Let S Begin with a Little Review

Econ 522 – Lecture 15 (March 24 2009)

Welcome back

Reminder: homework on contract law due next Tuesday
Who would like to move second midterm from Tues April 7 to Thurs April 9?

Let’s begin with a little review.

We started this class by defining the notion of efficiency
Basically: the idea of maximizing the total surplus realized by everyone in society
Efficiency requires that scarce resources be owned by whoever values them the most
And that any actionshould be if its total social benefit exceeds its total social cost

We made the claim that we’re interested in designing a legal system that leads to efficient outcomes
What makes this hard?
Once we set up the rules, we don’t expect individuals to act based on what’s efficient
We expect individuals to do whatever is in their own best interest
So the goal is to set up the rules in such a way that people acting in their own best interest will naturally lead to efficiency

Coase gives us one way to do this
Efficiency requires things to be owned by whoever values them the most
Suppose we set up a legal system where things can be bought and sold
If I value something more than you, I can buy it from you
As long as property rights are clearly defined and tradeable, and there are no transaction costs, people have an incentive to trade until each resource is owned by whoever values it most
This argument doesn’t depend on who starts with what – so Coase tells us that the initial allocation of rights doesn’t matter for efficiency, only for distribution

On the other hand, when there are transaction costs – impediments to private bargaining – we may not get to efficiency this way

This led us to two different normative views of the legal system:
One, that the legal system should aim to minimize transaction costs (“lubricate” private exchange, the normative Coase), since if we make transaction costs low enough, efficiency will follow
Or two, that the legal system should aim to allocate rights efficiently (the normative Hobbes), so that less is lost when private exchange fails

We then looked in more detail at four questions a property system needs to address:

1. What things can be privately owned?

One of the motivations for property rights was that without them, common resources would be overused
We distinguished between public and private goods
General principle: private goods should be privately owned
While public goods should be publicly owned/provided/regulated

We pointed out that society has an incentive to privatize a resource when the costs of boundary maintenance are smaller than losses due to overuse of common resources
Demsetz: fur trade made furs more valuable and caused overhunting
Loss due to overuse went up, leading Native Americans to develop private land rights
Another neat theory is mentioned in the Friedman book: “we owe civilization to the dogs”
When dogs were domesticated, they could be trained to recognize their owner’s land and guard it, and so private ownership of farmland became feasible because the cost of boundary maintenance went down

Property rights over information – patents (to create incentive to innovate), copyrights (to encourage the supply of a public good)
Different types of public ownership (common access vs regulation vs unanimous consent)

2. What can (or can’t) an owner do with their property?

General principle: maximum liberty
You can do whatever you want with your property, as long as it doesn’t infringe on anyone else’s rights or property
Nuisances, public and private nuisances
Other limitations on property rights, and economic rationale for each
Rules against perpetuities – an owner can’t restrict heirs indefinitely (but can for one generation)
Emergency exception to rules against trespass
Inalienability –some entitlements can’t be sold (or even given away)
Unbundling – can’t always unbundle property rights
But in some instances, you can – for example, with land in Pennsylvania, and with conservation easements in some locations

3. How are property rights established?

Fugitive property – paradigms of first possession and tied ownership
first possession tends to be simpler to implement
but causes resources to be wasted in trying to gain possession
example of this: Friedman on Homestead Act, saying that the resources wasted in starting to farm before it was efficient basically wasted much of the value of the land (p. 120 in Law’s Order)
First possession versus tied ownership is one example of the general tradeoff between simple, “bright line” rules versus more complex rules that might be more costly to implement but create better incentives
Pierson v Post
Fast Fish/Loose Fish versus Iron Holds The Whale
Verifying legal ownership (property deeds and car titles), acquiring title
Losing property rights – adverse possession, estray rules
Government’s rights to claim private property – eminent domain/takings, limitations (public use, just compensation); regulatory takings, abuse of takings

4. What remedies are available when property rights are violated?

injunctions vs damages
injunctions simpler (cheaper) to implement, create bright-line property rights to encourage bargaining
damages more efficient when transaction costs are high (bargaining unlikely to succeed)

temporary versus permanent damages
temporary damages more efficient when damages are easy to calculate and technology is changing
permanent damages are more efficient when damages are hard to calculate and technology is stable

and we called all that “property law”

Part of what makes property law straightforward is that trade tends to be simultaneous

I give you an apple, you give me $1
However, in some situations, efficient trade can’t be done simultaneously
It might be efficient for me to build you an airplane
But it would be very complicated/costly for you to pay me each day for that day’s work
Contract law gives us a way to transact when one of us has to depend on a promise by the other

