Agenda for 15th Class

1. Agenda for 15th Class • Sarnoff (continued) • Cleaner Skies • Introduction to Information • Mid-semester feedback (A-C1 only) Assignment for Next Class • ## 61-64 • Questions to Think About /WritingAssignment. • P. 253ff Qs 4 & 5 • P. 272 Qs 1-3

2. Sarnoff Revew • If transactions costs are low, Sarnoff will start new business regardless of value of stock he is entitled to get if he does not compete. • If stock is worth more than anticipated business profits, then Sarnoff and AHP will negotiate • If Sarnoff starts his business, there is $500K more in net benefits, so there is a way for them to negotiate a mutually beneficial deal • Suppose the stock is worth 1.2M. Compare • If Sarnoff does not start his new business • Sarnoff. +1.2M ; AHP -1.2M • Total net benefits: 0 • If Sarnoff starts business, but no payment from AHP to Sarnoff • Sarnoff. 1M • AHP. -500K • Total net benefits are higher (500K), but Sarnoff is worse off • If Sarnoff starts business, but AHP pays Sarnoff 300K in exchange for dropping claim to stock • Sarnoff 1.0M + 300K = 1.3M • AHP. -300K -500K = -800K • Total net benefits still 500K, but now both are better off than if Sarnoff does not start business

3. Sarnoff Qs • 4. Posner’s opinion considers only the maximization of Sarnoff’s and American Home Products’ wealth. Are there any other persons whose wealth (or well-being) are affected? Should their interests be considered? • 5. What does Posner mean when he writes, “presumably the employee would have been compensated in advance for agreeing to a covenant that would restrict his freedom of future action”?

4. Externalities & Coase Theorem • When externalities affect small number of people who can negotiate ex ante or who deal with each other repeatedly, probably don’t need law to correct or encourage • Nice or mean things done to family or friends • Contracts usually deal explicitly with externalities • E.g. promisee pays for positive externality granted by promisor • Parties indemnify each other for harm • But law sometimes imposes mandatory terms • E.g. Product liability, medical malpractice liability • Covenants running with land, homeowners associations • Deal with externalities among neighbors • But when externalities affect large numbers of people, need law • Pollution, congestion, torts among strangers, etc.

5. Prisoners’ Dilemma • Dominant Strategy. Nash Equilibrium • Each suspect imposes negative externalities on the other • Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

6. Pollution Externalities Game • Almost identical to Prisoners’ dilemma • If numbers small, might expect agreement to install pollution control • When numbers large, negotiation very difficult • Collective action problem • Everyone better off if everyone installs pollution control equipment • But each person better off if free rides • Better to not install pollution control equipment, if everyone else does

7. Collective Action Problems • Collective Action Problems are ubiquitous • Becoming informed voter, voting • Funding public goods, e.g. fire departments, bridges, national defense • Global warming • Fishing • Every collective action problem is also an externalities problem • Sometimes groups can resolve • Political lobbying by interest groups • Democracy • Voluntary organizations • Clubs • Often government is only or best solution

8. Cleaner Skies

9. Information • Efficiency of competition assumes perfect information • Imperfect information is a transactions cost • Efficient allocation of resources may be impaired by imperfect information • Imperfect information (like externalities) is ubiquitous • When law school and student choose each other • Law school doesn’t know how smart or hardworking students are • Students don’t know how good school is • Law school tries to gather info – admissions process • Students try to gather info – US News, campus visits, blogs • But information gathering is expensive and imperfect • When promisor breaches • May not know how much harm will cause promisee • May not know whether judge will find breach or not • Judge or jury may not know whether breach intentional or accidental • Judge or jury may not know whether promisee could have mitigated damages • Discovery and trial try to get answers to these questions, but expensive and not completely accurate

10. The Market & Information • Market corrects or mitigates some informational problems • Product markets • Consumer Reports, Angie’s List, Amazon consumer reviews, EBay ratings, etc. • Insurance • Medical exam before life insurance • Loan markets • Credit ratings, loan applications • Schools (see previous slide)

11. Information & the Law • Much of law is concerned with information • Litigation is principally about production of information • Much consumer regulation is forced disclosure of information • Nutritional labeling • Securities Law • Prospectus before initial offering • Quarterly reporting of profits • MPG for cars • APR for loans and savings instruments • Contract law • Limitation of damages to those which are “forseeable” forces promisee with high damages to disclose (Hadley v Baxendale) • Product liability law makes price of product reflect producer’s estimate of expected liability • Expected liability likely (otherwise) unknown to consumer • Title recordation in Property law

12. Moral Hazard • Insurance context • Insured has suboptimal incentive to take precautions • If insured against fire, may not install sprinklers or be as careful with fireplace • If have health insurance, may not be as careful to eat right or exercise • If have health insurance, may request treatments that unlikely to be effective • Tort law is form of insurance • Product liability may make consumers less careful • Duty to rescue may make parents (and others) less careful • Government programs are a form of insurance • Welfare may dull incentive to work • Income tax may dull incentives to work • Contracts generally • After contract entered into, party may have incentive to act in way that is detrimental to other party • Employee may not work hard • Lawyer paid by hour may spend too much time on project • Renter may not take good care of apartment

13. Responses to Moral Hazard • Gather information • Moral hazard is result of fact that insurer does not know how insured is behaving • If insurer knew, then could condition insurance on insured behaving properly • Insurer’s “monitor” insured • Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc • Government monitors welfare recipients, requires job search, etc. • Deny insurance if precautions not taken • Comparative/contributory negligence in tort • Insurance exclusion for arson • Fire employees if shirk • Build incentive into contract • Insurance seldom covers full cost of hazard • So insured has some incentive to take precaution • Employer can make pay proportional to output • Government regulation seldom helpful • Government doesn’t usually have superior information • But sometimes can help • By using information gathering of criminal law • By threatening larger penalties (e.g. imprisonment) • E.g. imprisonment for securities fraud

14. Moral Hazard, Coase Theorem, & Externalities • Cost of obtaining relevant information is transactions cost • If info could be obtained costlessly, moral hazard wouldn’t exist • Since info is expensive, inefficiency may result • Moral Hazard is kind of externality • Insured imposes costs on insurer • Employee imposes costs (or less benefit) on employer • Sometimes not considered an externality, because • Insured and insurer are in contractual relationship • Employer and employee in contractual relationship

15. Principal-Agent Problem • Many situations where one person (agent) works for another (principal) • Lawyer works for client • Employee works for employer • Promisee works for promisor • Problem • How get agent to act in interest of principal • Problem is often moral hazard • Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)