Solution Manual for Law and Economics, 6th Edition, Robert D Cooter Thomas Ulen Solution Manual by Ace Test Banks

Law and Economics, 6th Edition By Robert D Cooter, Thomas Ulen

Email: Richard@qwconsultancy.com

Instructor’s Manual to accompany

Law and Economics Sixth Edition

Robert Cooter University of California, Berkeley

Thomas Ulen University of Illinois, Urbana-Champaign

Authored by Thomas Ulen University of Illinois, Urbana-Champaign

Acquisitions Editor: Noel Kamm Seibert Editorial Assistant: Melissa Pellerano Production Editor: Alison Eusden Manufacturing Buyer: Carol Melville Copyright © 2012 Pearson Education, Inc., 75 Arlington Street, Boston, MA 02116. Pearson Addison-Wesley. All rights reserved. Printed in the United States of America. This publication is protected by copyright and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permission(s), write to: Rights and Permissions Department. This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials.

Pearson Addison-Wesley™ is a trademark of Pearson Education, Inc.

ISBN-13: ISBN-10:

978-0-132-54070-4 0-132-54070-3

Contents Chapter 1

An Introduction to Law and Economics......................................................................

Chapter 2

A Brief Review of Microeconomic Theory ................................................................

Chapter 3

A Brief Introduction to Law and Legal Institutions ....................................................

Chapter 4

An Economic Theory of Property ...............................................................................

Chapter 5

Topics in the Economics of Property Law ..................................................................

Chapter 6

An Economic Theory of Tort Law ..............................................................................

Chapter 7

Topics in the Economics of Tort Liability ..................................................................

Chapter 8

An Economic Theory of Contract Law .......................................................................

Chapter 9

Topics in the Economics of Contract Law ..................................................................

Chapter 10

An Economic Theory of the Legal Process .................................................................

Chapter 11

Topics in the Economics of the Legal Process ............................................................

Chapter 12

An Economic Theory of Crime and Punishment ........................................................

Chapter 13

Topics in the Economics of Crime and Punishment ...................................................

Introduction Sixth Edition, Law & Economics, Cooter & Ulen This is the Instructor’s Manual for the sixth edition of Law and Economics. We have continued to maintain—and, we hope, improve—the website that we first put up several years ago in conjunction with the third edition. Indeed, we have undertaken a complete overhaul of the website to coincide with the publication of this edition. In this introduction we seek to explain what the manual tries to do and how the Website—www.pearsonhighered.com/cooter_ulen—might work with the book during a semester-long course. What roles do we perceive for the Companion website and for this manual? The Manual is meant for instructors only. It contains information on teaching techniques, extensions of the course material, emphases that you might want to place on the topics covered, and some ideas for making the material exciting, for helping the students learn the material better, and for enlivening class discussions. The Instructor’s Resource Center will also contain some additional material—sample examinations, PowerPoint presentations, sample syllabi, and more. The Companion Website, by contrast, is meant for both students and instructors as a means of updating the material that is in the text, bringing new and important topics to the attention of those studying the material, offering additional practice questions, dealing with material that is more current than that in the text, extending some of the discussions in the text, and so on. As in previous editions, we have inserted what we call “Web Notes” in the text of this edition. These refer readers to entries on the Companion website where we elaborate on the textual material. For an example, consider Web Note 1.1. That is at the end of the section in Chapter 1 in which we discuss the relationship between economic efficiency and equity. In 2001 Louis Kaplow and Steve Shavell of the Harvard Law School published a very important book entitled Fairness Versus Welfare. The book’s central contention is so important to law and economics that we considered discussing it in the text. But in the end we opted for textual brevity and left it out. The device of the Web Note allows us, however, to have our cake and eat it, too. So, returning to Web Note 1.1 we discuss Fairness Versus Welfare and several important reviews of that work, including work by Chris Sanchirico, Dan Farber, and Richard Fallon. Your students who are most eager to expand their understanding of the course material will probably have read the Web Notes. (We return to Kaplow and Shavell in Web Note 12.1.) Finally, Ulen has used PowerPoint presentations for his law students for several years. Those presentations are posted on the Instructor’s Resource Center.

◼

A Guide for the Use of the Text and of This Manual

One of the issues with which we have wrestled in putting together this Manual is how best to deal with the wide-ranging audience of instructors and students. Law and economics is taught principally in economics departments and law schools. We can testify from personal experience that those are two very different venues and two very different audiences. For example, a class of upper-level economics undergraduates may know microeconomic theory, mathematics, game theory, and some econometrics but has very little knowledge and understanding of the legal system. A class of second- or third-year law students has precisely the reverse set of talents: They are very comfortable with legal reasoning and the institutions of the legal system but have little understanding (and often a great fear) of economic theory and mathematics. Add the additional audiences of business school, public policy programs, other parts of the academy, and, importantly, other countries, and one realizes that law and economics is being taught to a very broad range of students and by a diverse range of instructors. This presents special challenges for us in putting together this Manual.

Introduction v

Our guiding principle here has been to include material that would be of interest to the broadest range of instructors and students. As should or will be evident, we find law and economics to be an extremely exciting field. That makes the material, we believe, easy to teach. Just as importantly, most students find the subject matter inherently interesting. Class discussions about issues in law and economics are usually vigorous and illuminating. Part of what we include here are examples of the issues that we have found to be most stimulating for the students, particularly in class discussion. This text is too long to march through in a semester, although we both try to do so. We almost invariably find that our best intentions to the contrary notwithstanding (to use a time-honored legal phrase), we get through the first nine chapters but do not get through all of Chapters 10, 11, 12, and 13. (Previous editions had only 12 chapters. We have now split Chapter 10 into two chapters, a theoretical and an applications chapter.) Of course, each instructor will change the coverage as he or she thinks best. But you should be prepared to cut and paste and rearrange and supplement the material to suit your own and your students’ purposes. Here are our suggestions concerning what to include and exclude in your class. You will notice that the recommendations stress the theoretical chapters and generally call for selected coverage of the more applied chapters. There will be differences in taste on these matters, but we believe that if sacrifices have to be made, they should be made with respect to the applications. If our experience is a guide, you will find that you get many, many opportunities in class discussion to apply this material to pressing issues. Recommended chapters

◼

Type of class

Prerequisite

Cover in full

Cover selectively

Omit

Undergrad. economics

Microeconomics

1, 3, 4, 6, 8, 10, 12

5, 7, 9, 11, 13

Undergrad. legal studies

Legal studies

1, 2, 3, 4, 6, 8, 10, 12

5, 7, 9, 11, 13

Undergrad., general

None

1, 2, 3, 4, 6, 7, 10

Grad. policy or business Grad. policy or business

Microeconomics None

1, 3, 4, 6, 8, 9, 13 1, 2, 3, 4, 6, 8, 9, 12

5, 7, 10, 12 5, 7, 10, 11, 13

Law class

Microeconomics

1, 4, 6, 8, 10, 12

applications

2, 3

Law class

None

1, 2, 4, 6, 8, 10, 12

5, 7, 9, 11, 13

Law seminar

None

1, 4, 6, 8, 10, 12

5, 7, 9, 11, 13

2, 3

5, 7

Additional Course Materials

We each use additional course materials beyond the text, the Web material, and the materials posted on the Instructor’s Resource Center. These additional materials include excerpts from journal articles, clippings from newspapers, court opinions, and the like. If you are interested in seeing what things we use, please don’t hesitate to contact us and ask. We’d be happy to send you copies of the materials that we use. You have some great ideas, too. As you’ll see in the next section, we’d love to hear from you about how you teach the course, what materials you use, and so on.

Cooter/Ulen • Law & Economics, Sixth Edition

◼

A Note to Previous Users

Please note that the order of the chapters in this edition has changed and that a new chapter has been added. We explain these changes in the preface to the new edition. Our hope is that this reordering will help the exposition without significantly disrupting previous lesson plans, and that the addition of a second applications chapter on the legal process will also help the book’s balance between theory and applications.

◼ Feedback We are eager to learn from you about your own experiences in teaching this material and any suggestions that you would like to share with us and with other users of this text about teaching techniques. You would be surprised to learn how much we have changed in the various editions of this book in response to communication with students and faculty. We have made provision on the Companion website for students and others to communicate with us. But we also invite you to let us hear from you directly. The best way to communicate with us is by means of e-mail. Cooter is available at rcooter@law.berkeley.edu. Ulen is available at tulen@law.illinois.edu; his phone number is (217) 333-4953. If you would prefer to write to us by U.S. mail, here are our addresses: Professor Robert D. Cooter Herman Selvin Professor of Law School of Law (Boalt Hall) University of California Berkeley, CA 94720 Professor Thomas S. Ulen Swanlund Chair Emeritus and Professor Emeritus of Law University of Illinois College of Law 504 E. Pennsylvania Ave. Champaign, IL 61820

◼

Acknowledgments

In the preparation of this manual and of the Web Notes that accompany the text we have had the great research help of Brian Doxey of the University of Illinois College of Law. Sally Cook has provided her usual superb help with all manner of things.

Chapter 1 An Introduction to Law and Economics The introductory material in this chapter is very similar to that in previous editions. Most law students will find it either off-putting or suspicious that economists pay so much attention to efficiency and not much to fairness or justice. So, it’s worth saying whatever one can early in the semester about this topic. The section on the efficiency aspects of achieving an equitable distribution of resources makes what seems to us to be an uncontroversial point—namely, that in seeking an equitable outcome, one ought to pay attention to efficiency considerations—but it is a point about which there has been much sturm und drang in the professional literature. There is more on this issue on our website.

◼

Efficiency; Positive and Normative; Ex Ante; and Empirical

Over the years we have found that although law students are becoming increasingly familiar with economic (and other social scientific) concepts, there is, nonetheless, some deep and persistent misunderstandings about economics among noneconomists. One that seems nearly impervious to reasoned refutation is that economics is a handmaiden to a very conservative political philosophy. It may be that there is a sensible explanation for why this view is so widespread, but if so, neither of us has expressed it or heard it. We have also found that there are some emphases that you might want to make in discussing the material in this chapter. First, be sure to stress the difference between positive and normative analyses. Economic analysis is insightful in both tasks. Even those who are skeptical of efficiency as a legal norm must recognize the value of economic analysis in performing positive analysis. Second, we have found that stressing the ex ante analysis of the effects of legal rules is crucial. This is especially so with regard to law students. Legal education tends to focus on the resolution of disputes. Indeed, in the United States the principal method of teaching any substantive area of the law is to read the opinions of appellate justices. There’s no denying the value of this method of teaching the law. But it also has costs. One is that law students tend to focus on how best to resolve disputes than on how best to avoid disputes. Law and economics clearly puts a much stronger emphasis on the prospective effect of law—that is, on a law’s likely effect on future human behavior—than does traditional doctrinal analysis. Third, we believe that one of the most significant developments in law and economics since the publication of the early editions of this book has been the rapid rise of empirical legal studies. Indeed, there is now a first-rate scholarly journal entitled the Journal of Empirical Legal Studies. You might want to alert your students to the fact that this edition of the book, unlike previous editions, now contains, as an integral part of each subject, an extensive discussion of the empirical literature in this area. Preparing the students to think about the empirical aspects of the subject—does the patent system really encourage innovative and inventive activity, and how would we know?—is an important innovative element of law and economics in the legal curriculum.

Cooter/Ulen • Law & Economics, Sixth Edition

◼ Introduction to Law and Economics Part of the delight of this course is the reading and discussion of written opinions of courts in some real disputes. The founding article of law and economics—Ronald Coase’s, “The Problem of Social Cost,” 3 J. Law & Econ. 1 (1960)—contained this wonderful case. We’ll describe it in some detail because it serves as a wonderful introduction to the subject. Or you might use these facts in an examination or in a later class discussion. The case of Sturges v. Bridgman involves a dispute about the use of property in London in the 1870s. The plaintiff (the person who files a complaint) was a Dr. Sturges. He felt that his neighbor, Mr. Bridgman, had interfered with his legitimate use of his property. Dr. Sturges had built a consulting room at the end of the garden behind his home. As was the custom for doctors then, he held examinations of his patients in that room. Apparently to save money in building the room and to preserve as much of his garden as possible, Dr. Sturges had built the wall of his consulting room hard against the back wall of his neighbor, Mr. Bridgman. Thus, the neighbors shared a wall, which was called a “party wall.” The Bridgmans operated a confectionery-manufacturing operation in their kitchen, and their kitchen wall was also the back wall of Dr. Sturges’ consulting room. When the confectionery-manufacturing machines were going, they made such a racket that Dr. Sturges could not properly examine his patients. He brought an action against the Bridgmans to ask the court to order them to stop making so much noise during his office hours. The Bridgmans answered this complaint by saying that they were using their property in a perfectly legitimate manner, and, moreover, they had been doing so for over 60 years without anyone’s complaining of noise and vibration. They suggested that the doctor could not fairly claim that he had been surprised by their manufacturing activity. He knew or should have known that they were using noisy machinery when he decided to build his consulting room hard against their kitchen wall. Here is what the court said about the matter and how they tried to resolve this dispute: Sturges v. Bridgman 11 Ch.D. 852 (1879)1 The Plaintiff in this case was a physician. In the year 1865 he purchased the lease of a house in Wimpole Street, London, which he occupied as his professional residence. Wimpole Street runs north and south, and is crossed at right angles by Wigmore Street. The Plaintiff’s house was on the west side of Wimpole Street, and was the second house from the north side of Wigmore Street. Behind the house was a garden, and in 1873 the Plaintiff erected a consulting-room at the end of his garden. The Defendant was a confectioner in large business in Wigmore Street. His house was on the north side of Wigmore Street and his kitchen was at the back of his house, and stood on ground which was formerly a garden and abutted on the portion of the Plaintiff’s consulting-room and the Defendant’s kitchen [abutted] the party-wall. The Defendant had in his kitchen two large marble mortars set in brickwork built up to and against the party-wall which separated his kitchen from the Plaintiff’s consulting-room, and worked by two large wooden pestles held in an upright position by horizontal bearers fixed into the party-wall. Those mortars were used for breaking up and pounding loaf-sugar and other hard substances, and for pounding meat.

Recall what this citation means. The report of this case may be found in volume 11 of the Chancery Division, one of the major courts in England, beginning on page 852. The opinion was published in 1879.

Chapter 1

An Introduction to Law and Economics

The Plaintiff alleged that when the Defendant’s pestles and mortars were being used the noise and vibration thereby caused were very great, and were heard and felt in the Plaintiff’s consulting-room, and such noise and vibration seriously annoyed and disturbed the Plaintiff, and materially interfered with him in the practice of his profession. In particular the Plaintiff stated that the noise prevented him from examining his patients by auscultation for diseases of the chest. He also found it impossible to engage with effect in any occupation which required thought and attention. The use of the pestles and mortars varied with the pressure of the Defendant’s business, but they were generally used between the hours of 10 a.m. and 1 p.m. The Plaintiff made several complaints of the annoyance, and ultimately brought this action, in which he claimed an injunction to restrain the Defendant from using the pestles and mortars in such manner as to cause him annoyance.2 The Defendant stated in his defense that he and his father had used one of the pestles and mortars in the same place and to the same extent as now for more than sixty years, and that he had used the second pestle and mortar in the same place and to the same extent as now for more than twenty-six years. He alleges that if the Plaintiff had built his consulting-room with a separate wall, and not against the wall of the Defendant’s kitchen, he would not have experienced any noise or vibration. [The trial court focused on a single issue: whether the Bridgmans had acquired a right to create noise and vibration against their neighbors by virtue of having done so continually for 60 years with one mortar and pestle and for 26 years with two. The trial court held that no one can acquire a right to create a nuisance and that, therefore, Dr. Sturges was entitled to an injunction against the Bridgmans. The Bridgmans appealed this judgment to a higher court.] 1879, July 1. THESIGER, L.J., delivered the judgment of the Court (James, Baggallay, and Thesiger, L.JJ.)3 as follows: [If the general rule was that the Plaintiff had a right to be free from the noise and vibration being generated from the Defendant’s property, this rule] would result in the most serious practical inconveniences, for a man might go—say into the midst of the tanneries of Bermondsey, or into any other locality devoted to a particular trade or manufacture of a noisy or unsavory character, and, by building a private residence upon a vacant piece of land, put a stop to such trade or manufacture altogether. The case also is put of a blacksmith’s forge built away from all habitations, but to which, in course of time, habitations approach. We do not think that either of these hypothetical cases presents any real difficulty. As regards the first, it may be answered that whether anything is a nuisance or not is a question to be determined, not merely by an abstract consideration of the thing itself, but in reference to its circumstances … where a locality is devoted to a particular trade or manufacture carried on by the traders or manufacturers in a particular and established manner not constituting a public nuisance, Judges and juries would be justified in finding, and may be trusted to find, that the trade or manufacture so carried on in that locality is not a private or actionable wrong. … It would be on the one hand a very high degree unreasonable and undesirable that there should be a right of action for acts which are not in the present condition of the adjoining land, and possibly never will be any annoyance or inconvenience to either its owner or occupier; and it would be on the other hand in an equally degree unjust, and, from a public point of view, inexpedient that the use and value of the adjoining land should, for all time and under all circumstances, be restricted and diminished by reason of the continuance of acts incapable of physical interruption, and which the law gives no power 2

An injunction is an order from the court to the defendant requiring him or her to do something or, as here, to refrain from doing something. We shall discuss injunctions at more length in Chapter 5.

