ECO320Y5 Study Guide - Midterm Guide: Coase Theorem, Avoidance Speech, Social Cost

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Published on 31 Mar 2020
School
Department
Course
Professor
ECO 320
Economic Analysis of Law
Test I
Thursday, June 6, 2019
6:10 PM to 8:00 PM KN L1220
SOLUTION
Students may use a non-programmable calculator. All work should be in pen
written on the lined portions of the test booklets. Full marks will only be awarded to fully
explained answers accompanied by a fully labelled diagram or diagrams where
appropriate. Please read all questions carefully before answering them.
(10 marks) QUESTION 1
When people strongly disagree, they may try to harm each other, or they may walk
away from a potentially profitable exchange. What does the Normative Hobbes Theorem
suggest the response of the law should be to these two possibilities? Why?
The Normative Hobbes Theorem (NHT) has greater application in the case of strong
disagreements, due to the possibility of harm. “Structure the law so as to minimize the
harm caused by failures in private agreements.”
If an exchange is potentially profitable, the Normative Coase Theorem more likely
applies as this usually means that an impediment like transaction costs is likely the
problem the parties can still see potential profits so “structure the law so as to
remove the impediments to private agreements.”
For full marks it was sufficient just to deal with NHT and how it applies in two (2)
situations where people who cannot contract either ignore each other or apply
harmful tactics.
(10 marks) QUESTION 2
Doctors who form a partnership may say nothing in the partnership agreement
concerning its future dissolution. The parties may deliberately avoid discussing
dissolution for fear of breeding distrust. Explain when and why this behaviour could be
efficient? Provide and explain some other examples of gaps left in contracts for strategic
reasons.
The parties expect to save transaction costs by leaving gaps in contracts whenever the actual
cost of negotiating explicit terms exceeds the expected cost of filling a gap.
The doctors expect to save transaction costs by leaving gaps in contracts whenever the actual
cost of negotiating explicit terms exceeds the expected cost of filling a gap.
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For example, uncertainties as to why partnerships might break up can vary so expectation
damages might vary, so keep these possibilities open because default rules cover these
eventualities. Text pp. 292 -293.
(Students can use two (2) of several examples.)
A deliberate gap may be left in a contract for psychological reasons, as when a couple
promises to marry and remains silent about dividing property in the event of divorce.
Gaps in contracts may be deliberate because parties believe that the event is too remote. A
construction contract may not mention the possibility of zoning officials rejecting the
construction plan the parties both believed that this possibility is too remote.
(The students may use other examples as well.)
(10 marks) QUESTION 3
Prior to 2000, in Ontario, governments limited non-smoking prohibitions to public
places. Municipalities, then the province (May, 2006), extended the prohibition to private
businesses such as restaurants and bars. Using microeconomics, compare and contrast
this regulation with the willingness of some businesses to voluntarily segregate
customers and staff into smoking and non-smoking areas without regulation as some
businesses did prior to the municipal and provincial rules.
The key point is externalities and who should regulate them. In the US, the
issue of second hand smoke was deemed important enough to require
investigation and potential regulation at the national level.
There is a potential double externality. There is SHS effecting non-smokers.
There are inconveniences to smokers.
The message of the theorem of Coase (based as it is on the case of Sturges
v. Bridgman) is that the more localized the bargaining, the more efficient
the outcome. So initially, railroads designated smoking cars, airlines and
restaurants had smoking sections, and employers had smoking areas.
As greater knowledge about negative side effects of SHS increases, the
smoking bans become wider and private choice may not be adequate in
internalizing the broader harms. So municipal bans and provincial bans
become more popular.
(10 marks) QUESTION 4
A house built on a flood plain has a fair market value of $50,000. When a
government plan to insure the house against floods applies, the fair market value of the
house increases to $150,000. Now the government wants to expropriate the house in
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order to preserve the environmental quality of the flood plain. What is the socially
efficient price the government should offer? $50,000? $150,000? Another price? Explain
your answer.
The best answer is a price greater than $150,000.
Firstly, in expropriation cases fair market value tends to underestimate the subjective value
that an owner places on his or her property. Factors such as sentimentality, rootedness in the
land, etc. are not always captured in fair market value. In economics, a socially efficient or
socially optimal price reflects this subjective value.
Secondly, there is a public goods externality when one tries to offset the loss to an owner
with the gains public users place on the owners’ loss. For example, there may be a social cost
to converting a private good to a public (environmental good) where the government cannot
exclude users of it who do not pay their share of the costs. Text p. 104.
Thirdly, to the point that the “insurance gain” should be offset this might apply if the
insurance gives rise to identifiable or quantifiable moral hazards, these “costs” could be
applied to offset the expropriation price. See Text pp. 181 184.
(10 marks) QUESTION 5
Electric Company E emits smoke, dirtying the wash at Laundry L. E earns $1,000 if
it does not install scrubbers. L loses $200 if E does not install scrubbers. L earns $300 if
E does install scrubbers. E can abate its pollution by installing scrubbers that would cost
E $500. L can eliminate E’s externality by installing filters that would cost L $100. (Each
part is worth 2.5 marks)
(a) Set up the social contract game showing the four possible outcomes of this
problem?
(b) Which outcome is socially optimal? How this is determined?
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