We motivated contract law by looking at the agency game
if you can’t trust me to return your money, we miss out on a valuable investment opportunity
Contracts give a way for a promise to be legally binding, allowing us to cooperate in instances where we could not have otherwise
The first purpose of contract law: to enable cooperation

We introduced the Bargain Theory of contracts
A promise is binding if it was given as part of a bargain
This requires three elements, offer, acceptance, and consideration

Unlike the Bargain Theory, efficiency requiresenforcing a promise if both the promisor and the promisee wanted it to be enforceable when it was made

We gave an example of how private or asymmetric information can disrupt trade and cause inefficiency
Second purpose of contract law is to encourage efficient disclosure of information

We introduced the idea of efficient breach
Even when a promise is made in good faith, it sometimes becomes efficient to break the promise
Breach is efficient when the promisor’s cost of performing is higher than the promisee’s benefitfrom performance
Third purpose of contract law is to secure optimal commitment to performing
Expectation damages lead to efficient breach

We introduced idea of reliance investment
Investments by the promisee which make performance more valuable
Fourth purpose of contract law is to secure optimal reliance
When expected gains from reliance are included in expectation damages, we get efficient breach but overreliance
When expected gains from reliance are excluded from expectation damages, we’ll get efficient reliance but excessive breach
(This is the paradox of compensation – neither rule leads to efficient actions on both margins)
Cooter and Ulen propose modifying expectation damages to cover gains from only efficient reliance – nice theoretically, hard practically
Courts tend to reward only foreseeable reliance

We discussed the notion of default rules – rules that cover gaps in contracts
We saw two different approaches to default rules
Cooter and Ulen: set default rule to rule that is efficient in most cases, so most parties can save transaction costs
Ayres and Gertner: in some cases, use penalty defaults, to encourage information disclosure by better-informed party
Famous case of Hadley v Baxendale as an example
Baxendale (shipper) is likely the efficient bearer of the risk of delay, since he can take steps to avoid it
But the ruling penalized Hadley (the miller) for not disclosing how urgent the shipment was – to give an incentive to provide that information

Also discussed a few immutable rules, or regulations

Next, we looked at a number of situations where a contract would be invalidated/not enforced, and economic reasons for why

Contracts which derogate public policy

Incompetence (but not drunkenness)

Dire constraints – duress and necessity
Contracts extracted under threat of refusing to create value are enforceable; contracts extracted under threat of destroying value are not
Contracts renegotiated under duress are not enforceable; contracts renegotiated under changed circumstances are

Impossibility
When performance becomes impossible, assign liability to the party that can bear the risk at the least cost
(either by mitigating it, or by spreading it out over many transactions)

Several doctrines having to do with information: fraud, failure to disclose, frustration of purpose, mutual mistake
When performance becomes pointless, assign liability to the party that can bear the risk at the least cost
Under common law, there is not a general duty to disclose information about an object for sale
But there is a duty to disclose information that makes a product unsafe; and some states have imposed other duties
While mutual mistake is grounds for voiding a contract, unilateral mistake is generally not
Efficiency often requires enforcing contracts which unite knowledge and control, not those which separate knowledge and control
To give an incentive for discovery, efficiency generally requires enforcing contracts based on one party’s knowledge of productive information, especially if that knowledge was the result of active investment; but efficiency need not reward purely redistributive information

Vagueness
In general, this can be seen as a penalty default – by refusing to enforce vague contracts, the courts force parties to be more clear

Adhesion and unconscionability (lesion)

We examined a number of remedies for breach of contract, among them:
Expectation damages
Opportunity cost damages
Reliance damages
Restitution, disgorgement
Specific performance
General unenforceability of penalty clauses in contracts

We looked at the effects of different remedies on decisions to breach, to invest in reliance, and to invest in performance

Just like with injunctions versus damages in nuisance cases: with low transaction costs, any remedy can lead to efficient breach through renegotiation

But with high transaction costs, only expectation damages lead to efficient breach

When damages < benefit from performance – for instance, when they exclude the gains from reliance – we get inefficient breach, or underinvestment in performance

When damages include any expected gains from reliance, we get overreliance by the promisee

(“Paradox of compensation” – no damage rule that achieves efficient levels of everything
Anti-insurance – one cute attempt to solve the problem
Rewarding only efficient reliance – another.)

And we wrapped up contract law by discussing repeated games
In the agency game we started with, repeated interactions can lead to trust
Promisor gets more future value by keeping his promise
This gives promisee a reason to trust him
The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts for enforcement
But we also saw that trust based on repeated interactions can break down when the relationship is expected to end on a certain date

and that brings us up to date

Today, we begin tort law

The word tort is from French, and means injury
With contract law, we studied situations where someone injured you by breaking a promise they had made
With tort law, we will look at situations where someone harmed you without having made any promises.