The abbreviations mean “Lord Justice” and “Lords Justice.”

Cooter/Ulen • Law & Economics, Sixth Edition

to prevent. The smith in the case supposed might protect himself by taking a sufficient curtilage4 to ensure what he does from being at any time an annoyance to his neighbor, but the neighbor himself would be powerless in the matter. Individual cases of hardship may occur in the strict carrying out of the principle upon which we found our judgment, but the negation of the principle would lead even more to individual hardship, and would at the same time produce a prejudicial effect upon the development of land for residential purposes. The Master of the Rolls in the Court below took substantially the same view of the matter as ourselves and granted the relief which the Plaintiff prayed for, and we are of opinion that his order is right and should be affirmed, and that this appeal should be dismissed with costs. What legal rule did the court propound? What is the implicit price placed on different types of behavior affected by that rule? And is that rule (and its implicit price) efficient? The court in Sturges found for the plaintiff and in so doing said that noise and vibration produced on one person’s private property is a nuisance if it causes harm to some other person’s use of her private property. Moreover, the nuisance-creator (in this case, the Bridgmans) did not acquire a right to create noise and vibration by having done so without complaint over a long period of time. As to the implicit price on different types of behavior affected by this rule, note that the court speculated on this matter. It asked whether this rule might induce someone to build a private residence in an area previously devoted to the very smelly operation of tanneries and then to seek an injunction against the continued operation of those tanneries on the ground that they were disturbing the new residents. Or the court suggested that its rule might induce potential nuisance-creators, such as a blacksmith, to purchase large tracts of land around their operations to serve as buffers against harming others. These are valid points, but notice that the court dodges the issue of whether these results, these types of behavior induced by its rules, are desirable. Instead, the court said—as courts frequently do—that it would not speculate on these hypotheticals. Rather, it would prefer to let future courts resolve these issues as future parties brought new circumstances before those courts. (This strategy is frequently referred to as dealing with issues “on a case-by-case basis,” rather than by the application of a blanket rule. You might ask the students about the differences between the institutional competencies of legislatures and courts to deal with these broad questions. The general feeling is that legislatures can tackle broader issues than can courts, which must, by and large, confine themselves to the facts before them.) What about the efficiency of the legal rule in Sturges? From an economic standpoint, we are eager to have the legal rule in situations of conflicting uses of property or of nuisance encourage the most productive use of all of the resources involved. In the case of Sturges v. Bridgman it is fairly certain that the two conflicting uses—the manufacture of confectionery and the examination of patients—are simply incompatible. One of them will have to cease at its present site and re-locate. The question is which one ought to do this. Presumably the use that should cease is the one that is, all things considered, less valuable. If, for instance, confectionery manufacture is more valuable than the doctor’s provision of medical services, the Bridgmans should remain, and Dr. Sturges should go. If the doctor’s services are more valuable, then Dr. Sturges should remain, and the Bridgmans should go. (Be sure to contrast this with the way in which the court—typically any court—would deal with this matter. It would try to find out who had the prior right or who was inflicting unwarranted harm on whom. Having answered those questions, the court will have resolved the matter legally.) One way to use this case is to anticipate the discussion of the Coase Theorem in Chapter 4. The discussion that follows shows how this might be done.

“Curtilage” is the land around a house and within an enclosure.

Chapter 1

An Introduction to Law and Economics

Assuming this to be the economic way to look at issues of conflicting property rights, we are led to ask if the legal rule enunciated in 1879 is efficient. However, as we’ve seen, the legal rule is not entirely clear. On the one hand, the court may have said that the nuisance-creator should never prevail. If that were the rule, we could say that it is not necessarily efficient because it does not allow for the possibility that the nuisance-creator’s actions are more valuable than those of the plaintiff. On the other hand, the court may have said that in this case only the nuisance-creator (Bridgman) should lose but that in different circumstances he or she might win, depending on the facts. This interpretation is more compatible with our efficient rule that the more valuable use should prevail (and, implicitly, that the more valuable use might sometimes be the plaintiff and sometimes the defendant). There is a third possibility—that the legal rule in situations like that in Sturges does not matter to the efficient use of resources by the confectioner and the doctor. That is, it could be that the more valuable use will prevail regardless of which rule the court adopts. This would be the case if the costs to the nuisancecreator and the complainant of concluding a private agreement to limit the nuisance are very low. In those circumstances the amount of the nuisance and the amounts of production by both parties will be efficient, whatever the legal rule. Thus, when the costs of concluding a private agreement are low, whether the law states that the Bridgmans are entitled to create noise and vibration or that Dr. Sturges is entitled to be free from noise and vibration, there will be an efficient amount of the nuisance and an efficient amount of confectionery and of doctor’s services. This remarkable conclusion—which we shall explore in much more detail in Chapter 4—is, of course, the Coase Theorem, named after its author, Professor Ronald Coase, in this very article from which Sturges v. Bridgman is taken—“The Problem of Social Cost.” To see why this conclusion follows, let us imagine an unlikely but dramatic solution to this nuisance problem in Sturges: Dr. Sturges marries the owner of the confectionery factory. As a result, the cost of coordinating the activities of the factory and the doctor become very low. We would confidently expect the couple to coordinate their activities so as to maximize the total profits of the two enterprises—that is, to maximize their combined income, regardless of whether the law would protect the doctor’s practice from the noise and vibration from the confectionery. Rational bargainers facing low bargaining costs will do just as well as a married couple, because they will bargain until they exhaust the possibilities for mutual gain, which occurs when the total profits of the two enterprises are maximized. For example, suppose that the damage suffered by the doctor because of the disruption is $5,000 in lost income and that the cost to the factory of installing less noisy equipment, moving the existing equipment, or adjusting its production schedule so as to eliminate the nuisance to the doctor is $10,000. Assume, furthermore, that the two parties can bargain between themselves at low cost. How will different rules of law affect this situation? If the rule of law entitles the factory to make as much noise and vibration as it likes, then the factory can create its nuisance with impunity. So, it will go on polluting. The doctor will simply have to suffer $5,000 in losses. But what if the law gives a right to the doctor to be free from the factory’s noise and vibration? One might think that the result of this different assignment of rights would force the factory to spend $10,000 to eliminate its nuisance entirely. But under our assumption of low bargaining costs, that result is unlikely. A mutually beneficial transaction is possible that allows the factory to continue its production and nuisance and also allows the doctor to be compensated for the loss of $5,000 that the noise and vibration inflict. If the factory stops its noise and vibration entirely, then it loses $10,000, and the doctor benefits $5,000. Both will benefit if some alternative can be found that pays the doctor more than his $5,000 in losses but costs the factory less than $10,000. Suppose, for example, that the Bridgmans pay Dr. Sturges $7,500 in exchange for the doctor’s waiving his right to be free from the nuisance and allowing the factory to continue to create the noise and vibration. Under this alternative, the doctor is paid $7,500 for putting up with $5,000 ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

in damages, thus enjoying a net profit of $2,500. Similarly, the factory is better off paying $7,500 to the doctor instead of incurring the expense of $10,000 to reduce the noise and vibration. Both parties are better off. So, under the assumption of low bargaining costs, the factory will continue its method and location of production whether the law gives the doctor the right to be free from the nuisance or gives the nuisancecreator the right to emit noise and vibration.

Chapter 1

An Introduction to Law and Economics

There is a useful, general way to describe these facts: if someone values an asset—whether it be automobiles, wheat, labor, or legal rights—more than its owner, then there is scope for mutual gain by exchange. We may think of the agreement between the doctor and the factory as an exchange of legal rights. The potential gains from exchange are not exhausted unless the total profits from the two enterprises are maximized.

◼ Impact of Law and Economics One of the exciting things to tell the students is that law and economics is having a real impact on how courts decide cases. In a recent article by Professor Carol Rose of the Yale Law School—“Canons of Property Talk, or, Blackstone’s Authority,” 108 Yale L.J. 601 (1998)—these two cases are cited as examples of how law and economics is becoming part of the general language of judges: Westfarm Assocs. v. Washington Suburban Sanitary Comm’n., 66 F.3d 669, 679 (4th Cir. 1995) (discussing “externalities”); and Gail v. United States, 58 F.3d 580, 585 n.7 (10th Cir. 1995) (discussing “transaction costs”). The bigger impact of law and economics is clearly on legal scholarship, particularly, but not exclusively, in the United States. Every law student today learns a lot of law and economics in the study of the traditional law school courses. Indeed, one can hardly go through the first semester of an American law school education without hearing about the Coase Theorem in property law, efficient breach of contract in contract law, and the least-cost-avoider in tort law. And the impact of law and economics continues in almost every other course taught in the modern curriculum. Most law professors today in the United States use law and economics in their research. In fact, some of them are so adept at economic reasoning and the techniques of game theory and econometrics that you would think that they have had formal training in economics—even though most have not. One could argue—one of us has—that this is revolutionizing legal scholarship and legal education. But those contentions are not, perhaps, as important as assuring the students that a knowledge of law and economics is vital to the well-trained lawyer today and essential for those who wish to pursue a scholarly career in the law.

◼

Efficiency and Equity

The most startling aspect of law and economics, especially to law students, is the normative contention that law should be efficient. It is good to say something about this matter early on because it is going to be a constant source of discussion throughout the semester or term. There are two general methods of dealing with this matter. One is to take a temporizing position and say something like this, “Efficiency is important but not necessarily the most important quality of a legal command. Distributional or equitable concerns are, without a doubt, extremely important, and many people feel that, as important as efficiency is, it must play second fiddle to distributional concerns. Presumably even if one believes this, one is also willing to concede that legal decisionmakers should consider efficiency. For example, if we could agree on a distributional goal, we would presumably want to reach it in the most efficient method possible.” The other method is to take a more aggressive position. One might say that the private law adjudication process ought to focus on efficiency and not on distribution. Distribution, one might argue, is the province of the democratic process, of the legislature, but not of the judges who resolve private law disputes. This second method of dealing with the matter takes strength from the article by Steven Shavell and Louis Kaplow referenced in a footnote and from their recent book, Fairness Versus Welfare, and in the Second Fundamental Theorem of Welfare Economics, which holds that issues of efficiency and equity are, in principle, separable. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

◼ Law and Economics Moot Court One of the devices that we have found to be fun and instructive in teaching undergraduates law and economics is to hold a law-and-economics moot court. Typically, we hold the court toward the end of the semester, when the students have a better understanding of the full range of private law and, perhaps, of criminal law. If you are interested in trying this, we urge you to begin thinking about it early because the organization of the exercise takes some effort. The organizational aspects are three. First, you have to choose and edit suitable cases. You will find some edited cases that we have used on our webpage. Second, you must divide the students into small law firms of three or four, enough so that there are an even number of firms, and pair the firms. We frequently ask each firm to designate one of their members to act as the managing partner so that we can funnel all our paperwork and messages through that one person. Then give each firm a copy of the case and instruct the firm, not each individual, to write a short brief by a certain date and to be prepared for oral argument about one week later. The instructions usually instruct the students that the “Supreme Court of Coseana,” which will hear their oral argument, only entertains economic arguments, although they expect all those who appear before them to understand and to be sensitive to the legal constraints. Third, you will need to ask local attorneys, law school faculty colleagues, local judges, and third-year law students to serve in panels of three judges to hear the oral argument. In addition, you will have to prepare for these judges a “bench brief,” which summarizes the facts in the case, suggests the economic reasoning that you hope the students will pursue in arguing the cases, and even proposes questions that the judges might want to ask. The judges will almost certainly get into the spirit of the moot court on their own, but you can help direct them toward the economic reasoning you hope that the students will pursue by means of this bench brief. Our experience has been that the students take this exercise very seriously. Indeed, many of them spend more time on this than on other requirements of the course. Interestingly, the rigors of oral argument and of the brief seem to reveal the student abilities that might not be evident through the usual methods of evaluating student performance.

Chapter 2 A Brief Review of Microeconomic Theory This chapter reviews microeconomics theory. As the suggested guide for teachers in the Introduction to this manual has indicated, not every class using this text will find that they need to cover this material. Some instructors tell us that even if their students do not know microeconomic theory, they do not take time early in the semester to review this chapter. Rather, they tell the students to read through the chapter on their own. No one should expect students who have never studied economics to emerge from their reading of Chapter 2 a full-blown economist. Perhaps the better message to give to students who have not heretofore studied economics is to read through the chapter solely to familiarize themselves with where in this chapter they can later find treatment of various economic topics. For example, a student may not want to labor over the material on game theory now. Rather, she may want to know where this treatment is in Chapter 2 so that when she meets game theory in Chapters 4 and 8 she can return to this point in Chapter 2 for a refresher. Other teachers tell us that they spend up to three weeks of a fifteen-week semester reviewing microeconomic theory before they get to the legal material. Still others take three or four lectures at the beginning of the semester or term to go over selected parts of Chapter 2. For example, in teaching law students (some of whom were economics majors as undergraduates, but many of whom have never studied economics) one might focus on the sections in Chapter 2 on market failure and decisionmaking under uncertainty. Our experience has been that because a great deal of the economic analysis of law consists of demonstrating that legal commands and institutions can correct for such market imperfections as external costs and benefits, public goods, information asymmetries, and collective action and group coordination problems, students need to be thoroughly familiar with those concepts before launching into Chapter 4 and the subsequent material. Ulen frequently uses the first week of the semester to stress only limited aspects of micro theory for the law students he teaches. For example, he discusses welfare economics much more extensively than is the case in the text, stressing the sources of market failure and their correctives, spending time on the Arrow Impossibility Theorem, and introducing some intriguing uses of economics to discuss important public policy issues, which we describe in more detail below and in the PowerPoint presentations that are available on the Instructor’s Resource website.

◼ Notions of Efficiency Be certain to distinguish between Pareto and Kaldor-Hicks efficiency. Pareto efficiency requires consent— that is, the gainers from a reallocation must receive the explicit consent of the losers. Presumably, they will only be able to do so when their gains are greater than the total of all losses. (In Chapter 4 we refer to this difference as “cooperative surplus.”) In contrast, Kaldor-Hicks efficiency is a species of cost-benefit analysis in which a change is deemed efficient if the total gains exceed the total losses but without the requirement

Chapter 2

A Brief Review of Microeconomic Theory

that the gainers compensate the losers.

Cooter/Ulen • Law & Economics, Sixth Edition

There are several reasons for taking care with this distinction between two very different definitions of efficiency. First, many economics students will not be aware of the difference. Modern microeconomic theory uses the notion of Pareto optimality almost exclusively, so that even those with some familiarity with microeconomics may not be aware of Kaldor-Hicks efficiency. Law and economics uses Pareto optimality as its efficiency criterion in relatively few instances, most having to do with contractual matters. Instead, the literature uses, implicitly or explicitly, Kaldor-Hicks efficiency as its central efficiency concept. Second, the difference between Pareto and Kaldor-Hicks efficiency has very much to do with transaction costs—a central notion in law and economics that we develop in Chapter 4. (Transaction costs are, in brief, the costs of effectuating a bargain.) The connection between the different efficiency norms and transaction costs is this: when transaction costs are so high that they make consensual, mutually advantageous bargaining unlikely or impossible, there must be some criterion other than consent for deciding on the efficient allocation of resources. The transaction costs of compensation—identifying the gainers and the losers and transferring resources from the gainers to the losers—may be greater than the difference between the benefits and the costs. In those circumstances, a bargain cannot take place, even though (leaving transaction costs to one side) the total gains from a reallocation exceed the total costs. Kaldor-Hicks efficiency allows us to speak about those reallocations in the absence of unanimous consent.

◼

Optimality

We stress the point—unremarkable for economists, but striking for non-economists—that the optimal amount of anything occurs when social marginal cost and social marginal benefit are equal. An important implication of this point is that the optimal amount of many bad things is not zero. That is because it costs something to get rid of bad things. Much as we might like to eradicate all air and water pollution, the costs of doing so eventually far outweigh the benefits. An example of an important law that flies in the face of this point is the Delaney Clause of the Food and Drug Act. That clause instructs the Food and Drug Administration to prohibit all food additives that pose any risk of cancer. This is a good matter for class discussion. There are, of course, lots of other examples. We would be extremely grateful to those of you who send us your examples.

