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ECO320H1 Final: eco320 Readings all summarized

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Robert Barber

Lecture 1 Readings INTRODUCTION Economics: scientific theory to predict the effects of legal sanctions on behavior; generally provides a behavioral theory to predict how people respond to laws. Economists are experts on two policy values: efficiency and distribution - A prediction can be neutral or loaded with respect to social values. Economics provides such a method for efficiency (aka additional cost of collecting higher fines vs. decrease in accidents). - Economists understand how laws affect the distribution of income across classes and groups (aka who bears the burden of alternative taxes?). - Profits are closely related to efficiency. Economic efficiency measures public benefits that include the profits of firms, the well being of consumers, and the wages of workers. A good legal system keeps the profitability of business and the welfare of people aligned, so that the pursuit of profits also benefits the public. Examples: 1. White-collar crimes are usually committed after rational consideration of the potential gain and the risk of getting caught and punished. How high should the fine for these crimes be? - Rational crimes seldom occur unless the expected gain to the criminal exceeds the expected cost. The expected cost depends on: the probability of being caught and the severity of the punishment. - Expected cost of crime = probability of a fine * magnitude - Cost of increasing the probability of catching white-collar criminals > administering fines. So invest little in apprehending and prosecuting offenders, and fine severely those who are apprehended. 2. An oil company contracts to deliver oil from the Middle East to a European manufacturer but a war breaks out. Who should pay for the loss of the European manufacturer if war wasn’t a consideration in the contract? - The oil company and manufacturer can take precautions against war in the Middle East. The oil company can sign backup contracts and the manufacturer can store oil for emergency use. - Efficiency requires the party to take precaution who can do so at least cost, so the court might hold the oil company liable since they are located in the Middle East and are better suited to take precautions against war. This is the principle of the least-cost risk-bearer. 3. Eddie’s Electric Company emits smoke that dirties the wash hanging at Lucille’s Laundry. Eddie’s can completely abate the pollution by installing scrubbers on its stacks, and Lucille’s can completely exclude the smoke by installing filters on its ventilation system. Installing filters is cheaper than installing scrubbers. - If they cannot bargain, it is efficient for Lucille’s to lose the action. - If they can bargain, their joint profits will be higher if they choose the cheaper means of eliminating the harm from pollution. When their joint profits are higher, they can divide the gain to make both of them better off. Focus on efficiency rather than distribution because pursuing redistributive goals shouldn’t be the usual use of private law. Economists generally agree about redistributive means. Many economists believe that progressive taxation and social welfare programs— the “tax-and-transfer system”—can accomplish redistributive goals in modern states more efficiently than can be done through modifying or reshuffling private legal rights because… 1. Income tax precisely targets inequality but redistribution by private legal rights relies on crude averages. 2. The distributive effects are hard to predict. 3. The transaction costs are typically high 4. Redistribution by private law distorts the economy more than progressive taxation. BEHAVIORAL ECONOMICS Behavioral Economics: Rational choice theory cannot explain the observed behavior. 1. ultimatum bargaining game- splitting money rationally 2. hindsight bias- things that actually happen seem, in hindsight (ex post), to have been far more likely than they were in foresight (ex ante) LAW AND LEGAL INSTITUTIONS Legislatures make laws by enacting bills, which judges must interpret and apply. Judges make law by interpreting legislation in all legal systems with independent courts. The common law is called that because they are allegedly rooted in the common practices of people. Common law judges traditionally justify their findings of law by reference to precedent and social norms or broad requirements of rationality presupposed by public policy. In common law countries, where the court follows the adversarial process, the judge acts more or less as a neutral referee who makes the lawyers follow the rules of procedure and evidence. The principle underlying this system is that the truth will emerge from a vigorous debate by the two sides. Civil law is a comprehensive set of statutes so people would know what counts as property, how a valid contract is formed, and who is to bear the cost of accidents. Civil law judges traditionally justify their interpretation of a code directly by reference to its meaning, which scholars tease out in lengthy commentaries. In civil law countries, where the court follows the inquisitorial process, the judge is supposed to ferret out the truth. The lawyers often have to respond to the judge, rather than develop the case themselves. The principle underlying this system is that the court has a direct interest in finding the truth