Econ 522, Fall 2008, Dan QuintLecture 2 (Sept 4, 2008)First, logistics…- Some people have been added to the class; the process isn’t complete yet- If you’re still not registered and want to be, put name on list - Sections start next week, not this week- also, someone pointed out to me that Law’s Order is available as an online text if you have a City of Madison library cardTuesday, we discussed- the point of this class – using microeconomic tools to evaluate the incentives created by different laws and legal systems, and the actions and outcomes they will therefore lead to- very brief history of the common law and civil law traditions- one example of how the common law responds to existing norms and practicesI’ll begin with a useful distinction between two types of economic statements: positive and normative- positive statementso “economics of what is”o can be descriptive: “U.S. GDP in 2007 was $13.8 trillion”o or a theoretical prediction: “If prices increase, demand will fall”- normative statementso “economics of what ought to be”o contains value judgment: “Government should encourage innovation”The type of analysis I discussed on Tuesday is positive- we’ll mostly be making theoretical claims: “if the law says this, it will lead to this outcome”. (For example, “a rule of strict liability will lead to fewer accidents than a negligence rule”)- however, in the background, we’d like to know when one outcome is better than another, to have a sense of how the law should be designed- that will be today’s topic – in particular, we’ll examine the notion of efficiency, and arguments for whether the law should aim to be efficient(I’ll also note that for now, I’m using the term “outcome” to mean just about everything: how much money each person has, what stuff they consume, how hard they work, how likely they are to get hit by a car, and so on.)One possible standard for when one outcome is better than another: Pareto superiority.- We say outcome A is Pareto superior to outcome B if everyone in society is at least as well off under A, and at least one person is strictly better off.- Or to put it another way, a Pareto improvement is a change that makes nobody worse off and somebody better off.- and an outcome is Pareto efficient if there are no available Pareto improvements- For example, if my car is worth $3,000 to me and $5,000 to you, and I sell it to you for $4,000, that’s a Pareto improvement; you and I are both strictly better off, and nobody else is affected- If one legal system leads to outcomes that are Pareto-superior to another, it’s pretty easy to argue that it’s better- But Pareto improvements are pretty hard to come by.- Most new laws or legal changes will create some winners and some losers – if we can only say one outcome is better if it’s Pareto-superior, there are very few normative statements we’ll be able to make- Even in the car example, other people might end up worse off when I sell you my car – maybe my car’s ugly, so your neighbors end up a little worse off because you park it in front of your houseA weaker standard for “better” is Kaldor-Hicks superiority.- The move from Outcome A to Outcome B is a Kaldor-Hicks improvement if you could turn it into a Pareto improvement by moving money around- To put it another way, something can be a Kaldor-Hicks improvement and still have winners and losers; but the winners have to gain more than the losers lose; so that the losers could theoretically be given enough money to compensate for the change, and the winners would still come out ahead- Kaldor-Hicks improvements are also called potential Pareto improvements- An outcome is Kaldor-Hicks efficient if there are no available Kaldor-Hicks improvements- Going back to our earlier example… if I value my car at $3,000 and you value it at $5,000, it’s a Pareto-improvement for me to sell it to you for $4,000; it’s a Kaldor-Hicks improvement for you to just take it- Another way to think of it: Kaldor-Hicks efficiency is about maximizing the size of the overall pie, without any regard for how it’s divided – so taking away from me and giving to you is OK, as long as you get more than I give upA reasonable question to ask: if we’re going to allow potential Pareto improvements, that is, changes where the winners gain enough to compensate the losers and still come out ahead, then why not just have them do that? That is, if money is freely transferable, why not make the actual transfers to turn a Kaldor-Hicks improvement into a Pareto-improvement?Polinsky, in his book, gives an example of a dam whose benefits would outweigh its costs, but whose benefits would go to one person and its costs to another. Indeed, in those cases, rather than checking whether the gains are bigger than the losses, why not just see whether the winner was willing to pay the loser and turn it into a Pareto-improvement?In a case like that with just two players, that may make sense. But in some cases, there will be lots of winners and losers, and it may be hard to know exactly how much they’ve gained or lost. For example, suppose you need to be somewhere, and can either drive or go by bus.Driving’s a little more convenient – you can park pretty close to where you’re going, don’t have to worry about the bus schedule – so you’d rather drive.On the other hand, driving imposes an externality on others – a little bit more pollution, a little bit more traffic, a little bit less parking – and overall, if you do the math, it’s more efficient for you to take the bus – the overall costs outweigh the benefits.But it’s pretty hard to get everyone else on the road that day to contribute one cent, and everyone else in town who is breathing the air to contribute one-tenth of a cent, and everyone else who wants to park downtown that day to contribute five cents, to collect the $10 it would take for you to be just as happy taking the bus.So in cases where the costs or benefits are diffuse, turning potential Pareto improvements into actual Pareto improvements may be nearly impossible, and it makes sense to at least consider Kaldor-Hicks improvements.- When we use “efficiency” in this class, we’ll generally mean Kaldor-Hicks efficiencyo If one allocation is a Kaldor-Hicks improvement over another, we’ll say it’s more efficientWhat Kaldor-Hicks efficiency really does is consider something an improvement if the
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