◼

Opportunity Cost

This is a central notion in microeconomic theory, and we commend the boxed example that is included in Chapter 2. However, we also highly recommend that you look at the article by Paul J. Ferraro and Laura O. Taylor, “Do Economists Recognize an Opportunity Cost When They See One?: A Dismal Performance from the Dismal Science,” 4 Contributions to Econ. Analy. & Pol’y. 1 (2005). That article’s findings about the inabilities of professional economists to compute opportunity cost are contained on the Microeconomic Theory II set of slides.

Chapter 2

A Brief Review of Microeconomic Theory

◼ Further Examples A marvelous example of an external benefit is the automobile theft prevention system known as LoJack.1 Here are the stylized facts about that system. The LoJack company will sell its system to automobile owners for approximately $500. If an owner pays that fee, representatives of the company insert a secret device in the owner’s car. Not even the owner knows where or what the device is. If the car is stolen, the owner calls the LoJack company, and they then turn on their equipment, which picks up a signal transmitted from the device they put into the car, helping the police to locate the car quickly. Because of the large capital expenditure involved for the company, LoJack is currently available only in large cities in the United States. See Ian Ayres and Steven D. Levitt, “Measuring the Impact of Unobservable Victim Precaution: An Empirical Analysis of LoJack,” 113 Q.J. Econ. 43 (1998), and then the brief summary of that article on the Microeconomic Theory II slides. An interesting sidelight of the LoJack is how thieves and police have responded to it. Thieves recognize now that any car they steal might be LoJack-equipped and that if it is, they will be caught quickly. So, bright auto thieves in major cities where LoJack is available drive a stolen car to a safe place, park the car, and watch it to see if anyone comes to get it. The police now recognize that this is what thieves do; so, when the LoJack company notifies them that one of their protected cars has been stolen and is parked at a particular place, the police then go to watch that car, too. How does the LoJack create an external benefit? Contrast the LoJack with a car alarm. Typically there is an external indication that the car is equipped with an alarm. Therefore, a potential thief can look at a car equipped with an auto alarm, recognize that that car is not a viable acquisition, and turn his attention to less well-defended cars. As a result, a car equipped does not confer a benefit on other cars. Indeed, it may make their theft more likely. But a LoJack does not have this problem. Because one cannot tell whether a car is equipped with a LoJack, thieves may be generally deterred from auto thievery if they suspect that cars are equipped with the system. And, indeed, that is what the early experience with LoJack indicates. In some major cities there has been a significant drop in auto theft after LoJack became available. We are grateful to Ian Ayres and Steve Levitt for bringing this matter to our attention. If there is time, you might also discuss, or at least recommend, Ronald A. Coase’s “The Lighthouse in Economics,” which originally appeared in the Journal of Law and Economics and is reprinted in Coase’s The Firm, the Market, and the Law. The lighthouse has been cited by John Stuart Mill, Paul Samuelson, and generations of economics teachers as an example of a public good—something that because of free riding consumers, private enterprise cannot produce in a socially optimal amount. But Coase demonstrates that in the United Kingdom until late in the 19th century a private company successfully operated lighthouses for commercial shipping. There are lots of other pithy examples that will illustrate for law students the intriguing view of the world that economics brings. We have found that chapters from Steven Landsburg’s The Armchair Economist are wonderfully stimulating methods of getting the students to see the world in an economic fashion.

The company’s name is a play on the word “hijack,” which means to stop someone and take something from him or her forcefully. Some thieves used to hijack trucks containing valuable materials. Several years ago some criminals began to stop automobiles and take them, usually at gunpoint, from their rightful owners. That practice was called “carjacking.”

Cooter/Ulen • Law & Economics, Sixth Edition

Please don’t hesitate to send us your examples so that we might share them with other teachers who use this book.

◼ The London Congestion Charge Ulen used this example of the application of pricing a non-market good—traffic congestion—to illustrate the ability of economics to help address societal problems. See the Microeconomic Theory II slides, and Jonathan Leape, “The London Congestion Charge,” 20 J. Econ. Persp. 157 (2006). Ulen has also assigned John Tierney’s article, “The Autonomist Manifesto,” from the September 26, 2004, New York Times Magazine as a great discussion item. Finally, Ulen has found that Harold Winter’s Trade Offs is a wonderful short introduction to the use of economics in the discussion of public policy items.

◼ The Arrow Impossibility Theorem Among many if not most law students, the hardest pill to swallow about law and economics is the elevation of efficiency to the status of a serious legal norm.2 Many law students have come to law school to further their ability to foster social justice. They will react very negatively to a contention that that goal is misguided or that it should give way to efficiency as a legal norm. We are not ones to pander to our student audiences. Nonetheless, we try to make clear to them that there are sound scholarly reasons that modern economics focuses on efficiency rather than equity. Two of the most important are the First and Second Fundamental Theorems of Welfare Economics, which argue, essentially, that efficiency and equity are separable and the Arrow Impossibility Theorem. One of us uses a handout on the Arrow Theorem that says the following: The Arrow Impossibility Theorem addresses the issue of how society aggregates individual preferences about social matters (e.g., about the distribution of income and wealth) into societal preferences. Suppose that these aggregations are made by majority voting. We could imagine that elections are devices for converting individual preferences into societal preference orderings: candidates announce their social welfare functions and the associated distribution on the utility-possibility frontier that they intend to pursue and voters then choose among the candidates, with that policy, social welfare function, or candidate winning that commands the highest number of votes. Make the following five assumptions about this means of aggregating individual preferences into social preferences: 1.

There is no dictatorship—i.e., no one person’s preferences determine the group choice.

Each individual has ordered all the alternatives according to her preferences and votes for that policy, social welfare function, or candidate that ranks highest in her preference ordering.

If every individual unanimously agrees on an alternative, then that alternative is indicated as the society’s preference.

Some authors, such as Kaplow and Shavell in Fairness Versus Welfare, make a serious case that efficiency (in the sense of improvements in individual welfare) should be the only legal norm. We discuss their claims at Web Note 1.1.

Chapter 2

A Brief Review of Microeconomic Theory

Each individual’s choices are complete, transitive, and reflexive.

The preferences between any two candidates or policies depend on how people rank those two alternatives, not on how they rank other alternatives. (This is known as the axiom of the independence of irrelevant alternatives.)

For the purpose of illustrating the Theorem, let us assume that there are only three individuals in society and three policies, candidates, or social welfare functions. Suppose that the individuals’ preferences among the three policies—call them x, y, and z—are as follows (with P indicating the relationship “is preferred to”): Individual 1

xPy

yPz

xPz

Individual 2

yPx

yPz

zPx

Individual 3

yPx

zPy

zPx

Each individual has complete, transitive, and reflexive preferences over the relevant social choices. For instance, for Individual 2, y is preferred to z, and z is preferred to x, and so by transitivity y should be preferred to x, and it is. What happens if we try to aggregate these individual preferences into a societal preference ordering by means of majority voting? Suppose that we begin with a choice between x and y, with the winner advancing to a runoff against policy z. Thus, letting S stand for the relationship “is socially preferred to,” we may write that y S x because both Individuals 2 and 3 prefer y to x, while only Individual 1 prefers x to y. What now happens in the runoff election between y and z? Individual 1 votes for y; Individual 2 votes for y; and Individual 3 votes for z. Thus, y wins so that y S z, and y is the socially preferred policy. Just for the sake of completeness, what would have happened if we had begun with the pairing x and z? In that case, Individual 1 would have voted for x, but the other two individuals would have voted for z, making z the winner. Thus, z S x. If we then advanced the winning policy, z, to a runoff against policy y, we already know that y would have won. This means that y is the socially preferred alternative, regardless of the order in which the alternatives are considered. Matters seem to be in good order. Majority voting has converted completed, transitive, and reflexive individual preferences into complete and transitive social preferences. (Can you show that the social preferences are, in fact, transitive?) But Professor Kenneth J. Arrow, a Nobel laureate in economics, demonstrated in Social Choice and Individual Values (1952) that this result did not always hold. That is, he showed that complete, transitive, and reflexive individual preferences cannot necessarily be converted into complete, transitive, and reflexive social preferences by means of majority voting that obeys the five assumptions listed previously. To see why, suppose that individual preferences over the three policies of candidate alternatives were as follows: Individual 1

xPy

yPz

xPz

Individual 2

yPx

yPz

zPx

Individual 3

xPy

zPy

zPx

Cooter/Ulen • Law & Economics, Sixth Edition

At first glance there appears to be very little to distinguish this set of individual preferences from the first set. (The only difference has to do with how Individual 3 feels about x and y.) In both instances each individual has complete, transitive, and reflexive preferences. Let us conduct an election among these policies or candidates to get the social preferences. If we begin with an election between policies x and y, x wins 2-1, so that x S y. Now pit x against the remaining policy z; z wins 2-1, so that z S x. It appears to be the case that z is the socially preferred policy. But suppose that the first pairing is not x and y, but z and y. If we held an election between alternatives z and y, y wins 2-1. And we know that if we were then to hold an election between y and x, x would be determined to be the socially preferred winner. Finally, if we were to start our election by pitting x against z, z would win. If we were then to pit z against y, y would be determined to be the socially preferred policy. There’s clearly a problem here. We get three different socially preferred policies depending on the order in which we pair then initially. (This possibility of circular group preferences in majority voting was first noted by Condorcet (1743–1794) and is sometimes called the “Condorcet paradox.”) The problem is that majority voting may not give rise to transitive social preferences. We know that if the group preferences were transitive, then, because z S x and x S y, it should be the case that z S y. But notice that y S z because two people prefer y to z. The gist of the Arrow Impossibility Theorem is that even though individual preferences are complete, transitive, and reflexive, group preferences determined through majority voting may not be. There is apparently no way to distinguish between those sets of complete, transitive, and reflexive individual preferences that will give rise to transitive social preferences and those that will not. The only method of guaranteeing transitive social preferences through majority voting is to relax one of the five assumptions made at the beginning. But it is difficult to see which of those five ought to be relaxed. As you probably know, one of the implications of the Arrow Impossibility Theorem that social choice theorists have teased out is that there are circumstances in which one can achieve one’s objectives by controlling the agenda. For example, in the second example given above (the one on page 6) suppose that you are Individual 3, whose preferences indicate that you prefer z to either of the alternatives. Further suppose that you, Individual 3, are in control of the voting procedures for your group of three. If so, then by suggesting that the first pairwise voting to occur will be between x and y, you can guarantee that z will be the ultimate selection of your group. There is a wonderful real-world example of how a clever former law professor used this knowledge of the value of agenda control to achieve his desired end. See “The Flying Club,” Chapter 3 in William H. Riker, The Art of Political Manipulation (1986). For more on the Arrow Theorem and some possible solutions to its dire predictions, see Daniel A. Farber and Philip P. Frickey, Law and Public Choice: An Introduction 38−62 (1991). Please feel free to use that material. It may not take long to present it in class, and it may serve to indicate why economists are somewhat skeptical about aggregations of individual choices into social choices.

Chapter 3 A Brief Introduction to Law and Legal Institutions Some students will have no background in law. While we think that reading the material in Chapter 3 will equip them with a sufficient knowledge to read the remainder of the text, some instructors may want to do more. In what follows here, we lay out two additional cases—one to which we make no reference in the text but that we believe raises marvelous instructive points and a second that we mention in a footnote after the discussion of Davies v. Mann. There are discussion questions following each excerpt.

◼ Riggs v. Palmer The dispute that we are going to look at here arose between private citizens in the State of New York in the 1880s. At issue was the division of the estate of a Mr. Francis Palmer between his daughters, Mrs. Riggs and Mrs. Preston, and his grandson, Elmer Palmer. Francis Palmer had left a last will and testament that specified how his property was to be divided among those parties. Elmer Palmer wishes his grandfather’s wishes to be followed to the letter; Mrs. Riggs and Mrs. Preston want the court to amend their father’s will to exclude Elmer Palmer from inheriting any of their father’s property. Their reason for so requesting is that Elmer Palmer murdered his grandfather when he learned that Francis was planning to change his will so as to exclude Elmer from inheriting. This dispute presented a novel and, obviously, fascinating question of law: Can a murderer inherit from the person whom he has murdered? After the opinion there are some discussion questions. Riggs v. Palmer 22 N.E. 188 (1889)1 EARL, J. On the 13th day of August, 1880, Francis B. Palmer made his last will and testament, in which he gave small legacies to his two daughters, Mrs. Riggs and Mrs. Preston, the plaintiffs in this action, and the remainder of the estate to his grandson, the defendant Elmer E. Palmer, subject to the support of Susan Palmer, his mother, with a gift over to the two daughters, subject to the support of Mrs. Palmer in case Elmer should survive him and die under age, unmarried, and without any issue. The testator, at the date of his will, owned a farm, and considerable personal property. He was a widower, and thereafter, in March, 1882, he was married to Mrs. Bresee, with whom before his marriage, he entered into an antenuptial contract, in which it was agreed that in lieu of dower and all other claims upon his estate in case she survived him she should have her support upon his farm during her life, and such support was expressly charged upon the farm. At the date of the will, and subsequently to the death of the testator, Elmer lived with him as a member of his family, and at his death was 16 years old. He knew of the provisions made in his favor in the will, and, that he might prevent his grandfather from revoking such provisions, which he had manifested some intention to do, and to obtain the speedy enjoyment and immediate possession of his property, he willfully murdered

The opinion will be found in volume 22 of a court reporter entitled “North Eastern Reports”; the opinion begins on page 188 of that volume; and the decision was handed down in 1889.

Chapter 3

A Brief Introduction to Law and Legal Institutions

him by poisoning him. He now claims the property, and the sole question for our determination is, can he have it? The defendants say that the testator is dead; that his will was made in due form, and has been admitted to probate; and that therefore it must have effect according to the letter of the law. It is quite true that statutes regulating the making, proof, and effect of wills and the devolution of property, if literally construed, and if their force and effect can in no way and under no circumstances be controlled or modified, give this property to the murderer. The purpose of those statutes was to enable testators to dispose of their estates to the objects of their bounty at death, and to carry into effect their final wishes legally expressed; and in considering and giving effect to them this purpose must be kept in view. It was the intention of the law-makers that the donees in a will should have the property given to them. But it never could have been their intention that a donee who murdered the testator to make the will operative should have any benefit under it. If such a case had been present to their minds, and it had been supposed necessary to make some provision of law to meet it, it cannot be doubted that they would have provided for it . . . The writers of laws do not always express their intention perfectly, but either exceed it or fall short of it, so that judges are to collect it from probable or rational conjectures only . . . What could be more unreasonable than to suppose that it was the legislative intention in the general laws passed for the orderly, peaceable, and just devolution of property that they should have operation in favor of one who murdered his ancestor that he might speedily come into the possession of his estate? Such an intention is inconceivable. We need not, therefore, be much troubled by the general language contained in the laws. Besides, all laws, as well as all contracts, may be controlled in their operation and effect by general, fundamental maxims of the common law. No one shall be permitted to profit by his own fraud, or to take advantage of his own wrong, or to found any claim upon his own iniquity, or to acquire property by his own crime. These maxims are dictated by public policy, have their foundation in universal law administered in all civilized countries, and have nowhere been superseded by statutes. They were applied in the decision of the case of Insurance Co. v. Armstrong, 117 U.S. 599, 6 Sup. Ct. Rep. 877. There it was held that the person who procured a policy upon the life of another, payable at his death, and then murdered the assured to make the policy payable, could not recover thereon . . . Here there was no certainty that this murderer would survive the testator, or that the testator would not change his will, and there was no certainty that he would get this property if nature was allowed to take its course. He therefore murdered the testator expressly to vest himself with an estate. Under such circumstances, what law, human or divine, will allow him to take the estate and enjoy the fruits of his crime? The will spoke and became operative at the death of the testator. He caused that death, and thus by his crime made it speak and have operation. Shall it speak and operate in his favor? If he had met the testator, and taken his property by force, he would have had no title to it. Shall he acquire title by murdering him? If he had gone to the testator’s house, and by force compelled him, or by fraud or undue influence had induced him, to will him to hold it. But can he give effect and operation to a will by murder, and yet take the property? To answer these questions in the affirmative it seems to me would be a reproach to the jurisprudence of our state, and an offense against public policy. Under the civil law, evolved from the general principles of natural law and justice by many generations of jurisconsults, philosophers, and statesmen, one cannot take property by inheritance or will from an ancestor or benefactor whom he has murdered. . . . My view of this case does not inflict upon Elmer any greater or other punishment for his crime than the law specifies. It takes from him no property, but simply holds that he shall not acquire property by his crime, and thus be rewarded for its commission. Our attention is called to Owens v. Owens, 100 N. C. 240, 6 S. E. Rep. 794, as a case quite like this. There a wife had been convicted of being an accessory before the fact to the murder of her husband, and it was held that she was nevertheless entitled to dower. I am unwilling to assent to the doctrine of that case. The statutes provide dower for a wife who has the misfortune to survive her husband, and thus lose his support ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