A line I like from the Friedman book:

“If someone shoots you, you call a cop. If he runs his car into yours, you call a lawyer.”

The line between the two isn’t always that clear
Some torts are crimes as well – if someone assaults you, they may go to jail, and you may also sue them for damages
(Plus, there’s the OJ Simpson case.)
We’ll get to criminal law in a few weeks; for now we’ll focus on the tort side.

Before we get to the material, though, I’d like to do a quick experiment.

As with nuisance law and contract law, our focus in torts will not be on fairness or equity, but on efficiency

That is, our goal is to structure the law in a way that provides incentives for people to behave in a way that leads to efficiency

For deliberate harms, this will usually be fairly simple
If we don’t want people to get in bar fights and break each others’ noses, we can just make the penalty for being in a bar fight very severe
This is roughly the intent of criminal law

For accidental harms, though, setting the correct incentive to avoid harm is tricky
We could prevent all traffic accidents by outlawing cars
We could prevent all construction injuries by outlawing construction
But this would clearly be inefficient
What we want, instead, is the “efficient number of accidents”

Unlike in nuisance law, when it comes to torts, injunctive relief is usually not an option

Much as we’d like to imagine that nobody could run into your car without negotiating for permission, it doesn’t work that way

Unlike with contract law, there is no promise or agreement made ahead of time; something happens, and then we deal with it.

Tort cases may involve parties who are complete strangers

We can think of tort law as covering the situations where transaction costs were too high to allow for bargaining
it’s impossible to negotiate with every driver for the right to hit you
it’s not always possible to bargain with an angry drunk about whether or not he breaks your nose.

Thus, Cooter and Ulen define the economic essence of tort law this way:
the attempt to make injurers internalize the externalities they cause, in situations where transaction costs are too high to do this through property or contract rights

With contract law, we started out by discussing a “classic” legal theory of contracts (the bargain theory), and then moved on to an economic analysis

With torts, we’ll do the same

The traditional theory of tort liability was developed about 100 years ago

It specified three key elements of a tort, which must be present for he plaintiff to recover damages:
harm
causation
breach of duty

harm

First, and simplest, the plaintiff needs to have been harmed.
Without harm, there is no tort
An example from the textbook:
A gas company sold gas with a defective additive
It had no effect on cars with normal carburetors, but was dangerous in cars with turbocharged carbs
The owner of a car with a normal carburetor might be outraged by the situation
But since the gas did no damage to his car, he cannot sue

Similarly, traditional tort theory does not compensate for exposure to risk.
Suppose a manufacturer accidentally exposed a bunch of workers to some chemical
Doctors agree the exposure will cause 15% of them to develop liver cancer later in life
Under traditional tort doctrine, the victims must wait and see who gets cancer before suing
Similarly, if I do something negligent that causes you a 50% chance of dying, but you get lucky and escape the situation, I’m generally not liable for any damages.

(So far, U.S. courts have been reluctant to allow tort actions on the basis of exposure to harm, although some believe they should
Thus, safety regulation, administered by a government agency, is typically used instead of tort law to deal with exposure to low-probability harms.)

In theory, harm has a simple economic interpretation: a downward shift in the victim’s utility

Like in the hairy hand case, we can imagine a victim has some utility function over health and money, with some sort of indifference curves:

A car accident might lower my wealth
because my car is worth less
And also lower my health
because I got whiplash
So now I’m on a lower indifference curve
Perfect compensation should theoretically restore me to my original level of utility.
Money damages are typically how this is done.

Obviously, some amount of money can get me back to my original level of wealth
By repairing whatever broke on my car, or allowing me to buy a new car
If there is medical care available that would restore me to my original level of health, then the cost of this treatment would get me back to my original level of health as well, so I’d be back where I started.

Of course, there are some harms that can’t be undone
the amputated leg in the experiment, or other permanent injury
But there may be some amount of money that would compensate for it, by getting me back to the same indifference curve I started out on
Just like in the hairy hand case, we can work out perfect damages in this way.

So that’s the theory – the notion of “perfect compensation”

In reality, courts have traditionally been very willing to compensate victims for tangible losses
medical costs
lost income
damaged property
Historically, courts have been less willing to compensate for intangible losses or losses that are difficult to measure
emotional harm
pain and suffering
loss of companionship
Over the years, however, American courts in particular have expanded the list of compensable harms to include many of these intangibles

One area where there is a huge disparity between tangible harm and actual harm is in the death of a child
If a drunk driver kills a child, there is no loss of income to the child’s family; if anything, they avoid the expense of raising the child.
This used to be a difficult problem for courts, as they could not find a tangible, measurable harm on which to base compensation.
Allowing compensation for emotional distress and loss of companionship solves this problem

There are pros and cons to trying to compensate for intangible harms