regarding private disputes and crimes. MICROECONOMICS REVIEW Allocatively/Pareto efficient- impossible to make at one person better off without making someone worse off. 1. Theory of consumer choice and demand: describes how the typical consumer, constrained by a limited income, chooses among the many goods and services offered for sale. The consumer’s preference ordering or ranking be complete, transitive, and reflexive. Socially optimal output is where MC=MB. 2. Choices made by business organizations or firms: models show how the firm decides what goods and services to produce, how much to produce, and at what price to sell it’s output. Perfectly Competitive Market Rental Controls Monopoly Market 3. Supply and demand for inputs into the productive process: labor, capital, land, and managerial talent; more generally, inputs are all the things that firms must acquire in order to produce the goods and services that consumers or other firms wish to purchase. Lecture 2 Readings MARKET FAILURE 1. Monopoly and Market Power 2. Externality Difference Between Private and Social Marginal Cost 3. Public Goods a. Nonrivalrous consumption: consumption of a public good by one person does not leave less for any other consumer. b. Nonexcludability: the costs of excluding nonpaying beneficiaries who consume the good are so high that no private profit-maximizing firm is willing to supply the good. ECONOMIC THEORY OF PROPERTY Bargaining Theory: The cooperative surplus (=cooperation solution – noncooperation solution) is the name for the value created by moving the resource to a more valuable use. Facts about the bundle of legal rights constituting ownership: 1. These rights are impersonal in the sense that they attach to property, not persons. Any person who owns the property has the rights. In this respect, property rights are different from contract rights. Contract rights are personal in the sense that one person owes something to another person. 2. The owner is free to exercise the rights over property, no law forbids/requires the owner to exercise those rights. 3. Others are forbidden to interfere with the owner’s exercise of his rights. COASE THEOREM Fairness apparently requires the party who causes harm to pay for it. In contrast, efficiency requires allocating the right to the party who values it the most. When the parties bargain successfully, the legal allocation of rights does not matter to efficiency and the use of resources is efficient, regardless of the legal rule. Threshold level of transaction costs distinguishing the areas in which the Coase Theorem does & doesn’t apply. Coase theorem: if transaction costs are low and property rights are clearly defined, private bargains will ensure that the market equilibrium is efficient even if there are externalities. If the government can define property rights and lower transaction costs, new market can be created to control externality problems. Normative Coase Theorem: Structure the law so as to remove the impediments to private agreements. The principle is normative because it offers prescriptive guidance to lawmakers. Normative Hobbes Theorem: Structure the law so as to minimize the harm caused by failures in private agreements. According to this principle, the law should be designed to prevent coercive threats and to eliminate the destructiveness of disagreement. When the parties fail to reach a private agreement where one is possible, they lose the surplus from exchange. To minimize the resulting harm, the law should allocate property rights to the party who values them the most, making exchange of rights unnecessary and saving the cost of a transaction. The Coase and Hobbes Theorems characterize two ways that law can increase efficiency when transaction costs are positive. 1. Law can lubricate private exchange by lowering transaction costs. 2. Law can allocate rights to the party who values them the most. IC = information costs to a court of determining who values a legal right the most TC = transaction costs of trading legal rights. Efficient courts would follow this rule: IC < TC = allocate the legal right initially to the person who values it the most TC < IC = strictly follow precedent EFFICIENT REMIDIES - Low transaction costs: enjoin the defendant’s interference with the plaintiff’s property. - High transaction costs: award compensatory money damages. When transaction costs preclude bargaining, the court should protect a right by an injunctive remedy if it knows which party values the right relatively more. Conversely, the court should protect a right by a damage remedy if it knows how much one of the parties values the right absolutely. Property is a bundle of rights with incentive effects. Efficient property rights create incentives to maximize a nation’s wealth by: 1. Forming legal basis of voluntary exchange, which achieves allocative efficiency by moving goods from people who value them less to people who value them more. 2. Forming part of the law that makes owners internalize the social costs and benefits of alternative uses of the goods that they own. Owners achieve productive efficiency by balancing the social costs and benefits of what they do with what they own. Lecture 3 Readings PROPERTY RIGHTS General principles that can solve the problem of establishing ownership: 1. First possession: goods in ground are not the property of anyone until reduced to possession by extraction. This rul
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