and protection. It is clear beyond their purpose to make provision for a wife who by her own crime makes herself a widow, and willfully and intentionally deprives herself of the support and protection of her husband. As she might have died before him, and thus never have been his widow, she cannot by her crime vest herself with an estate. The principle which lies at the bottom of the maxim volenti non fit injuria [“He who consents cannot receive an injury”] should be applied to such a case, and a widow should not, for the purpose of acquiring, as such, property rights, be permitted to allege a widowhood which she has wickedly and intentionally created.2 The facts found entitled the plaintiffs to the relief they seek . . . The judgment of the general term and that entered upon the report of the referee should therefore be reversed, and judgment should be entered as follows: That Elmer E. Palmer and the administrator be enjoined from using any of the personalty or real estate left by the testator for Elmer’s benefit; that the devise and bequest in the will to Elmer be declared ineffective to pass the title to him; that by reason of the crime of murder committed upon the grandfather he is deprived of any interest in the estate left by him; that the plaintiffs are the true owners of the real and personal estate left by the testator, subject to the charge in favor of Elmer’s mother and the widow of the testator, under the antenuptial agreement, and that the plaintiffs have costs in all the courts against Elmer . . . GRAY, J., (dissenting.) This appeal presents an extraordinary state of facts, and the case, in respect of them, I believe, is without precedent in this state. The respondent, a lad of 16 years of age, being aware of the provisions in his grandfather’s will, which constituted him the residuary legatee of the testator’s estate, caused his death by poison, in 1882. For this crime he was tried, and was convicted of murder in the second degree, and at the time of the commencement of this action he was serving out his sentence in the state reformatory. This action was brought by two of the children of the testator for the purpose of having those provisions of the will in the respondent’s favor canceled and annulled. The appellants’ argument for a reversal of the judgment, which dismissed their complaint, is that the respondent unlawfully prevented a revocation of the existing will, or a new will from being made, by his crime: and that he terminated the enjoyment by the testator of his property, and effected his own succession to it, by the same crime. They say that to permit the respondent to take the property willed to him would be to permit him to take advantage of his own wrong. To sustain their position the appellants’ counsel has submitted an able and elaborate brief, and, if I believed that the decision of the question could be effected by considerations of an equitable nature, I should not hesitate to assent to views which commend themselves to the conscience. But the matter does not lie within the domain of conscience. We are bound by the rigid rules of law, which have been established by the legislature, and within the limits of which the determination of this question is confined. The question we are dealing with is whether a testamentary disposition can be altered, or a will revoked, after the testator’s death, through an appeal to the courts, when the legislature has by its enactments prescribed exactly when and how wills may be made, altered, and revoked, and apparently, as it seems to me, when they have been fully complied with, has left no room for the exercise of an equitable jurisdiction by courts over such matters. Modern jurisprudence, in recognizing the right of the individual, under more or less restrictions, to dispose of his property after his death, subjects it to legislative control, both as to extent and as to mode of exercise. Complete freedom of testamentary disposition of one’s property has not been and is not the universal rule, as we see from the provisions of the Napoleonic Code, from the systems of jurisprudence in countries which are modeled upon the Roman law, and from the statutes of many of our states. To the statutory restraints which are imposed upon the disposition of one’s property by will are added strict and systematic statutory rules for the execution, alteration, and revocation of the will, which must be, at least substantially, if not exactly, followed to insure validity and performance. The reason for the establishment of such rules, we may naturally assume, consists in the purpose to create those safeguards about these grave and important acts which experience has demonstrated to be the wisest and surest. That freedom which is permitted to 2

The judge’s point reminds us of the story of the young man who killed his parents and at his murder trial begged for mercy on the ground that he was an orphan.

Chapter 3

A Brief Introduction to Law and Legal Institutions

be exercised in the testamentary disposition of one’s estate by the laws of the state is subject to its being exercised in conformity with the regulations of the statutes. The capacity and the power of the individual to dispose of his property after death, and the mode by which that power can be exercised, are matters of which the legislature has assumed the entire control, and has undertaken to regulate with comprehensive particularity. The appellants’ argument is not helped by reference to those rules of the civil law, or to those laws of other governments, by which the heir, or legatee, is excluded from benefit under the testament if he has been convicted of killing, or attempting to kill, the testator. In the absence of such legislation here, the courts are now empowered to institute such a system of remedial justice. The deprivation of the heir of his testamentary succession by the Roman law, when guilty of such a crime, plainly was intended to be in the nature of a punishment imposed upon him . . . The statutes of this state have prescribed various ways in which a will may be altered or revoked; but the very provision defining the modes of alteration and revocation implies a prohibition of alteration or revocation in any other way. The words of the section of the statute are: “No will in writing, except in the cases hereinafter mentioned, nor any part thereof, shall be revoked or altered otherwise,” etc. Where, therefore, none of the cases mentioned are met by the facts, and the revocation is not in the way described in the section, the will of the testator is unalterable. I think that a valid will must continue as will always, unless revoked in the manner provided by the statutes. Mere intention to revoke a will does not have the effect of revocation. The finding of fact of the referee that presumably the testator would have altered his will had he known of his grandson’s murderous intent cannot affect the question. We may concede it to the fullest extent; but still the cardinal objection is undisposed of—that the making and the revocation of a will are purely matters of statutory regulation, by which the court is bound in the determination of questions relating to these acts . . . I cannot find any support for the argument that the respondent’s succession to the property should be avoided because of his criminal act, when the laws are silent. Public policy does not demand it; for the demands of public policy are satisfied by the proper execution of the laws and the punishment of the crime . . . Practically the court is asked to make another will for the testator. The laws do not warrant this judicial action, and mere presumption would not be strong enough to sustain it. But, more than this, to concede the appellants’ views would involve the imposition of an additional punishment or penalty upon the respondent. What power or warrant have the courts to add to the respondent’s penalties by depriving him of property? The law has punished him for his crime, and we may not say that it was an insufficient punishment. In the trial and punishment of the respondent the law has vindicated itself for the outrage which he committed, and further judicial utterance upon the subject of punishment or deprivation of rights is barred. We may not, in the language of the court in People v. Thornton, 25 Hun, 456, “enhance the pains, penalties, and forfeitures provided by law for the punishment of crime.” The judgment should be affirmed, with costs.

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Questions and Notes

1. Who are the plaintiffs in Riggs v. Palmer? What are they asking the court to do? You will often find that there are multiple plaintiffs and multiple defendants and yet the case is entitled in such a way as for you to believe that there was only one plaintiff and one defendant. In fact, that was the case here. Why is there this disparity between who the parties really were and what the title of the case is? The answer is that this is purely a matter of convenience. The full title of the case you have just read is Riggs et al. v. Palmer et al., where et al. means, in Latin, “and other people.” It is easier to remember this case as simply Riggs or as Palmer or even as Riggs v. Palmer than to add the full title. You will find that famous cases are often referred to in an abbreviated form (for example, Riggs) rather than by their full name.

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2. Is there a New York statute involved in this dispute? From the context of the opinions, what does that statute say about the resolution of the current dispute? Did the legislators who wrote that statute anticipate the sort of situation that we see here? Why not? Oliver Wendell Holmes characterized much of what common law judges do in the course of making law as “interstitial legislating”; Southern Pacific Co. v. Jensen, 244 U.S. 205, 221 (1917) (dissenting opinion). What he meant was that the common law judges were filling in the gaps in the work undertaken by legislators. Is that a fair characterization of what the majority is doing in this case?

Chapter 3

A Brief Introduction to Law and Legal Institutions

The following questions are those you can pose to your students to see if they are getting the drift of what is going on. 3. What happened in the court below? Who won? Who appealed that judgment? 4. How does the majority opinion seek to support its conclusion? Does it use analogy? Give two examples of analogies used by Justice Earl. Does the majority cite other cases as support? Are those other cases binding precedent or merely persuasive? Why is Insurance Co. v. Armstrong, 117 U.S. 599, a United States Supreme Court opinion, not binding authority? What about the North Carolina case, Owens v. Owens, 100 N.C. 240? 5. What are the central reasons given by the majority for voiding the will? An important argument made in the majority opinion is that if the testator (Francis Palmer) had thought of the possibility that his grandson (or anyone else) would kill him to prevent him changing his will so as to disinherit them, then the testator would have explicitly excluded a murdering heir. How do we know that the testator would have excluded Elmer? It’s a guess, but it’s a highly plausible guess. Experience, common sense, reflection—all those things and more suggest that Francis Palmer, like the vast majority of human beings, would not have wanted Elmer to profit from murdering his grandfather. (Notice that exactly the same argument could be made about the New York State legislature and its failure to specify what should be done in the case of a murdering heir. If the legislators had thought of this possibility, then they would have excluded a murdering heir.) 6. What is the holding in this case? You should know just a little about wills in order to appreciate Justice Gray’s dissent. For centuries in the common-law world there has been an extremely strong general rule to honor the explicit wishes of the testator in his last will and testament. Thus, even where there might be a mistake in the will, the judges have generally enforced the terms anyway. Suppose, for instance, that Henderson’s last will and testament says, “I leave $100,000 in cash to the Sam Charles who lives on Woodhaven in Amherst, NY.” Henderson dies. Suppose that it is then discovered that Henderson really meant to leave the $100,000 to a Sam Charles who lives on Main St. in Amherst. Somehow, Henderson or his attorney made a mistake in writing down the address. Perhaps there are two Sam Charles listed in the phone book and in writing down the address, Henderson or his attorney meant to indicate the one on Main St. but wrote down the one on Woodhaven instead. Can the court correct this mistake and give the $100,000 to the real Sam Charles? In general, no. The testator is gone, and it is often impossible after the fact to be sure that this really was a mistake. Courts have made the determination that, all things considered, it is better to honor the stated wishes of the decedent rather than to entertain speculation about what he or she really intended. There are, of course, circumstances in which it is impossible to honor the testator’s wishes. Suppose, in the previous paragraph, that there was no one named Sam Charles on Woodhaven. What is to be done? Generally speaking, the court will try to ascertain in whatever way it can what the testator’s wishes were and then come as close to complying with those wishes as it is possible to do. For example, suppose there is a Charles Sams who lives on Woodhaven. That’s easy; the testator simply scrambled the names. But what if there is no Sam Charles and no Woodhaven? Finding an appropriate means of coming close to Henderson’s wishes in those circumstances is a more difficult matter. This background should help you to see that Justice Gray’s position is not without merit. He says, in essence, that the New York Statute is silent on what to do in the situation before the court and that, therefore, the court should follow the testator’s explicit wishes. That is, Justice Gray argues for doing exactly what the will says to do. This view is in line with the strong presumption of the common law that we noted above. We’ll explore the implications of Justice Gray’s position in the following questions.

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As with questions 3, 4, and 5 above, these are questions to put to your class to make sure that they’re understanding what is going on in this case. 7. What precisely does Justice Gray think the appropriate solution to this dispute is? 8. How does he justify this position? Does he mention the strong presumption in favor of honoring a testator’s explicit wishes? How does he deal with the fact that the New York State legislature’s statute does not cover this situation? Does he rely on other authority to support his position? Whom does he cite? How does he make use of analogous reasoning in his dissenting opinion? 9. Suppose that Justice Gray, instead of being in the minority, had carried the day so that the law in New York was that a murderer could inherit. What are some of the consequences of this decision? Would you expect the number of testators who are murdered by prospective inheritors to increase? Would testators rewrite their wills so as to explicitly exclude a murdering heir? What might the state legislature do in its next session? Would it amend the statute to exclude a murderer from inheritance? An interesting aspect of the difference between the majority and minority opinions is the difference between a theory of (common law) judicial activism and restraint. Justice Earl and his colleagues felt that the gap in the New York statute should be filled. It was an oversight not to have thought of the possibility of a murdering heir, and the justices see no harm and a great deal of virtue in correcting that oversight. Justice Gray, on the other hand, can be interpreted as saying that this is not the court’s business. If the legislature had wanted to exclude murdering heirs, then they should have said so explicitly. Moreover, he can be interpreted as saying, “If it really was an oversight not to exclude murdering heirs under the statute, then the legislature, not the court, can take the appropriate corrective action at the earliest opportunity.” These two views—one of common-law judges actively filling in the gaps in the law, the other of judges deferring to the legislature—are characteristic of the debate about the appropriate role of judges and legislatures. And here are some more discussion questions for you and your students to mull over: 10. Suppose that you are member of a state legislature in 1890. Word of the majority opinion in Riggs reaches you and you decide that you should amend your state’s statute governing inheritance to exclude murdering heirs. Consider how you would deal with the following situations: The heir kills the testator by accident. Should he be allowed to inherit?  The heir kills the testator in a fit of passion, not in the premeditated fashion that Elmer Palmer chose. Should he be allowed to inherit?  The heir kills the testator in self-defense. Should he be allowed to inherit?  The heir and the testator are killed fighting one another. (Suppose that one of the heir’s creditors or heirs brings the action against the testator’s estate.) Does it matter if the testator was the aggressor? Should the heir’s estate be allowed to inherit? These questions are not easy to answer. Perhaps now you realize why common-law judges confine themselves to the exact facts presented to them rather than imagining all the possibilities.

Chapter 3

A Brief Introduction to Law and Legal Institutions

British Columbia Electric Railway Company v. Loach The text discusses Butterfield v. Forrester and Davies v. Mann in order to demonstrate how the law evolves. A footnote at the end of the discussion of Davies mentions that the story continues in a later case entitled British Columbia Electric Railway Company v. Loach. Because there is instructive value in knowing what happened, we here briefly summarize the Loach opinion. After Davies the law of negligence remained more or less the same for the next 70 years. Then in 1916 an accident in British Columbia between a train and a horse-drawn wagon presented yet another twist on last clear chance. The case was brought by Loach, who was the administrator of the estate of Benjamin Sands, who was killed by a train belonging to the British Columbia Electric Railway Co., Ltd. Loach won a judgment against the railroad in the trial court. The railroad appealed that judgment to the House of Lords in London, which was the court of last resort in the British Empire, on the grounds that the court below had misapplied the contributory negligence and last-clear-chance rules. Here is an excerpt from Lord Sumner’s opinion: British Columbia Electric Railway Co., Ltd. v. Loach [1916] 1 A.C. 7193 LORD SUMNER. This is an appeal from a judgment of the Court of Appeal of British Columbia in favour of the administrator of the estate of Benjamin Sands, who was run down at a level crossing by a car of the appellant railway company and was killed. One Hall took Sands with him in a cart, and they drove together on the level crossing and neither heard nor saw the approaching car till they were close to the rails and the car was nearly on them. There was plenty of light, and there was no other traffic about. The verdict, though rather curiously expressed, clearly finds Sands guilty of negligence in not looking to see that the road was clear . . . Hall, who escaped, said that they went “right on to the track,” when he heard Sands, who was sitting on his left, say “Oh,” and looking up saw the car about 50 yards off. He says he could then do nothing, and with a loaded waggon [sic] and horses going two to three miles an hour he probably could not. It does not seem to have been suggested that Sands could have done any good by trying to jump off the cart and clear the rails. The car knocked cart, horses, and men over, and ran some distance beyond the crossing before it could be stopped. It approached the crossing at from thirty-five to forty-five miles an hour. The driver saw the horses as they came into view from behind a shed at the crossing of the road and the railway, when they would be 10 ft. or 12 ft. from the nearest rail, and he at once applied his brake. He was then 400 ft. from the crossing. If the brake had been in good order it should have stopped the car in 300 ft. Apart from the fact that the car did not stop in time, but overran the crossing, there was evidence for the jury that the brake was defective and inefficient and that the car had come out in the morning with the brake in that condition. The jury found that the car was approaching at an excessive speed and should have been brought under complete control, and although they gave as their reason for saying so the presence of possible passengers at the station by the crossing, and not the possibility of vehicles being on the road, there can be no mistake in the matter and their finding stands . . . Clearly if the deceased had not got on to the line he would have suffered no harm, in spite of the excessive speed and the defective brake, and if he had kept his eyes about him he would have perceived the approach of the car, and would have kept out of mischief. If the matter stopped there, his administrator’s action must have failed, for he would certainly have been guilty of contributory negligence. He would have owed his death to his own fault, and whether his negligence was the sole cause or the cause jointly with the railway company’s negligence would not have mattered . . . If the jury accepted the facts above stated, as certainly they well might do, there was no further negligence on the part of Sands after he looked up and saw the car, 3

This is the correct citation form for some English cases. It is identical to that we have been using, save for the fact that the year appears first, not last, and in brackets rather than parentheses. “A.C.” stands for “Appeals Cases.”

