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Economics 320F – An Economic Analysis of Law
Midterm Exam 2-4pm
Fall 2004
University of Toronto
Joanne Roberts
Please answer all parts of the exam in the exam booklet provided.
Non-programmable calculators are permitted.
This test will be marked out of 60.
The marks for each question are noted throughout the exam.
Part 1: [24 marks -- 8 each]
Answer three of the following:
1. Define the concept of reliance and explain why we do not want to encourage excessive reliance in
See pages 205-210 of the text.
Parties to a contract may, in relying on the contract being performed, take actions in
advance of performance of that contract which will enhance their own value of
performance. For example, a retail store may advertise that they will be selling a
new product after they have entered into a contract with a supplier for the delivery
of that product.
The optimal level of reliance is that which maximizes the expected value of
performance less production cost less the costs of reliance.
If it turns out at the time of performance that performance is not optimal, then
reliance expenditures will have been a waste. Thus, the optimal level of reliance will
depend on the probability of performance.
Under the expectation measure of damages, overreliance can occur because the
buyer (or promisee) is implicitly insured by receipt of damages and will therefore
view his investment in reliance as one with a certain payoff. But if performance is
uncertain, this will lead the promisee to expend too much on reliance.
2. A contract is meant to be a mutually advantageous and voluntary exchange. If it turns out that one
party does not benefit as expected at contract time, is it efficient for the contract to be enforced?
See pages 201-205 of the text.
Efficiency requires maximizing the sum of the payoffs to the promisor and promisee.
If transaction costs are zero such that the contract is a complete contingent contract
(i.e., the parties specifically agreed about what should happen in each possible case),
then the contract should be enforced.
Where the contract is incomplete (the usual case), however, then a contract should
be enforced only where the cost of performing is less than the benefit.
If one party does not benefit as expected at contract time, this does not necessarily
mean that they do not benefit at all, or that the total benefit to both parties does not
exceed the costs of performance.

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3. A valuable resource in which we typically forbid voluntary exchange is votes. This may be
inefficient in that, as we have seen, given any initial endowment of resources, voluntary exchange
always makes both parties better off (absent any clear sources of market failure). Show that it
would be a Pareto improvement (i.e., that at least some people would be better off and no one
would be worse off) if we were to allow a legal market for votes. Are there any clear sources of
market failure in the market for votes? If so, can you think of any policy options which might
correct this market failure? Is it bothersome that there is a wide variance in income and wealth
among the participants in this market, and if so, why is that variance more troubling in this market
than in others and what would you do about it in the market for votes?
Assume that we allowed voluntary exchange of votes. If one voter sells her vote to
another, both the seller and the buyer must be at least as well off as they would have
been before the transaction (otherwise neither would have agreed to it). Everyone
else retains their votes and thus is as well off as if this transaction did not occur.
There is a free-rider problem here in that any one individual who is presented with
an opportunity to sell their vote may believe that their impact on the outcome is
negligible and will therefore place little value on their vote (i.e., they will accept a
relatively small price for it) if they believe that the outcome will be favourable.
However, if a lot of people believe this, then the outcome may in fact deviate from
the optimal outcome (i.e., the one that would obtain if everyone cast their own vote).
4. What economic justification can you give for why some types of torts, such as products liability,
are subject to strict liability, while others are subject to negligence?
In most instances of product-related harms, precaution lies unilaterally with the
manufacturers. Strict liability would therefore, be sufficient to induce optimal
precautions. It is also preferable since it is administratively cheaper for the courts
than is a negligence rule.
In the case of other accidents, precautions can typically be taken by both victim and
injurer and therefore a negligence rule would be needed to induce efficient bi-lateral
See page 379 of the text.

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Part 2: [36 marks -- 18 each]
Answer both of the following questions.
1. An accident may occur that will cost the victim $80,000. The probability of the accident is .006
(6/1000). Suppose that the victim can reduce this probability by .002 (to .004 if the injurer does
nothing) by spending $100, while the injurer can reduce the probability by .003 (to .003 if the
victim does nothing) by spending $150. If both parties take actions to prevent an accident, the
probability falls to .001.
i. Comment on the efficiency of the following four liability rules in this case: strict
liability, no liability, negligence, and strict liability with contributory negligence.
In this case, it is efficient if both injurers and victims take precautions since
for each the marginal cost of taking precautions is lower than the marginal
benefit of reducing the expected costs due to accidents (i.e., 0.002*80,000 =
160 > 100 and 0.003*80,000 > 150).
Strict Liability: only injurer will take precautions (inefficient)
No liability: only victim will take precautions (inefficient)
Negligence: victim and injurer will take efficient precautions so long as
negligence standard is correctly specified (i.e., injurers must have spent
$150 in precautions).
Strict Liability with Contributory Negligence: both will take efficient
precautions so long as the victim is required to spend $100 on precautions
to avoid being found contributorily negligent.
ii. Of those rules which are efficient, which would you recommend ? Explain why.
Choose Negligence if the victim’s activity levels have a greater effect on
Choose Strict Liability with Contributory Negligence if injurer’s activity
levels are more important.
See page 332-333 of text.
iii. What circumstances might lead you to favour strict liability as a liability rule in tort
Strict Liability is preferable where it is optimal for only the injurer’s to
take some precaution to prevent accidents.
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