect. CU – NIE Seminar June 11, 2008

24. New developments in law and economics • Empirical research. • Behavioral law and economics. • The impact of law and economics on the legal academy. CU – NIE Seminar June 11, 2008

25. Empirical law and economics 2 • Robert Ellickson, “Of Coase and Cattle,” 38 Stan. L. Rev. 623 (1986), and Order Without Law (1991). • Natural experiment: damage done to property by unsupervised cattle in Shasta County, California. • In part of the county the owners of cattle were responsible for damage done by their unsupervised cattle. • In the other half of the county, owners were not responsible. CU – NIE Seminar June 11, 2008

26. Ellickson and social norms • Should there be a difference between the two halves of the county in terms of the number of cattle and other indicators of efficiency? • Not necessarily, if the Coase Theorem is true. • There was no difference in behavior between the two halves, even though the liability rules were different. Why? CU – NIE Seminar June 11, 2008

27. Ellickson 2 • Not because neighbors were bargaining to the most efficient result, regardless of the law. • Rather, because neighbors were not paying attention to the law. • They sought to conform their behavior to the prevailing social norms, not to the law. CU – NIE Seminar June 11, 2008

28. Behavioral law and economics • Recall the close connection between rational choice theory and traditional law and economics. • Social and cognitive psychologists have found some systematic deviations from the predictions of RCT. • Taking these deviations into account in analyzing law leads to changes in the economic analysis of that flowed from RCT. CU – NIE Seminar June 11, 2008

29. Behavioral law and economics 2 • Consider four examples: • Endowment effect / status quo bias. • The ultimatum bargaining game experiments. • Loss aversion. • Difficulties with probabilistic reasoning. • In each case I’ll seek to seek to show how these empirical findings necessitate our amending some settled conclusions of “traditional” law and economics. CU – NIE Seminar June 11, 2008

30. Endowment effect / status quo bias • People seem to place a very high value on the things they have and the way things are. • Systematic difference between the willingness-to-pay (WTP) price to acquire something one doesn’t have and the willingness-to-accept (WTA) price to give up that same thing if one already possesses it. CU – NIE Seminar June 11, 2008

31. Status quo bias 2 • WTA ≈ 2 WTP. • Not experience-related. • Applies to pens, coffee mugs, and other trivially valuable items. • Implication: • Far more difficult to change the way things are than one might anticipate. • Change may not just be a matter of transaction costs. CU – NIE Seminar June 11, 2008

32. Status quo bias 3 CU – NIE Seminar June 11, 2008

33. The ultimatum bargaining game. • Two parties are to split $20. • This is a pure cooperative surplus. • The players are not allowed to talk or meet. • Player 1 makes an offer for division of the $20. • Player 2 can accept the offer, in which case they each get the proposed division, or reject the offer, in which case neither player receives anything. CU – NIE Seminar June 11, 2008

34. Results of the game • The game has been played in over 100 countries with thousands of players of all ages and socio-economic circumstances. • The modal result is a 50-50 split. • An unexpected finding (although not necessarily inconsistent with rational choice theory) is that if Player 1 proposes a split that give him or her more than 70 percent of the surplus, Player 2 almost always rejects the offer. • People have a strong sense of what is fair. • Interestingly, if Player 1 is selected on some seemingly meritorious criterion, Player 2 will tolerate Player 1’s receiving more of the surplus than if Player 1 is selected randomly. CU – NIE Seminar June 11, 2008

35. Implications • Perhaps we need not worry overly about how parties divide up cooperative surpluses. They seem to do it equitably. • But we need, perhaps, to pay attention to the fact that overreaching can cause otherwise mutually beneficial transactions to fail. • The Normative Hobbes Theorem. CU – NIE Seminar June 11, 2008

36. Loss aversion • The standard social science theory of decisionmaking under uncertainty is that of subjective expected utility (SEU). • Individuals are thought to maximize expected utility rather than expected value. • The difference arises from attitudes toward risk: risk-neutrality, risk-preferring, and risk-aversion. CU – NIE Seminar June 11, 2008

37. Loss aversion 2 • Kahneman and Tversky found that most people are risk-averse with respect to gains but risk-seeking with respect to losses. • Option A: $50 with certainty • Option B: $100 with probability 0.5 or $0 with probability 0.5 • Same expected value. • Most people prefer Option A. CU – NIE Seminar June 11, 2008

38. Loss aversion 3 • Option C: -$50 with certainty • Option D: -$100 with probability 0.5 or $0 with probability 0.5 • Same expected value. • Most people prefer Option D. • Implication: In civil actions, defendants may be less likely to settle than plaintiffs. • The standard law-and-economics theory of litigation versus settlement is that trial almost always results from mistaken and inconsistent estimates of the likelihood of prevailing at trial. CU – NIE Seminar June 11, 2008

39. Difficulties with probabilistic reasoning • Many legal situations imply that decisionmakers make probabilistic calculations. • Rational criminals are thought to compare expected costs and expected benefits of crime. • Tortfeasors and victims are imagined to compare precaution costs with expected liability. • Jurors engage in Bayesian updating in determining liability in civil trials and guilt in criminal trials. CU – NIE Seminar June 11, 2008

40. Probabilistic reasoning 2 • The Monty Hall (or Three Door) Problem • You are a guest on “Let’s Make a Deal” and are invited to play the final prize game. • There are three doors on stage, each marked with a number—1, 2, or 3. • Behind one door is $60,000 in cash. Behind the other two doors are goats. • Monty invites you to choose a door. CU – NIE Seminar June 11, 2008

41. Probabilistic reasoning 3 • Suppose that you choose Door 1. • Monty turns to his assistant and asks her to open Door 3, revealing a goat. Doors 1 and 2 remain closed. • Now Monty says to you, “You’ve chosen Door 1. That door and Door 2 remain closed. Would you like to remain with Door 1 or would you like to switch to Door 2?” • What should you do? CU – NIE Seminar June 11, 2008

42. Probabilistic reasoning 4 • You should switch! • Your chances of winning if you switch are 2/3. CU – NIE Seminar June 11, 2008

43. Why should you switch? CU – NIE Seminar June 11, 2008

44. Implications • Decisionmakers may not do as able a job in estimating probabilities as RCT assumes. • For example, they may overestimate their abilities to avoid an accident. Therefore, there may be too many accidents. • A possible corrective is to take safety decisions away from individuals and place them on manufacturers. Auto safety. CU – NIE Seminar June 11, 2008