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and there was then nothing that he could do. There he was in a position of extreme peril and by his own fault, but after that he was guilty of no fresh fault. The driver of the car, however, had seen the horses some perceptible time earlier, had duly applied his brakes, and if they had been effective, he could, as the jury found, have pulled up in time. Indeed, he would have had 100 ft. to spare. If the car was 150 ft. off when Sands looked up and said “Oh,” then each had the other in view for 50 ft. before the car reached the point at which it should have stopped. It was the motorman’s duty, on seeing the peril of Sands, to make a reasonable use of his brakes in order to avoid injuring him, although it was by his own negligence that Sands was in danger. Apparently he did his best as things then were, but partly the bad brake and partly the excessive speed, for both of which the appellants were responsible, prevented him from stopping, as he could otherwise have done. On these facts, which the jury were entitled to accept and appear to have accepted, only one conclusion is possible. What actually killed Sands was the negligence of the railway company, and not his own, though it was a close thing . . . Their Lordships are of opinion that, on the facts of the present case, the above observations apply and are correct. Were it otherwise the defendant company would be in a better position, when they had supplied a bad brake but a good motorman, than when the motorman was careless but the brake efficient. If the superintendent engineer sent out the car in the morning with a defective brake, which, on seeing Sands, the motorman strove to apply, they would not be liable, but if the motorman failed to apply the brake, which, if applied, would have averted the accident, they would be liable . . . In the present case their Lordships are clearly of opinion that, under proper direction, it was for the jury to find the facts and to determine the responsibility, and that upon the answers which they returned, reasonably construed, the responsibility for the accident was upon the appellants solely, because, whether Sands got in the way of the car with or without negligence on his part, the appellants could and ought to have avoided the consequences of that negligence, and failed to do so, not by any combination of negligence on the part of Sands with their own, but solely by the negligence of their servants in sending out the car with a brake whose inefficiency operated to cause the collision at the last moment, and in running the car at an excessive speed, which required a perfectly efficient brake to arrest it. Their Lordships will accordingly humbly advise His Majesty that the appeal should be dismissed with costs. The question before the Law Lords was how to balance the railroad’s negligence in not maintaining the brake against Sands’ clear negligence in stopping his cart on the level crossing. Was this simply a case of contributory negligence barring recovery? Or did the railroad fail to exercise the last clear opportunity to avoid the accident? If the court had decided that Sands’ contributory negligence was controlling, then the British Columbia Electric Railway Co., Ltd. (BCER) would have been excused from liability. On the other hand, if the court determined that the railroad failed to exercise the last clear chance to avoid the accident, the railroad would be held liable, despite Sands’ contributory negligence. To clarify the issues, let’s reproduce the gist of each side’s argument and counterargument. Loach first says that the railroad was negligent in traveling too fast and failing to stop before hitting Sands’ cart. The BCER answers that even if that is correct, Sands was contributorily negligent in driving the cart onto the level crossing without checking to see if a train was coming. Applying the rule in Butterfield that contributory negligence is a complete bar to recovery would thus preclude Loach from recovery on behalf of Sands’ estate. “But wait!” says Loach. You have forgotten the last-clear-chance doctrine from Davies v. Mann. Conceding that Sands was contributorily negligent, Loach argues that once Sands was on the tracks by his own fault, any possibility of avoiding injury passed to the railroad company. Because, as the facts apparently show, Sands could not have moved his cart or jumped to safety, any chance to avoid the accident, once Sands

Chapter 3

A Brief Introduction to Law and Legal Institutions

was on the tracks, belonged to the BCER. In the words of Davies v. Mann, the railway had the last clear chance to avoid the accident and did not take that chance.

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The railroad company’s final counterargument is that it did not, in fact, have the last clear chance to avoid the accident. Why? Because the train’s brake was defective. With the defective brake, the motorman did not have the last clear chance to avoid the accident, because the motorman could not have stopped the train short of the cart. Loach’s final counterargument is that the railroad cannot escape liability because of a defective brake. Trains should not have defective brakes. If the train’s brake had been effective, not defective, the motorman could have stopped the train short of the cart. If the defective brake allows the railroad to avoid liability, then other injurers (not just railroads) will operate defective vehicles to escape liability by removing from them the last clear chance to avoid an accident. Allowing an injurer to escape liability by being negligent creates perverse incentives. Loach’s final point seems like a powerful and persuasive one. The question, of course, is how to amend the last-clear-chance doctrine to exclude prior negligence like that of the BCER in not adequately maintaining its brakes. We can do so by inserting the four words “or should have had” into the rule from Davies v. Mann as follows: contributory negligence is a complete bar to recovery unless the defendant had or should have had the last clear chance and did not take it. A maxim asserts that “ought implies can.” This phrase means that a person can only have an obligation to do what he is able to do. In other words, a person is not responsible for failing to do what he is unable to do. Sometimes, however, the law violates this maxim and holds a person responsible for failing to do what he is unable to do. This happens when his inability is his own fault. For example, a company is unable to stop its train because it failed to maintain the brakes. To make someone responsible for an inability, the law often uses such phrases as “had or should have had,” “knew or should have known,” “said or should have said,” and “did or should have done.” And here are two discussion questions regarding this case. Note, as I’m sure will be obvious, that it would be an odd world and the law would seem to be a silly institution if the order in which these cases had appeared would lead to their being decided differently from how they were, in fact, decided.

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Questions

Suppose that Butterfield came after the rule we have just proposed in Loach. Would Butterfield have been decided differently or would the defendant still have won?

What about Davies v. Mann? Would that case have been decided differently under the rule proposed in Loach? (The resolution of these cases should be identical regardless of the order in which they were decided, provided that one did not overturn another.)

Chapter 4 An Economic Theory of Property There are three central concepts in this chapter that will form the basis of much that comes after. Therefore, it is very important that you and the students take a little bit of extra time to come to grips with these core concepts. The first of these concepts is our contention that one can profitably view property law as a method of fostering the efficient use of resources. Traditional legal scholarship views property law as a method of assigning, enforcing, and redistributing entitlements to resources but with no clear objective in mind, other than, perhaps, to do justice. (We review some of the possible traditional goals of property law in the appendix to Chapter 4.) The second core concept that the chapter develops is the Coase Theorem and the definition of “transaction costs.” These are, without doubt, the important ideas in law and economics. They apply not just to property law but to all law. Indeed, the central concern of the Coase Theorem is to articulate a method for choosing the most appropriate social method by which to move resources into the hands of those who place the highest value on them. One way of looking at the Coase Theorem is to read it as saying that you should use arm’slength bargaining to move resources to their highest use when bargaining works well (that is, when transaction costs are very low) and use other methods of determining the highest-valuing user when bargaining fails. (An important implication, which we develop in our discussion of the Normative Coase and Hobbes Theorems, is to use the law to facilitate bargaining. For instance, one could argue that contract law is a method of lowering the transaction costs for concluding mutually beneficial consensual agreements.) It is, therefore, extremely vital that the students get comfortable with the notion of transaction costs and the Coase Theorem and its variations that we present in this chapter. The third core concept is the distinction between property rules and liability rules. This distinction is one that Judge Guido Calabresi and his then student A. Douglas Melamed noted in a very famous article published in 1972. As should be evident from the text, the Calabresi-Melamed analysis is an extension of the Coase Theorem. This distinction between methods of protecting legal entitlements is one that arises in every area of the law. Students must leave this course with a clear understanding of the difference between property rules and liability rules. (Interestingly, as you will see from the references to the Ayres and Talley, Kaplow and Shavell, and Bebchuk articles mentioned on the website, there is still some controversy about the differences between property rules and liability rules and still some extremely important work being done on this issue.)

◼ The Coase Theorem and Transaction Costs We think that the treatment of the Coase Theorem in the text is a sufficient introduction to the subject. But years of teaching that material have alerted us to the issues that students are likely to raise about it. One of the first things to note is that law students will have a strong tendency to fight the assumption of the hypothetical situation posited by the Theorem—namely, zero transaction costs. Simply to get across what

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the Theorem means, one has to insist that they make that assumption. We come back later in the text to dealing with the issue of what to do when transaction costs are not zero.

Chapter 4

An Economic Theory of Property

Another issue that repeatedly arises is that “you economists” (a denigration that would probably excite legal action if applied to any other group) “ignore the distributional aspects of the assignment of entitlements.” One should face this issue head on at an early point in the semester. There are some hints in the text about how to deal with this (for instance, you might mention again that the Second Fundamental Theorem of Welfare Economics argues for the separation of efficiency and equity concerns—that is, that one need not try to achieve those policies simultaneously with the same policy instrument). We also discussed this issue in the first chapter in the section on redistribution of ice cream from one desert oasis to another. A third, and very important issue, is to turn at some point to an explicit consideration of what counts as a “transaction cost.” We will return to this in just a moment. Here are several questions that should help to frazzle the students on the meaning of the Coase Theorem and bargaining.

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Question

A rancher and a farmer live next door to one another. Although the boundaries of their properties are well defined, there is no fence or natural break that clearly demarcates the boundaries. As a result, from time to time the rancher’s cattle stray onto the farmer’s property. Assume that if the rancher’s cattle stray onto the farmer’s property, the farmer loses $60 in profits per year; that the annual cost to the rancher of building and maintaining a fence between his property and the farmer’s is $120; and that the annual cost to the farmer of building and maintaining a fence between his property and the rancher’s is $95. Assume that the transaction costs between the rancher and the farmer are zero. Compare the efficiency of these three legal regimes: a.

farmers’ rights: the farmer has a legally-enforceable right to be free from invasion; in the event of invasion, he is entitled to compensation in the form of his lost profits.

ranchers’ rights: the rancher bears no liability for any damage that his cattle may do to someone else’s property.

farmers’ super-rights: the farmer has a legally-enforceable right to be free from invasion; in the event of invasion, he is entitled to ten times his lost profits.

Note that if the Coase Theorem holds, the outcome under the three different legal regimes should be the same (or, to be completely accurate, equally efficient—although in this instance, the outcomes are, in fact, identical). The key is to convince the students that under farmers’ super-rights there will be no fence, even though the farmer might receive ten times his actual losses ($600) in the event of an invasion. The rancher can induce the farmer to do better by accepting a payment of between $60 and $95. Why will the farmer accept that? Because if he does not, the rancher will build a fence, in which case the farmer will receive only $60 in additional profits.

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Question

When Abe graduated from the University of California at Berkeley, he bought a diamond ring with a golden bear insignia (Berkeley’s symbol) to impress his high school friends. The person most impressed was his old sweetheart, Beth. They grew so fond of each other that Abe asked Beth to wear his ring. Then the quarreling began. The relationship deteriorated until, in a fit of anger, Beth enrolled as a student at Stanford (Berkeley’s hated rival). Abe, naturally, broke off the relationship and asked for the return of his ring. Beth replied that

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it was a gift to her and she was not about to return it. He answered that he had only loaned it to her to wear for the duration of their friendship.

Chapter 4

An Economic Theory of Property

Abe and Beth are now involved in a legal dispute over the ring. Beth possesses the ring and she declares that she intends to sell it. Abe threatens to sue her. If Abe wins at trial, the court will require Beth to return the ring to him. The ring is worth $1,000 to Abe. If Beth wins at trial, the court will allow her to keep the ring. She would then sell the ring for $400 to an acquaintance. (The acquaintance does not know Abe and will not resell the ring to him.) In the event of a trial, each one expects to win with probability 0.5. A trial will cost Abe $250 and it will also cost Beth $250. Abe and Beth start negotiating to reach a settlement and avoid a trial. The costs of settling out of court are nil. Supply numerical answers to the following questions concerning the bargaining situation: 1.

The threat values are: Abe _____________________________________________________. Beth _____________________________________________________. Sum of Abe’s and Beth’s threat values: __________________________.

The total value of cooperation to Abe and Beth: ___________________.

The surplus from cooperation: _________________________________.

The “reasonable” solution would be for Beth to return the ring to Abe and for Abe to pay Beth how much? ________________________.

If the judge were to decide the case by applying the “normative Hobbes Theorem,” who would win the case and get the ring? Abe or Beth (circle your answer).

Answers to the problem of Abe, Beth, and the Ring.

Abe: (1,000  0.5) − 250 = 250. Beth: (400  0.5) − 250 = −50. Sum: +200.

1,000. If the parties cooperate, then they will settle out of court. The settlement will require Abe to pay Beth an amount of money denoted “S” for settlement, and Abe will get the ring. Abe values the ring at $1,000. Thus the cooperative value of the game equals the payoffs to both parties: +S −S + 1,000. (We implicitly assume no transaction costs to settle.)

1,000 − 200 = 800. Notice that 800 equals the sum of the following two numbers: 500 = 250 + 250 litigation costs avoided by both parties 300 = 1,000 − (1,000  0.5 + 400  0.5) (the increase in expected surplus, which is equal to the value of the ring to Abe minus the expected value from flipping a coin to see who gets the ring).

threat value + 1/2 surplus. Using this formula, Abe must end up with 650 and Beth must end up with 350. If Abe pays 350 to Beth and Beth gives Abe the ring, then Abe ends up with 1,000 − 350 = 650, and Beth ends up with 350. Therefore, a reasonable settlement is for Abe to pay Beth 350 for the ring.

Abe.

Why is the answer the same whether the ring is initially given to the police or kept by Beth pending resolution of the dispute? Let the “status quo” refer to the situation the parties will be in if there is no trial and no settlement. Reducing the status quo of one player by $1 is exactly offset by increasing by $1 both that player’s threat value and the cooperative solution.

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To see this point, consider Beth. The position of Beth after a settlement equals her status quo position plus her share of the cooperative value. The status quo allows her to keep the ring whose value to her is $400, and her share of the cooperative value equals −$50, so her position after settlement is $350. In the revised formulation, the status quo has the court keeping the ring, so the value to her of this situation is $0, and her share of the cooperative value equals −$50, so her position after settlement is $350. The end result is the same. In general Beth’s final position is given by status quo + 0.5 (C − Ta − Tb) + Tb = status quo + 0.5 (C − Ta) + 0.5Tb. The value of this equation does not change if you subtract $400 from the status quo (the police get the ring, not Beth), and add $400 both to her threat value (it goes from −$500 to −$100) and to the value of cooperation (it goes from $600 to $1,000).

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Question

You cannot ride a horse across fenced fields, and you cannot grow crops in unfenced fields where people ride their horses. Does privatizing land and fencing increase or decrease liberty? Efficiency?

◼

What Exactly Are Transaction Costs?

A very important issue in coming to grips with the Coase Theorem is to be clear about what counts as a transaction cost. One reason that this is important is that application of the insights of the Coase Theorem to legal disputes requires one to judge whether the transaction costs between the disputants or similarly situated parties would be too high to preclude a bargain. But note that a bargain can fail for a very different reason than the presence of high transaction costs—there is no cooperative surplus. (We’ll mention a third reason in just a minute.) The maximum price that the potential buyer is willing to pay is less than the minimum price that the potential seller is willing to accept. Clearly, where this is the case, efficiency argues against a bargain. We urge you to belabor this point in class. We have found that when students first come across the notion of transaction costs, they may misuse it. Here’s the common mistake: if a transaction fails to take place, the reason must be that high transaction costs are frustrating them from concluding an otherwise mutually satisfactory transaction. Not necessarily. It could simply be the case that there’s no “scope for a bargain”— that is, no cooperative surplus. Why is this distinction important? Because these two different reasons for the failure of a transaction to take place lead to very different policy implications. Where the cause of a failure to transact is high transaction costs, it may be true that the law should take steps to lower the transaction costs and assist the parties to achieve their transaction. But if the cause of the failure to transact is that there’s no cooperative surplus, then the law ought to stay out. Nothing is to be gained by facilitating a deal. The implication here is that the students must be able to distinguish these very different reasons for failing to transact. In practice this means that they must become adept at identifying circumstances, contexts that give rise to high transaction costs. A third reason that transactions fail is that the parties are engaged in strategic behavior that causes them to miscommunicate about the value of a completed transaction. (This was the central point of Cooter’s marvelous early article “The Cost of Coase.”) The discussion questions that follow should help you and the students to wrestle with these issues. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 4

◼

An Economic Theory of Property

Question 1

A group of AIDS victims have jointly purchased a home in a residential neighborhood with the intention of having a quiet, mutually supportive atmosphere for their remaining days. Despite the fact that none of the victims is related to any of the others, their living together does not violate any relevant zoning ordinance. Nor is there anything about the house, other than the nature of the residents, that distinguishes it from others in the neighborhood. Naturally, word has gotten around that the house is now occupied by AIDS sufferers. The majority of the members of the neighborhood are convinced that AIDS is highly contagious and that they now face a greatly heightened risk of contracting the disease. A hastily-formed neighborhood association brings an action against the AIDS victims alleging that the AIDS victims constitute a nuisance that adversely affects the health and property values of the members of the association. Blissfully ignoring any Constitutional issues, the association has asked the trial court for $1,000,000 as compensation for the decline in property values that they allege to have resulted from the presence of the AIDS victims in the neighborhood. The issue has been raised that there has been or should be no loss in the value of property due to the AIDS victims’ presence because the sole premise for the decline in value is the factually untrue belief that AIDS is highly contagious. How would efficiency best be served in this case? Should the suit be dismissed on the grounds that there is no scientific basis for the fear and resulting decline in property values—that is, that there has been no compensable harm? Or should the court find that science has nothing to do with it on the grounds, say, that the fear, though unjustified, may be so widespread that people do fear living next to AIDS victims and, therefore, that the demand for houses in the neighborhood has fallen significantly? What evidence would convince you of this latter point? If you believe that there has been a compensable nuisance, would you enjoin the AIDS victims from living in this residential neighborhood or award money damages? Note that the normal measures of transaction costs between the neighbors and the AIDS-home residents— the number of people involved, the complexity of the transaction, and the ability to monitor—are not that burdensome. So, the failure to transact may be due to the lack of a cooperative surplus. But here the lack of a cooperative surplus is due to a widespread misunderstanding about the communicability of AIDS. Should that misinformation count as a legitimate reason for failing to transact? Note, before you move on to other topics, that racial, religious, gender, and ethnic dislikes can lead to a lack of a cooperative surplus. You may want to discuss with the class whether economics has anything to say about this matter. It seems to us that it would be inaccurate to characterize these dislikes as “transaction costs.” They are, rather, matters of subjective utility. And generally economics allows people to satisfy their preferences in the manner that they deem most fit. But are there some “tastes and preferences” that society deems inappropriate? They may not be so much inefficient as simply morally reprehensible. Society may say that you can fail to transact for lots of reasons, but not because you dislike the race of the potential buyer or seller. Note, finally, that economics clearly says that if these morally indefensible views are the true reasons for failing to transact, it will be very difficult for the law to discover this because people can sometimes disguise their true reasons for failing to transact. There is a marvelous phrase from labor law that captures this. The “termination-at-will” doctrine in common law employment contracts holds that an employee may be discharged for “good reason, bad reason, or no reason at all.” Should the same wide latitude apply to failure to transact for property? Or are there some reasons for failing to transact that would be illegitimate or even inefficient?

