Law & EconomicsFall 2008

Dr. Delemeester

What is Law & Economics? Three Strikes Laws? No-Fault Divorce Laws? Kelo v. City of New London (2005)? Good Samaritan Laws?

Review of Microeconomic Theory Rational man model

An individual seeks to maximize his or her utility.

For social optimality the rule is:

This involves taking actions till the marginal private cost of further action equals the marginal private benefit of that action.

Taking action till the marginal social cost of further action equals the marginal social benefit of that action

CS

Market Model

Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS

Free Market Outcome: P*, Q* Maximizes social welfare: SW = CS + PS

Supply

Demand

quantity

Price

Q*

P*

PS

Deadweight Loss

Q

Competitive Firm

MC

quantity

$

q1

P1

ATC

MR1

AVC

ATC1

Profit Maximization rule: P = MR = MC

What happens to the market price in the long run?

Consumer Choice Budget Line

I = PC*C + PAOG*AOG

Indifference Curves Shows all (C, AOG)

pairs that provide same level of utility coffee

AOG

1000

500

Ex: I = $1000 PC = $2 PAOG = $1

U1 = 40

AOG*

C*

Consumer optimum

Market Imperfections1. Market power

• monopoly and monopsony• imperfect competition

2. Externalities3. Public goods4. Severe informational asymmetries 5. Coordination and collective action

problems

Market Power Monopoly

The condition of one seller and significant barriers to entry.

A monopolist charges too high a price and sells too little of the monopolized good or service.

Corrective: antitrust and regulation. Monopsony

The condition of one buyer and significant barriers to entry.

The monopsonist charges pays too little for the resources that he uses and hires too few of them.

Externalities Unintentional Costs imposed on third parties by

the profit-maximizing actions of one person.

Examples: air and water pollution, secondhand tobacco smoke.

Unintentional Benefits that are conferred onto third parties by the profit-maximizing actions of one person.

Examples: elementary education, pollination services provided to beekeepers by a neighboring apple orchard.

Externalities in a Graph

steel

$

D1

Sprivate

Q1

P1

P2

Q2

External cost

Free Market: P1, Q1

Optimal Outcome: P2, Q2

Free market overproduces goodsthat generate a negative externality

Ssocial

a) greater; greater. b) greater; less. c) less; less. d) less; greater.

a) greater; greater. b) greater; less. c) less; less. d) less; greater.

A consequence of a positive consumption externality is that social benefits are ______ than private benefits, and the socially optimal level of output is ______ than the private level of output.

0% 0%0%0%

1 2 3 4 5

Public goods Two characteristics:

Non-excludability Non-rivalry

Free rider problem Corrective:

Public provision Public subsidization

Examples:• Fireworks display• Radio broadcast • National defense • Information

Severe informational asymmetries Two parties to a potential transaction have

very different information about some important aspect of the potential transaction. Example: consider the very different knowledge of

the true quality of a used car as between the buyer and the seller.

Why is this a problem? Because fear of uncertainty about the unknown

attributes may prevent otherwise value-maximizing transactions from taking place.

Corrective Compelling information disclosure by punishing

failures to disclose

Coordination and collective action problems Traffic congestion

Drivers make decisions about using the roads independently with the sometime result that the roads are terribly congested.

How can drivers coordinate their decisions so that the roads are not too crowded?

Congestion pricing London now charges £8 for cars to come within the central

business district on weekdays. Traffic is down 20 percent since early 2003.

Public goods present a collective action problem Free riders Corrective: compulsory contribution.

Game theory A formal means of modeling strategic interaction involving:

2 or more players Strategies Payoffs

Types of games Cooperative vs Non-cooperative Sequential vs simultaneous move Single play vs repeated play

Solution strategies and Nash Equilibrium

Prisoners’ DilemmaP

riso

ner

A

Confess Don’t Confess

Confess

Don’tConfess

Prisoner B

-5, -5 -1, -10

-2, -2-10, -1

What strategy would you choose in a single shot game?

Solution Strategies Dominant Strategy

One that is optimal no matter what opponent does

Nash Equilibrium No player has a unilateral incentive to change their

strategies

(Confess, Confess) is a Nash Equilibrium

Prisoner A: ConfessPrisoner B: Confess

Prisoners’ DilemmaP

riso

ner

A

Confess Don’t Confess

Confess

Don’tConfess

Prisoner B

-5, -5 -1, -10

-2, -2-10, -1

NE

PO, but not NEPareto optimal outcome maximizes joint payoff

What if you play a repeated prisoner’s dilemma?

Consider the voluntary contribution game below. What is the Nash Equilibrium for this game?

0% 0%0%0%

1. (C, C)2. (C, DC)3. (DC, DC)4. (DC, C)

Pla

yer

1

ContributeDon’t

Contribute

Contribute

Don’t Contribute

Player 2

30, 30 5, 35

10, 1035, 5

1 2 3 4 5

Stage Hunt

Hu

nte

r 1

Stag Hare

Stag

Hare

Hunter 2

10, 10 0, 8

8, 88, 0

Decision-making under uncertainty How to evaluate future outcomes when there are

multiple possibilities?

Calculate the expected value Weight each possible outcome by its probability and then

add them

Flip a coin gamble:Heads = $100Tails = $500

EV = 0.5 ($100) + 0.5 ($500) = $300

How much would you pay

to play this game?

Consider a lottery with three possible outcomes: $125 will be received with probability .2, $100 with probability .3, and $50 with probability .5. What is the expected value of the lottery?

60 80 90 105

0% 0%0%0%

a) $60b) $80c) $90d) $105

1 2 3 4 5

Decision-making under uncertainty Now suppose that there are two uncertain courses of action

Should one always choose the course of action with the higher expected value?

People have different attitudes toward risk or uncertainty and these attitudes may influence how they behave when facing uncertain outcomes Risk neutrality Risk aversion Risk seeking

A1: EV = $300 = 0.5 (100) + 0.5 (500)A2: EV = $400 = 0.99 (0) + 0.01 (40,000)

Expected Utility Theory: Risk Aversion

Utility

Income (thousands)$40$20

90

70

Utility when sick

E(U) = PHU($40,000) + PSU($20,000)

= PH•90 + PS•70 Let PS = .20

E(U) = (.80)90 + (.20)70 = 86

E(Y) = (.80)(40,000) + (.20)(20,000) = $36,000

$36

86

U

Assumes diminishing marginal utility of income Utility when

healthyPH = probability of being healthy

PS = probability of being sick

PH + PS = 1

Any risk-averse individual would always

a) b) c) d)

0% 0%0%0%

a) take a 10% chance at $100 rather than a sure $10

b) take a 50% chance at $4 and a 50% chance at $1 rather than a sure $1

c) take a sure $10 rather than a 10% chance at $100

d) take a sure $1 rather than a 50% chance at $4 and a 50% chance at losing $1

1 2 3 4 5

Decision-making under uncertainty Insurance

Allows risk-averse individuals to convert uncertain outcomes into certain outcomes

Two problems: Moral hazard Adverse selection

Corrective: Co-insurance and deductibles.