August 27, 2012What Are Economics and the Law About?Applied microeconomic theory in order to understand the interrelationships between the legal system and the economic systemBasic Assumptions in Economic AnalysisScarcity implies rationing and competitionThe individual is the relevant decision-making unitThe individual’s preferences are subjectiveThe individual is rationalNot just about market price and determinationGovernments can determine price and resource allocationIncentives arise in law, but only if law is enforcedAlso depends on community’s normsAnalogy Between Legal Rules and PricesExplicit price (i.e. a fine for breaking the law) & expected price (if commit a crime, do not expect to pay anything because do not expect to get caught)Calculating an implicit expected price requires knowledge of the law, and of the consequences of violating itIs ignorance of the law widespread? It is rational to be ignorant about laws that do not affect youAs price increases, buy less; as price increases, violate the law lessAugust 29, 2012New Law and EconomicsNew law: common law (property law, and tort)Often dated from the publication of Ronald Coase, “The Problem of Social Cost” (1960)Opened analysis to common lawComparative institutionsThe Coase Theorem: If the parties bargain to an agreement for themselves, then the value creating activities that they agree upon do not depend on the bargaining power of the parties or on what assets each owned when bargaining began. Rather, efficiency alone determines the activity choice. The other factors can affect only decision about how the costs and benefits are shared.If people can bargain and reach an agreement, the result of the bargain will be an efficient allocation of the goods and servicesBargain power determines how costs and benefits are shared, not the actual allocation of goods and servicesBargaining = costlyTransaction CostsTransaction costs: costs that arise when individuals exchange ownership rights to economic assets and enforce their claims to rightsThe costs of running the system: the costs of coordinating and motivatingCosts can prevent efficient allocation of resources  bargaining not possible all the timeWhen you exchange goods and services, you are also exchanging ownership rightsLaws can reduce transaction costs, but law can also create transaction costs (i.e. law against buying and selling marijuana = increase transaction costs)Middlemen lower transaction costsMarkets can be created because of transaction costs and the need for a middleman (i.e. real estate, retailers, etc.)Transaction costs = ½ of the U.S. economy in the 1970sTransaction costs can prevent bargaining and internalization of externalities (Coase)Comparative InstitutionsInstitutions = laws, norms, have incentives to followDifferent institutional arrangements affect allocations of resources in the economyYou either need more inputs (i.e. capital) or technological change, OR fix the institution (if that is the central problem) to achieve the technological production frontier (the maximum)Each curve represents production possibilities under different institutional arrangementsTPF = Technological Production Frontier: usually not close bc some sort of institution is probably not creating incentives to use the resources efficientlySPF = Structural Production FrontierSPF2 is higher than SPF1, indicating that SPF2 has “better” institutional arrangements (in the sense that they encourage more productivity than SPF1)Voluntary ExchangeExpect to be better offSubjective value — coerced exchange does not take subjective value into account and can often decrease the value held by the new owners of that good or serviceOpportunity costs — compare current transaction to alternative transactionsHighest valued use — the person buying values the product more than the person selling itWelfare and societyPareto superior: someone values the product poorly, the other values it highly, and the transaction occurs  no one ends up worse off, only either the same or better offNo cost-benefit analysisPretty Woman example — see producer and consumer surplus  both sides think they got a great dealKaldor-Hicks: reallocation is efficient and welfare enhancing if the party receives enough that they can pay back the party that loses itGains exceed costs (cost-benefit analysis)Welfare criteria to justify involuntary transactionsi.e. government transfers — take from one, but increase the welfare of many and if wanted to, can pay back the person who lost  can justify policyExamples: Coordination and the Exchange of Property Rights Between IndividualsThe reasons for transaction costs (not all exist in every type of transaction):1) The search for information (time and effort)2) Bargaining (i.e. flee market, but do not see bargaining in a convenience store)3) Drawing up contracts (i.e. leasing agreement)4) Monitoring contractual partners (i.e. upholding warranties, i.e. do not buy a car that was made during a World Series bc the assembly line and it’s supervisor are all watching the game, and the car would be more prone to defects — need to keep an eye on how things are made in that factory)5) Enforcement of a contract and the collection of damages (i.e. damage to a leased apartment)6) Protection of property rights against third party encroachment (i.e. putting an alarm system in your leased apartment)August 31, 2012CredibilityInformation is costly to obtainWill never have complete informationMay have so little, that you feel uncomfortable undertaking the transactionMost contracts are inevitably incomplete—usually contain items about the future, but the future is always uncertainAsymmetric information can give rise to moral hazardAsymmetric information: one party has more information than another partyMoral hazard: the more knowledgeable party has incentives to take advantage of the other party because they do not know as much as you doi.e. You do not have insurance, so you rarely go to the doctor when you are sick (which may be frequently). You decide to apply for insurance, and your record looks clean bc you rarely see doctors bc you cannot afford them. The insurance company takes you as a client bc they think you are low risk (even though you know that your medical history says otherwise). Consequently, your health demands increase after obtaining insuranceIndividuals may not enter into an exchange simply because they do not believe the other party is being