Cooter/Ulen • Law & Economics, Sixth Edition

◼

Question 2

A town debates whether restaurants should be required by law to set aside a given percentage of their customer area for the exclusive use of non-smokers. Ms. Expansive argues against the ordinance on the grounds that restaurant owners will find the efficient way to accommodate the interests of smokers and non-smokers in order to maximize their profits. If that requires declaring a portion of their restaurant offlimits to smokers, they will do so, and, moreover, Ms. Expansive argues, they will do so, after trial and error, in just the right amount. Ms. Expansive asserts that if the city government specifies the percentage of floor area that should be set aside for non-smokers, it will get the figure wrong. She points to the voluntary actions of hotels in declaring certain rooms and floors to be non-smoking as evidence for her contention that the market will take care of this problem. In contrast, Mr. Restrictive argues for enacting the ordinance. He asserts that non-smokers will never pay smokers not to smoke in restaurants, and he believes that smokers will not seek the consent of smokers. There are too many people involved for such a bargain to take place, and people simply do not make those sorts of bargains. Why take a chance that bargaining will work, especially when we have good reasons for believing that it will not work? Choose sides in this debate and make your argument based upon the Coase Theorem. Extend your arguments to distinguish smoking in a private residence, shopping mall, an indoor arena, or a commercial airplane.

◼ Transaction Cost Engineers The notion of transaction costs is so central to law and economics that Ulen tells his law students that if he ever asks a question in class about why some legal situation is the way it is, the most likely answer is “transaction costs.” There’s more than a little truth to that point, but there is an additional, very practical reason why we think that it’s important for students to focus on this notion—it could make them better lawyers. In the mid-1980s Professor Ron Gilson wrote a marvelous article about the many ways in which transactional lawyers (as they are called) have helped businesses overcome impediments to going forward and avoid problems in their relationships with employees, other firms, suppliers, and regulators. See “Value Creation by Business Lawyers: Legal Skills and Asset Pricing,” 94 Yale L.J. 239 (1984). Gilson said that in many instances business lawyers were acting as “transaction cost engineers,” identifying transaction costs and helping parties to lower them or avoid them. We like this notion very, very much and hope that you will find it useful, too. We mention Gilson’s idea explicitly in Chapter 10 when we discuss the role of lawyers. But this idea that a knowledge of transaction costs (of the factors that cause transaction costs to be high) and a recognition that a skillful lawyer can help parties to reduce those costs is, we believe, one of the most important practical notions that law and economics can offer to lawyers. You can find examples of lawyers acting as “transaction cost engineers” in all of the substantive areas of law that we will deal with in this book, including property.

Chapter 4

An Economic Theory of Property

◼ The Endowment Effect Recent literature, which we cite in a Web Note, suggests that there may be additional reasons—beyond high transaction costs and no scope for a bargain—that transactions do not take place: the endowment effect or status quo bias. The gist of this literature is that people typically place a much higher value on something that they have (or on an existing state of the world) than they would place on it if they did not have that thing (or if the state of the world were different). This seems to be a psychological regularity that applies not to goods that require experience to evaluate but to such simple goods as coffee mugs, pens, and chocolate bars. Economists sometimes refer to this as a difference between a person’s “willingness-to-pay” price—the price that they would be willing to pay to acquire something that they do not have—and their “willingness-toaccept” price—the price that they would be willing to accept to give up something that they have. Generally speaking, experiments have shown that people’s WTA price is on the order of twice their WTP price. This may create a problem for the Coase Theorem. First, it suggests an ambiguity about what “highest value” means. Does it refer to WTA or WTP price or value? Second, the difference could lead to failures to transact after a good or legal entitlement is assigned. To see why, suppose that two persons—A and B—have the WTA and WTP prices shown in the accompanying chart for a particular legal entitlement:

A B

WTA price

WTP price

$10,000 $ 8,000

$4,000 $6,000

First, note the ambiguity as to who “values” this entitlement more. If we use WTA price as our measure of value, then A values it more. If we use WTP price, then B values it more. There’s no compelling reason to think that one measure of value is inherently better than the other. Second, there is a problem for the Coase Theorem in that, even though transaction costs are zero, there are going to be no transactions of this entitlement. If this entitlement were initially assigned to A, it will remain with A. The reason is that A will not sell the entitlement for less than $10,000, but the maximum that B is willing to pay to acquire the entitlement is $6,000. Similarly, if this entitlement were initially assigned to B, it will remain with B. The minimum price for which B is willing to give up the entitlement is $8,000, and the maximum that A is willing to pay to acquire it is $4,000. There’s nothing special about the figures in the table above. They are merely meant to illustrate the possibility that transactions might not take place even if transaction costs are zero because of the so-called “endowment effect” or “status quo bias.” How often do these sort of valuations occur to prevent resources from moving to their highest-valuing use? We have no idea. But the implication of the example is that it could happen and that we ought not, therefore, be excessively sanguine about the ability of bargaining to move resources to their highest-valued use. Nor should we be too eager to have courts (or other legal decisionmakers) assign initial entitlements. We discuss some additional matters regarding the Coase Theorem at Web Note 4.1.

Cooter/Ulen • Law & Economics, Sixth Edition

◼

Property Rules and Liability Rules

Calabresi and Melamed argue that the best manner in which to protect an entitlement, once it has been assigned, is to determine the level of transaction costs between the entitlement holder and the potential infringer. If the level of transaction costs between them is low, then the law should use a property rule to protect the entitlement. If the level of transaction costs is high, then the court should perform a “hypothetical market transaction” and name a price (“compensatory money damages”) that the infringer must pay to the entitlement-holder. Be certain that you see the Web Note that mentions some additional recent scholarly work on this topic. We discuss this issue in much greater detail and with examples in the following text chapter. Additional Matters

In the University of Virginia’s “Libel Show,” the law faculty sings the following refrain to the students to the tune of Gilbert & Sullivan’s “Sweet Little Buttercup”: We don’t berate old Vilfredo Pareto; His great golden rule we obey. To get the solution, Ignore distribution, And that makes the world seem okay. In a paper presented at the 11th Annual Meeting of the European Association for Law and Economics, held in Leuven, Belgium, Professors Bouckaert and De Geest, of the Faculty of Law of the University of Ghent, said that French law recognizes the right to make a bordering wall common. Suppose I want to build a house, but in order to save the costs of one additional wall I would like to use your wall as one of my own. So, I go to you and ask whether you are willing to sell 50 percent of the property of the wall to me. If you do not agree with this transfer, then, under French law, I can oblige you to make the wall common. A judge will determine the price. Comment on the efficiency of this law. French law also obliges the owner of a house to compensate his neighbor for the costs that neighbor might have incurred in fixing the roof of the house after a storm while the owner was abroad. Comment on the efficiency of that law. The State of Wyoming declares all “wildlife” to be state property. Farmers are suing the State for damage done to crops by marauding elk. The farmers are suing under the theory that the state has “taken” private property (the crops) by not controlling state property (the elk). Construct an economic argument to support the farmers. Now construct an economic argument against the farmers.

Chapter 5 Topics in the Economics of Property Law The main order of business in this chapter is to elaborate the economic theory of property law of the previous chapter through the use of examples. Despite the emphasis on examples, we do attempt to develop some additional theory—such as that of intellectual property rights, inalienability, and governmental taking. Our emphasis in this chapter of the Instructor’s Manual will be on some additional examples, with occasional forays into the elucidation of the theoretical matters raised.

◼

Property Rights in Wild Animals

We mention the famous case of Pierson v. Post in Question 5.1. It is such a good discussion subject that we include here an excerpt from the decision. A hunter flushed a wild fox from hiding, and, while he was chasing it, the fox ran across the path of a bystander who shot and kept it. The question is, who owns the fox, the original hunter or the person who shot it? As was the case with fugitive natural gas, discussed briefly in the text, there are apparently two possible legal rules: 1.

A wild animal is not the property of anyone until reduced to actual possession by one who catches or kills it, or

A person who locates and pursues a wild animal with the intention of catching or killing it thereby acquires a right to it so long as there is a reasonable chance that his pursuit will succeed.

Here is the excerpt from the New York Court opinions: Pierson v. Post 2 Am. Dec. 264 (Supreme Court of New York, 1805). “. . . Post, being in possession of certain dogs and hounds under his command, did, ‘upon a certain wild and uninhabited, unpossessed and waste land, called the beach, find and start one of those noxious beasts called a fox,’ and whilst there hunting, chasing and pursuing the same with his dogs and hounds, and when in view thereof, Pierson, well knowing the fox was so hunted and pursued, did, in the sight of Post, to prevent his catching the same, kill and carry it off. A verdict having been rendered for [Post, who was] the plaintiff below. [Pierson appealed] . . . TOMPKINS, J . . . The question submitted by the counsel in this cause for our determination is, whether Lodowick Post, by the Pursuit with his hounds in the manner alleged in his declaration, acquired such a right to, or property in, the fox, as will sustain an action against Pierson for killing and taking him away? . . . It is admitted that a fox is a ferae naturae, and that property in such animals is acquired by occupancy only. These admissions narrow the discussion to the simple question of what acts amount to occupancy, applied to acquiring rights to wild animals? . . .

Cooter/Ulen • Law & Economics, Sixth Edition

If the first seeing, starting, or pursuing such animals, without having so wounded, circumvented or ensnared the animal, so as to deprive them of their natural liberty, and subject them to the control of their pursuer, should afford the basis of actions against others for intercepting and killing them, it would prove a fertile course of quarrels and litigation. However uncourteous or unkind the conduct of Pierson towards Post, in this instance, may have been, yet his act was productive of no injury or damage for which a legal remedy can be applied. We are of opinion the judgment below was erroneous, and ought to be reversed. [Justice Livingston now gives his dissenting opinion.] LIVINGSTON, J. My opinion differs from that of the court. . . . By the pleading it is admitted that a fox is a ‘wild and noxious beast.’ . . . His depredations on farmers and on barn yards have not been forgotten; and to put him to death wherever found, is allowed to be meritorious, and of public benefit. Hence it follows, that our decision should have in view the greatest possible encouragement to the destruction of an animal, so cunning and ruthless in his career. But who would keep a pack of hounds; or what gentleman, at the sound of the horn, and at peep of day, would mount his steed, and for hours together, sub jove frigido, or a vertical sun, pursue the windings of his wily quadruped, if, just as night came on, and his stratagems and strength were nearly exhausted, a saucy intruder, who had not shared in the honours or labours of the chase, were permitted to come in at the death, and bear away in triumph the object of pursuit? [W]e are at liberty to adopt one of the provisions just cited . . . that property in animalsferae naturae may be acquired without bodily touch or manucaption, provided the pursuer be within reach, or have a reasonable prospect (which certainly existed here) of taking, what he has thus discovered an intention of converting to his own use. Those who like to see a sophisticated economic discussion of Pierson v. Post and application of its principles to modern issues of the Internet should see Dhammika Dharmapala and Rohan Pitchford, “An Economic Analysis of ‘Riding to Hounds’: Pierson v. Post Revisited,” 18 J. L., Econ., & Org, 30 (2002).

◼

Owning Water

Water has always been one of the most valuable natural resources, but because it tends to run away, there have always been problems in defining and assigning property rights in water. Centuries ago in England the low density of population and the relative plenitude of water meant that disputes about the use of and ownership rights to water were infrequent. The leading uses of water were for the home and as the source of reservoirs to create controlled streams, called mill races, to turn water wheels. Such cases as arose usually were between a landowner and the owner of a mill regarding their respective rights of access to a stream or river. The general rule that the law established in resolving competing claims to water was that rights would be assigned based on priority in time (the rule of first possession) and that these rights would vest in the riparian owner, that is, in the person who owned the land on the bank of the river. The riparian owner’s principal right was to a flow of water past his land. This rule for initial assignment was supplemented by the restriction placed on the initial right-holder to use his water rights so as to cause no harm to others. Because the principal attribute of the water rights was a right to a flow, the implication was that it would be a violation of someone else’s rights for an upstream user to use the water that passed by his property in such a way as to harm downstream users with similar rights. The upstream user could not, therefore, divert so much of the water to his own use that the flow would be significantly diminished for those downstream.

Chapter 5

Topics in the Economics of Property Law 33

The English common law property rules governing water are known as the natural-flow theory and were accepted unchanged into the law of the early United States. However, in the nineteenth century this legal arrangement had to be altered. There were two reasons spurring the change: the first was the great increase in the demand for water as a source of power for industry and the second was the expansion of settlement in the United States into the relatively dry and sparsely populated West. The increase in the use of water as a source of power meant that the demands on the natural flow of a river frequently exceeded the supply. Indeed, it became necessary in some circumstances to alter the natural course or dimensions of the river in order to accommodate the demands of the industrial users. The law handled this change by, first, refining and applying to the new circumstances the principles of priority and of no-harmto-others and, second, by focusing not on the flow of the stream but rather on the use of that flow. Because it was the case that the demand for the use of the flow exceeded the supply, the courts had to discover some means of allocating this increasingly scarce resource. In the eastern United States, these issues were resolved by elaborating the natural flow theory of water rights that had been adopted from the English common law. One of the important American elaborations of the natural-flow theory was that the right of the riparian owner to use the water was limited to use on the riparian owner’s land. Thus, the riparian owner who had no intention of using the flow on his own land could not divert water in order to resell it to someone who was removed from the bank but desired to purchase access to the flow. The reason for this restriction was to prevent just the sort of unproductive, speculative ownership of riparian land that is likely to take place under a pure rule of first possession. An alternative theory of water rights appeared in the western United States and is now the predominant theory in this country. Under the reasonable-use theory, the riparian owner is entitled to use the water flow in any way that does not unreasonably interfere with the reasonable use of others. The differences between this theory and the natural-flow theory are subtle but important. They are as follows: 1.

Under the reasonable-use theory a riparian owner does not have a fundamental right to have the natural integrity of a body of water maintained.

A riparian owner whose rights are established under the reasonable-use theory may use those rights for either riparian or non-riparian uses so long as his use does not interfere with the reasonable use of others. There are no other proscriptions on the use of the water.

One owner may use all of the water in a stream or lake when others are making no use of it.

A riparian owner may transfer his rights to use to non-riparians, so long as his doing so does not interfere with the reasonable use of others.

Is there an underlying economic explanation that caused the reasonable-use theory to be attractive in the western United States but not in the eastern or southern United States or in England? In the West the land is arid, meaning that access to water for farming as well as for livestock was one of the most important attributes of land. In order for settlement to proceed, the law had to accommodate uses, such as irrigation, that were almost unknown in the much wetter sections of the country and that sometimes completely dried up the stream. The reasonable-use theory allowed the appropriation of water in ways that facilitated agricultural and industrial development of that region. The value of a body of water for other uses—for example, scenery—was virtually nil. Thus, the law had to change in order to reflect the different relative prices of the underlying factors of production. In the East and the South, as well as in England, a stream is an amenity that can add value to land even though it is not being used. Thus, in those regions there was an emphasis on preserving the natural flow and other amenities of a stream.

Cooter/Ulen • Law & Economics, Sixth Edition

◼ Intellectual Property When one stands back and tries to come to grips with the economic theory of information in order to determine the appropriate role of property law in leading to an efficient amount of information, one finds three competing hypotheses with very different public policy prescriptions: 1.

The standard theory, which holds that the market will underproduce information because of the problem of nonappropriability. To correct the problem of the suboptimal provision of information, the government should either produce and disseminate information itself, subsidize the private production of information, or grant special monopoly rights to creators of information.

The theory that the market will, unaided, produce the optimal amount of information because of the possibility of the original producer’s indirectly appropriating enough revenue to justify incurring the costs of producing information. The recommended public policy is not to intervene (beyond guaranteeing competitive conditions in the market for information).

The theory that competitive markets for information generate overproduction of information in the form of duplicative investment. The recommended public policy in this case is to restrict competition by, for example, assigning a monopoly right to a single producer of a particular type of information at a very early stage of production.

Clearly, not all three theories can be simultaneously true. Just as certainly, there are circumstances or different kinds of information for which only one theory is appropriate. To the extent that this is so, a policymaker who mistakenly assumes that there is only one kind of information and that there is, therefore, only one rule of property law for all markets in information will create inefficiencies, leading to the generation of the wrong amount and the wrong kinds of information. What is required and what the economics profession has not yet provided is a taxonomy of information so that we may decide which theory of information is appropriate to different kinds of information. Currently, we do not have such a taxonomy, and until one is produced, a policy of restricting competition among the producers of information is premature. If categories of information can be distinguished, then the appropriate public policy may be invoked to produce the socially optimal amounts of information. Since the publication of the third edition of Law and Economics in 1999 and the fourth edition in 2003, there has, perhaps, been more work on the law and economics of intellectual property than on any other topic covered in this book. We could not include a summary of all that material in our text; instead, we chose to stick to a discussion of the basics of the economics of intellectual property. But on our website we have included discussions of some interesting new topics in this area. And we will continue to update that site to incorporate new literature. Here is a very brief guide to some of those issues. 1.

One of the most interesting general developments in the scholarly writing on intellectual property is the increasing realization that real property (and property in chattels) is only a starting point for a discussion of IP. In the earlier editions of this book we pursued the analogy—common in the literature—that IP was just a form of property with a few small quirks, such as the time-delimited nature of IP rights. The newer literature is beginning to suggest that the analogy between IP and real property is far less exact than we previously thought. IP is a distinctive form of property with some special problems and issues. For what it is worth, we think that the clearest traditional analysis of IP (which stresses the nonrivalrous and inappropriable characteristics of information) applies most clearly to the instance of pharmaceuticals.

Chapter 5

Topics in the Economics of Property Law 35

For example, “property rules” are for protecting property. Invasions or trespass to real property are dealt with by means of damages for past infractions and an injunction against future invasions. And, following the analogy that IP is just an analogue of real property, the standard remedy for trespass on an IP interest is a property rule. (To quote Mark Lemley of Stanford, “Patent infringement is a strict liability offense.” There are almost no excuses for trespass on another’s patent. There is, in the United States, no “independent invention defense.” See the PowerPoint slides.) But Lemley and Weiser have indicated in an interesting article in the Texas Law Review that there are reasons. Ex post versus Ex ante reasons for protecting IP. The traditional argument for IP is that by providing a reward for successful invention, innovation, improvement, or creative or expressive work, society creates an ex ante incentive for investment in those activities. Recently, some scholars have stressed the great importance of having a large and growing body of inventive and creative work in the public domain. The thought is that almost all invention and expressive work are cumulative and, ultimately, derivative from the work of others. So, having a large public domain from which current inventors and creators can draw inspiration is important. Notice that this changes the emphasis in IP from creating enforceable rights as an ex antespur to a focus on the ex post reasons for having IP. See Mark A. Lemley, “Ex Ante Versus Ex Post Justifications for Intellectual Property,” 71 U. Chi. L. Rev. 129 (2004). Lemley recognizes the force of these ex post concerns but continues to believe that the creation of the ex ante incentives to invent and create is the central focus of IP law. In your class discussions of copyright, you might have discussions about the “fair use exception.” Explaining why that exception to the general principal that a user must get the permission of the copyright holder will demonstrate the power of transaction costs as an explanatory variable. Notice, however, that the transaction cost explanation may explain some parts of the “fair use” exception but not all. For example, we can imagine that educators and publishers would typically agree to a standardform agreement to let the educator use some of the copyrighted material without permission and at no cost; reviewers might only allow this contract if the reviewer agreed to provide a favorable review. And we readers and concert-goers don’t want only favorable reviews. We want honest reviews. As a policy matter, one of the most interesting issues of recent years has been the extension of the life of copyright terms from the “author’s life plus 50 years” to the “author’s life plus 70 years.” Here are two issues to discuss with regard to that extension: a. Do you think that this extension will increase the amount of creative or expressive work? Why or why not? The students must have some strong intuition or, better yet, empirical evidence that this extension will, in fact, increase the amount of copyrightable work. Shouldn’t the “optimal copyright life” be set to maximize the amount of creative and expressive work? If so, what happened prior to 1998 (the date of passage of the Sonny Bono Copyright Extension Act) to indicate that the term was suboptimal? b. Could there be an argument for getting rid of these periodic battles to extend copyright life in favor of creation of a regime of “infinitely renewable copyright”? Although Landes and Posner do not tell us what the term of the copyright should be, they are the source of the proposal. See William Landes and Richard A. Posner, “Indefinitely Renewable Copyright,” 70 U. Chi. L. Rev. 471 (2003). File Sharing. A great discussion can be had with your students on the issue of file sharing. Since about 1999 peer-to-peer (P2P) computer networks, such as Napster, have allowed computer users to share their music files with one another, usually without cost to either of them. Does that file sharing cause a decline in CD sales and thereby threaten the incentives for creators to engage in expressive activity? See Felix Oberholzer-Gee and Koleman Strumpf, “The Effect of File Sharing on Record Sales: An Empirical Analysis,” 115 J. Pol. Econ. 1 (2007). Be warned that that article is technical and beyond the ability of most undergraduates and law students to follow. One of our PowerPoint presentations has, however, a summary of the results. You’ll find more about some recent literature in the PowerPoint slides from Ulen’s classes that are available at the Instructor’s Resource Center. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

◼ More on Optimal Patent Life You can use the very general treatment of the optimal patent life in Figure 5.1 to raise some questions about how to determine the optimal patent life. Consider two extreme cases, one of which is a remarkably valuable invention, say, a cure for cancer, and the other of which is a minor improvement to an existing process. Distinguish the two by, for example, letting the marginal social costs of the inventions remain the same but letting their social benefits be dramatically different. Specifically, let that of the cancer cure be much higher than that of the minor improvement, at each point in time. The upshot of all this is that the optimal patent life for each of the two inventions—the point in time at which its marginal social benefit equals its marginal social cost—is very different. The general point to discuss is that a single 20-year patent life may not be the optimal social policy for balancing the social benefits of inventive activity against the social costs of limited access. Ideally, there would be a different patent life for each invention that would set a term for which the social benefits of that invention would be maximized. How could that be done? The United States has tried to do it with respect to the Orphan Drug Act. (See the slides on this Act in the PowerPoint presentation in the InstructorResourceCenter.) You might invite several students, for extra credit, to look up that Act (and its amendments) and report to the class on how that legislation addresses the sort of problem that arises in a patent system that allows only one term of protection. Another possible method of dealing with the problem of different optimal patent lives is to impose an annual renewal fee on patent-holders. If this fee could be set equal to the marginal social cost of continuing a patent for one more year, then, in general, the renewal fee would increase for each year of additional patent life. If the fee were not paid, the patent would be canceled. Presumably, the patent-holder would pay the fee in the early years of his patent because the (private) benefits from continuing his patent would exceed the renewal fee (or social cost). But as the renewal fee increased and the private benefits of extending the patent one more year decreased, there would come a point beyond which it would be better for the patent-holder to discontinue paying the fee because the benefit to him of the monopoly right would have fallen below the annual renewal fee. If the fee had been calculated correctly, then this discontinuance would occur at t, the socially optimal patent life. In Germany, where an annual-renewal-fee policy is in force, the annual fee is relatively modest for the first several years of a patent’s life but thereafter escalates at regular intervals until the patent period is exhausted. The result of the German renewal-fee system is that fewer than 5 percent of German patents remain in force for their entire term, the average patent life being a little less than eight years. Thus, the renewal-fee system reduces the social cost of patent monopolies. In addition, it has apparently had no adverse effect on inventive activity in Germany. A fascinating topic for class discussion is the issue of the clash between intellectual property rights protection and the demands of public health in the developing countries. Here is a brief summary of the issue. Pharmaceutical companies in the developing world invest vast sums of money—$500 million per new drug—to research and develop new pharmaceuticals. And after they have done so, they must recoup the costs of research and development plus a competitive profit within the limitations of patent life (20 years from the date of filing). (The effective patent life for drugs may be far less than 20 years because of the regulatory requirements on safety and effectiveness.) For some of those new drugs the patient population is so small (see Web Note 5.3) that the price that each patient must pay per year is very, very high. Drug treatment for AIDS, for example—what is called ART, antiretroviral treatment—costs approximately $10,000 per year. That is a large sum of money to a patient in the developed world. But think how astronomical that sum must seem to patients in, say, sub-Saharan Africa. There the percentage of the population that is HIV positive is often as high as 33 percent, while the average annual income is $500 or less. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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In those circumstances—where there is a drug treatment that will ease the patients’ sufferings but is unaffordable—there is a very strong temptation to pirate the drugs, not paying the legitimate manufacturers’ price but either illegitimately copying the drug oneself or buying illegitimate copies from other countries. And that is precisely what is happening. Sub-Saharan Africa does not have a drug industry capable of manufacturing illegitimate ART copies, but India does. And so Indian manufacturers are selling (or will sell) those illegitimate copies to patients in southern Africa for less than $300 per year’s treatment. What can or should be done about this? How can the world protect the incentive to develop new drugs by enforcing intellectual property interests of the pharmaceutical companies and yet see to it that the drugs are priced reasonably for those who need them? There is an excellent article by Professor Alan O. Sykes that you should see (“TRIPS, Pharmaceuticals, Developing Countries, and the Doha ‘Solution,” 3 Chi. J. Int’l. L.47 (2002)). The World Trade Organization members recently (late-August 2003) reached an agreement on this matter that we summarize on our website. A related topic for discussion, one that we treat at Web Note 5.3, is the issue of Orphan Drugs. This concerns special patent treatment for pharmaceuticals whose patient population is so small that, in the absence of special governmental efforts, profit-maximizing drug companies will ignore.

◼

A Dissenting View of the Economics of Copyright

Recall that our survey of the economic theory of information in the previous chapter revealed that there are alternatives to the standard theory’s perception that most information is a public good. One of those alternatives holds that some information is such that competition will lead to “too much” information, not too little as the standard theory holds. We discussed that alternative theory in the context of possibly duplicative research into a cure for cancer. Another alternative to the standard theory holds that some information is sufficiently private—that is, appropriable—that the unregulated market will produce an efficient amount of it. We discussed this theory in the context of an invention of a weather-forecasting technique. Professor (now Justice) Stephen Breyer has argued that this latter theory comes close to describing the market for many original artistic creations currently protected by copyright. The benefits of creative activity are, he argues, generally appropriable by means of private contracts among creators, book publishers, and the consuming public. Thus, even in the absence of special legal treatment, there will be a socially optimal amount of creative activity. And, as we have seen, this creative activity rarely confers monopoly power. Professor Breyer concludes that because the unregulated market for creative output is not as inefficient as the standard theory of information indicates, the case for having special copyright protection to induce creative activity and for extending that protection to new types of creative activity is weak.1 Professor Breyer’s interesting analysis is worth looking at more closely. He focuses on book publishers (not authors) and asks if it is true, as the standard economic theory argues, that in the absence of copyright there will be an inefficiently small number of books published. Recall from the standard theory that one of the difficulties in a market for information is that a consumer of the information becomes a rival to the original disseminator. Because the rival’s costs of transmitting the information are so low, he can almost always undercut the original disseminator. As applied to book publishing, this analysis predicts that the original publisher of a book could always be undercut by another, illegitimate publisher. This other publisher who copies the legitimately published work does not incur the fixed costs of discovering and editing the author’s work, cutting plates, making corrections, and so on; instead, he can produce the book for the relatively low cost of photographing the pages of the original and distributing it. In fact, actual estimates suggest that a copying publisher’s costs will be about one-third lower than the original publisher’s. Because his costs are lower, the copying publisher can market the book at a lower price than the original publisher. This much seems to confirm the standard theory. 1

Stephen Breyer, The Uneasy Case for Copyright: A Study of Copyright in Books, Photocopies, and Computer Programs, 84 HARV. L. REV. 281 (1970). But see, also, Barry W. Tyerman, The Economic Rationale for Copyright Protection of Published Books: A Reply to Professor Breyer, 18 UCLA L. REV. 1100 (1971).

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However, Professor Breyer points out that the original publisher has countervailing advantages that may more than offset the cost advantages of the copier. One of these countervailing advantages is lead time: the original publisher’s product reaches the market first. This advantage is meaningful only for certain types of books. For instance, those books that must make a profit in their first few months on the market or not at all (which is the case, Professor Breyer suggests, for novels and general nonfiction books) give the original publisher a large lead-time advantage that may overcome a copier’s cost advantage. Moreover, the more rapidly a copier attempts to cut this lead-time advantage by rushing his copies to market, the more likely he is to incur higher production costs and thus to reduce his cost advantage. For those books for which there is not much of a lead-time advantage—Professor Breyer gives college textbooks as an example— the copier’s cost advantage cannot be so easily overcome. A second countervailing advantage that the original publisher may have is that of retaliation. At a minimum, the original publisher can match the copier’s lower retail price, and this action reduces the incentive to copy. But additionally, the original publisher may have better quality reproduction, a better distribution network, and the ability to claim his as the authorized edition (for whatever that is worth). Taken together, these retaliatory actions may offset a copier’s cost advantages. There is much more to Professor Breyer’s economic analysis of the case for copyright. For example, he discusses whether private contractual arrangements between book consumers (organized in buying clubs) and book publishers might further reduce the copying publisher’s profits. He asks if a policy of using general tax revenues to subsidize book publishers might not be a more efficient method of correcting for the small inefficiencies of the market for books than is the system of granting copyright. Professor Breyer concludes that there is a case to be made for copyright protection of books (and other original creations) but that the case is not as strong as the standard theory makes out and that, as a result, the protections granted by copyright law need not be as extensive as they currently are.

◼ Droid de Suite: The California Resale Royalties Act Many European countries supplement an artist’s copyright protection with a droit de suite. This right entitles the artist to a fixed percentage of the sale price of her work whenever it changes hands. California, the home of many artists, is the only state in the United States that has a droit de suite: the California Resale Royalties Act [Cal. Civ. Code Sec. 986 (1976); amended in 1982]. The Act entitles an artist to a 5 percent royalty on the sale price of her work each time it is sold, excluding the initial sale. No royalty is given if the gross sale price is less than $1,000. If she is not paid, the artist may bring an action for damages. However, the action must be brought within three years of the date of sale or one year after the artist’s discovery of the sale, whichever is later. In the original Act no royalty was due for any resale after the artist’s death. But in the Amendment of 1982, the rights of the artist were to continue and inure to the benefit of her heirs, legatees, and a few others until the 20th anniversary of her death. In general, this right to royalties is not transferable to others and inures only to the benefit of her heirs, legatees, and certain other transferees. The reasons that are given for granting this right to royalties upon resale are several. First, the right would seem to put fine artists on an equal footing with authors. Copyright affords the right to control reproductions of one’s work, and this allows an author or graphic artist or composer to participate in the proceeds from every new sale or re-issue of his work. But a fine artist’s work is rarely reproduced; indeed, much of its value comes from its being unique. In the absence of a droit de suite, the artist’s only opportunity to participate in the value of her work is at its initial sale. By granting her the right to participate in resale, the artist is put in the same position as authors and composers.

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It was also argued that the droit de suite would encourage artistic activity. Many artists sell their first works at relatively low prices because they are unknown talents. If the value of those works appreciates later, then the benefit inures to the current owners of that early work rather than to the artist. The classic example of this phenomenon is Vincent Van Gogh (1853–1890), who is today considered a great painter but is said to have sold only one painting during his life. If artists were allowed to participate in this increase in the value of their work, then, in the absence of a droit de suite, they would stick to their creative activity rather than try some more lucrative but nonartistic employment. The economic issues raised by the droit de suite are fascinating. To take but one such issue, it may be doubted whether the Act really encourages creative activity. This is because of the fact that without the Act an artist can already participate in the appreciation of the value of his work. Typically, an artist keeps an inventory of his work on hand so that if his work catches on and its value rises, he may participate in this increase by selling other works from his inventory. Alternatively, the artist can simply produce more original work after her talent becomes known. In fact, it is possible that these actions accomplish the same end as that intended by the droit de suite. If so, then a persuasive case has not been made for that legislation. Indeed, to the extent that artists indirectly participate in the increase in the value of their previous work by keeping inventories and by increasing their later output, legislation like the California Resale Royalties Act introduces inefficiencies into the market for artistic activity. (Can you see how?)

◼ More on Trademarks and Servicemarks Trademarks have their origin in the markings that ancient craftsmen placed on their work. The clear intention was to establish in the consumer’s mind a connection between a particular craftsman’s work and its high quality. It must have been obvious at an early date that unscrupulous traders could imitate the marks of established craftsmen in an effort to capture some of their market without having incurred the costs of establishing themselves as the makers of high quality merchandise. This practice was known as palming off. In an effort to minimize its adverse effects, both the common law and statutes from as early as the 13th century in England provided protection for trademarks. Although there was a robust common law of trade- and servicemarks, in 1870 Congress for the first time provided guidelines for general trademark registration and enforcement. That act was held to be unconstitutional in 1879 (United States v. Steffens, 100 U.S. 82—called The Trademark Cases) because it did not limit the federal registration to goods in interstate or foreign commerce, the only areas of commerce that the Constitution allowed Congress to oversee. Those cases also noted that, unlike patent and copyright, there is no Constitutional provision for federal protection of trademarks. Modern trademark law stems from the Federal Trademark Act of 1946, commonly called the Lanham Act. That Act defines “trademark,” “servicemark,” and other important categories of commercial symbols and provides a method for obtaining federal registration for those marks. (Note, however, that one does not have to register a mark in order to receive a property right in that mark.) As in the case of patents, the applicant must establish that the mark passes certain criteria, the most important of which is distinctiveness, before the registration is approved. That registration with the U.S. Trademark Office entitles the holder to certain protections and rights, among which is the privilege of placing beside one’s trademark a sign, ®, that indicates a registered trademark.2

Some producers place the symbol TM or SM (for servicemark) on their products, but those symbols have no legal status.

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We have already identified the principal economic justification for granting property rights to trade- and servicemarks: they lower consumer search costs and create an incentive for producers to invest in producing distinctive, quality output. Can we make the same economic argument for limiting the duration of the property rights in trademarks as we did in the case of patents and copyrights? The answer is no. Trademarks, unlike the other forms of intellectual property, are not good for a fixed term but forever. The registered owner can transfer his rights (subject to an important restriction you will explore in a question below), and those rights, like those in tangible assets such as land, are good until abandoned.3 What is it about trademarks that argues against imposing a time limit on them? Remember that with regard to other forms of intellectual property there was a legitimate fear of social costs’ increasing the longer the property right was enforceable. Limits on the duration of patents and copyrights were justified by an attempt to minimize the social costs of tracing and of monopoly. By contrast, trademarks almost never confer monopoly power, nor do they involve substantial tracing costs. Trade- and servicemarks are valuable in distinguishing the output of particular producers. Presumably that value is directly related to the number of producers there are in the market. A monopolist has little need to distinguish her output. As to tracing costs, the commercial nature of trademarks and servicemarks makes their use open and obvious. Who may legitimately use the mark is ascertainable at reasonably low cost. To see how widespread this phenomenon is, consider the following list of names that were once trademarks but have since become generic product names.4 The former trademark is given in capital letters, and the former generic product name is given in parentheses: ASPIRIN (acetyl salicylic acid) BRASSIERE (women’s bust support) CELLOPHANE (transparent cellulose sheets and film) COLA (type of soft drink) EASTER BASKET (Easter floral bouquet) ESCALATOR (moving stairway) HOAGIE (type of sandwich) LIGHT BEER (beer light in body and taste) MONOPOLY (real estate trading game) MONTESSORI (educational method and toys used for this method) POCKET BOOK (paperback books) SHREDDED WHEAT (baked wheat biscuit) SUPER GLUE (rapid-setting cyanoacrylate adhesive) THE PILL (oral birth control contraceptive) THERMOS (vacuum-insulated bottle) TRAMPOLINE (rebound tumbling equipment) YO-YO (return top toy) The other side of this coin is the following list, which gives trademarks that have been challenged as being generic but were held to be valid trademarks: COKE (cola beverage) DICTAPHONE (dictating machines) LEVI’S (denim pants) POLAROID (light-polarizing materials) TEFLON (nonstick resin coating) THE UNCOLA (noncola soft drink) 3

See generally William Landes and Richard A. Posner, “Trademark Law: An Economic Perspective,” 30 J. LAW & ECON. 265 (1987).

The lists come from J. Thomas McCarthy, Trademarks and Unfair Competition 533-37 (2d ed. 1984).

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◼ Bequests and Inheritances A good discussion topic is the difference between the marginal private and social costs of imposing posthumous conditions on the disposition of one’s property. As an exercise, particularly for law students, you should ask students to show you how, using the graph in the text, you could illustrate the difference between these private and social costs and how that difference makes a case for public intervention into the private decision to encumber property after death. The private costs can be considerable. Provision must be made for the many contingencies that can arise after the testator's death to frustrate his desires. For example, one of the beneficiaries might die childless, or it could be that selling hamburgers becomes illegal because they are found at some future date to be seriously carcinogenic. The document imposing the posthumous conditions must note as many of these contingencies as possible and must specify what is to be done if each of these contingencies comes to pass. Clearly, the longer the conditions are to be imposed, the more the contingencies that must be dealt with. As a result, the private costs of drafting a document that covers these contingencies increase with each year for which the conditions are to be met. As a result, the private marginal costs of encumbrances should slope upward. There are also social costs of imposing conditions on the future disposition and use of property. These social costs have two parts. First are the efficient opportunities for the use of the property that must be foregone because of the decedent’s restriction, such as the surplus a buyer would have enjoyed if the will had not prevented sale of the property. Second is the possibility that the restriction on use imposed by a dead property owner may come to violate changing conceptions of social justice for which the testator made no provision. For example, suppose that a landowner in 1850 left land to the city in which he lived on the condition that the land be used only as a city park from which blacks and other minorities were to be excluded. Continuing to honor this testator’s wish would clearly do a grave injustice and thereby impose substantial social costs. Like private costs, these marginal social costs increase the longer the restriction is to be imposed. Thus, marginal social costs of encumbrances should also slope upward over time. Ask also if there are private and social benefits to allowing a property owner to restrict the use of his property in the future. The purely private component of the benefits of being able to impose posthumous conditions on one’s property is the satisfaction that the property owner enjoys during his lifetime from knowing that the conditions will be honored. Perhaps that satisfaction increases with each year that the restrictions on use are to be in place, but eventually the marginal benefit from an additional year of restriction declines. In order to be enjoyed during the testator’s lifetime, these benefits must be discounted back to present value. And the more remote the time period beyond death from which this discounting is done, the less that present value will be. Therefore, the private component of encumbrances declines over time. The social benefit of a restriction on the future use of the decedent’s property is the satisfaction that other property owners enjoy from observing that the restrictions that someone else has placed on the use of his property after his death are being honored. As a result of observing this, other property owners presumably use their property more efficiently. By contrast, if they saw decedents’ conditions being flouted, they would be inclined to use up their property during their lifetime or in other ways make inefficient decisions about their property. Like the private component, the marginal value of this social component presumably declines with each additional year of restriction. Thus, both the private and social marginal benefits from increasing the length of time of a property restriction decline over time.

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Generally speaking, a property owner wishes to impose conditions on the use of her property for a longer period than is socially desirable. From the testator’s point of view the (private) costs and (private) benefits of imposing posthumous conditions need to be balanced. (Assume for the sake of argument that private and social marginal benefit are equal.) In fact, following the usual rule for determining an optimum, the testator will impose a time limit of tP on her posthumous conditions. That is the period for which the net private benefit of the restriction is maximized, or, equivalently, the period for which the marginal cost of providing for one more year of the condition’s holding equals the marginal benefit of having that condition adhered to. But the testator reaches this conclusion by ignoring the social costs her restriction may impose. If she could be induced to take those social costs into account, then the term for which her conditions would run is tS, which is less than tP.

◼

Some Additional Questions on Bequests and Inheritances

Consider the following bequests: “To my dog Fifi I leave all my land.” Or, “It is my wish that the trustee should burn the house in which our family lived as soon as the last of us is dead.” How can these instructions be set aside by law? What is the economic rationale for setting them aside? A trust is created with a life-beneficiary and a remainderman (someone who takes possession of what is left of the trust when the life-beneficiary dies). If the trust’s asset is wasted during the tenancy of the lifebeneficiary, should the remainderman be able to sue the trustee for breach of fiduciary duty?

◼ Conflicting Property Interests Here are some additional thoughts on Boomer: In our initial comparison of the two types of damages above, we referred to the fact that they differ in their ability to deal with changing sensitivities and identities of those affected by the cement company’s pollution. To illustrate, suppose that shortly after the nuisance is resolved by an award of permanent damages, Mr. Boomer and some of the neighbors independently decide to take their share of the judgment and move to Florida. They put their houses up for sale, and new people buy them and move in. If the new homeowners awake to discover the smoke, noise, dirt, and vibration from the cement company, can they maintain a nuisance action? The answer is no, for sound economic reasons. Recall that the majority’s opinion in Boomer insisted that the payment of permanent damages was compensation to the plaintiffs for the imposition of a servitude on their land. In this context this servitude means that those who have received part of the permanent damages agree to insert a notice into their deeds of title acknowledging the fact that they have been compensated for the cement company’s pollution at the specified level. The economic purpose of this servitude is to internalize the external costs of the cement company’s pollution into home prices once and for all. Thus, the new homeowners are on notice (because of the recital of the servitude in their title deeds) that there is a pollution problem, and they will make their decisions about home-buying with that information in mind. For example, they will discount the amount they are willing to pay for homes close to the Atlantic Cement Company to reflect the disutility they expect from the cement plant’s operation. One way of putting this is to say that the new homeowners have already been compensated for the externality because of the lower prices they pay for the homes near the cement plant. And because they have already received this compensation, it would be inefficient to allow them to seek compensation from the cement company again. In following this economic argument, the law would dismiss the new homeowner’s nuisance action on the grounds that they had “come to the nuisance.” The new homeowners knew or should have known what they were getting into. To carry forward some of these ideas, we mention the Spur case in the text. It is such a good teaching tool that you may find it good for the law-and-economics moot court or as a test question. We have also put this edited version on the website. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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Spur Industries, Inc. v. Del E. Webb Development Co. 494 P.2d 701 (Ariz. 1972) CAMERON, Vice Chief Justice. From a judgment permanently enjoining the defendant, Spur Industries, Inc. from operating a cattle feedlot near the plaintiff Del E. Webb Development Company’s Sun City, Spur appeals. . . . [W]e feel that it is necessary to answer only two questions. They are: 1.

Where the operation of a business, such as a cattle feedlot, is lawful in the first instance, but becomes a nuisance by reason of a nearby residential area, may the feedlot operation be enjoined in an action brought by the developer of the residential area?

Assuming that the nuisance may be enjoined, may the developer of a completely new town or urban area in a previously agricultural area be required to indemnify the operator of the feedlot who must move or cease operation because of the presence of the residential area created by the developer?

The area in question is located in Maricopa County, Arizona, some 14 to 15 miles west of the urban area of Phoenix. In 1956, Spur’s predecessors in interest, H. Marion Welborn and the Northside Hay Mill and Trading Company, developed feedlots, about one-half mile south of Olive Avenue. . . . The area is well suited for cattle feeding and in 1959, there were 25 cattle feeding pens or dairy operations within a 7-mile radius of the location developed by Spur’s predecessors. . . . In May of 1959, Del Webb began to plan the development of an urban area to be known as Sun City. For this purpose, the Marinette and the Santa Fe Ranches, some 20,000 acres of farmland, were purchased for $15,000,000 or $750 per acre. This price was considerably less than the price of land located near the urban area of Phoenix. . . . By September 1959, Del Webb had started construction of a golf course south of Grand Avenue, and Spur’s predecessors had started to level ground for more feedlot area. In 1960, Spur purchased the property in question and began a rebuilding and expansion program extending both to the north and south of the original facilities. . . . Accompanied by an extensive advertising campaign, homes were first offered by Del Webb in January 1960, and the first unit to be completed was south of Grand Avenue and approximately 2½ miles north of Spur. By 2 May 1960, there were 450 to 500 houses completed or under construction. At this time, Del Webb did not consider odors from the Spur pens a problem, and Del Webb continued to develop in a southerly direction, until sales resistance became so great that the parcels were difficult if not impossible to sell. . . . By December 1967, Del Webb’s property had extended south to Olive Avenue, and Spur was within 500 feet of Olive Avenue to the north . . . Del Webb filed its original complaint alleging that in excess of 1,300 lots in the southwest portion were unfit for development for sale as residential lots because of the operation of the Spur feedlot. Del Webb’s suit complained that the Spur feeding operation was a public nuisance because of the flies and the odor which were drifting or being blown by the prevailing south to north wind over the southern portion of Sun City. At the time of the suit, Spur was feeding between 20,000 and 30,000 head of cattle, and the facts amply support the finding of the trial court that the feed pens had become a nuisance to the people who resided in the southern part of Del Webb’s development. The testimony indicated that cattle in a commercial feedlot will produce 35 to 40 pounds of wet manure per day, per head, or over a million pounds of wet manure per day for 30,000 head of cattle, and that despite the admittedly good feedlot management and good housekeeping practices by Spur, the resulting odor and flies produced an annoying if not unhealthy situation as far as the senior citizens of southern Sun City were concerned. There is no doubt that some of the citizens of Sun City were unable to enjoy the outdoor living that Del Webb had advertised and that Del

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Webb was faced with sales resistance from prospective purchasers as well as strong and persistent complaints from the people who had purchased homes in that area. [The court next discusses the difference between a public and a private nuisance. It says that the former threatens to harm the general public while the latter threatens to harm only easily identifiable individuals. The court asserts that a private nuisance can be adequately dealt with through the payment of money damages but that a public nuisance, for which the total harm is much greater, is subject to an injunction. The trial court had held that Spur’s feedlot had become a public nuisance, and the Arizona Supreme Court agreed. The court next discusses whether Spur should be exonerated from being a public nuisance because Webb “came to the nuisance.”] In the so-called “coming to the nuisance” cases, the courts have held that the residential landowner may not have relief if he knowingly came into a neighborhood reserved for industrial or agricultural endeavors and has been damaged thereby. [In Dill v. Excel Packing Company, 183 Kan. 513 (1958), the Kansas Supreme Court said,] “People employed in a city who build their homes in suburban areas of the county beyond the limits of a city and zoning regulations do so for a reason. Some do so to avoid the high taxation rate imposed by cities, or to avoid special assessments for street, sewer and water projects. They usually build on improved or hard surface highways, which have been built either at state or county expense and thereby avoid special assessments for these improvements. It may be the case that they desire to get away from the congestion of traffic, smoke, noise, foul air and the many other annoyances of city life. But with all these advantages in going beyond the area which is zoned and restricted to protect them in their homes, they must be prepared to take disadvantages.” Were Webb the only party injured, we would feel justified in holding that the doctrine of “coming to the nuisance” would have been a bar to the relief asked by Webb, and, on the other hand, had Spur located the feedlot near the outskirts of a city and had the city grown toward the feedlot, Spur would have to suffer the cost of abating the nuisance as to those people locating within the growth pattern of the expanding city. . . . There was no indication in the instant case at the time Spur and its predecessors located in western Maricopa County that a new city would spring up, full-blown, alongside the feeding operation and that the developer of that city would ask the court to order Spur to move because of the new city. Spur is required to move not because of any wrongdoing on the part of Spur, but because of a proper and legitimate regard of the courts for the rights and interests of the public. Del Webb, on the other hand, is entitled to the relief prayed for (a permanent injunction), not because Webb is blameless, but because of the damage to the people who have been encouraged to purchase houses in Sun City. It does not equitably or logically follow, however, that Webb, being entitled to the injunction, is then free of any liability to Spur if Webb has in fact been the cause of the damage Spur has sustained. It does not seem harsh to require a developer, who has taken advantage of the lower land values in a rural area as well as the availability of large tracts of land on which to build and develop a new town or city in the area, to indemnify those who are forced to leave as a result. Having brought people to the nuisance to the foreseeable detriment of Spur, Webb must indemnify Spur for a reasonable amount of the cost of moving or shutting down. It should be noted that this relief to Spur is limited to a case wherein a developer has, with foreseeability, brought into a previously agricultural or industrial area the population which makes necessary the granting of an injunction against a lawful business and for which the business has no adequate relief. It is therefore the decision of this court that the matter be remanded to the trial court for a hearing upon the damages sustained by the defendant Spur as a reasonable and direct result of the granting of the permanent injunction.

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Questions

In reaching its conclusion the Supreme Court of Arizona made much of the distinction between a public and a private nuisance. The court said that for a private nuisance, where the injury is to only a few individuals, a payment of money damages would adequately deal with the situation. But when a large number of people are involved, so that the nuisance is public, the Court says that the appropriate course is to enjoin the nuisance. Explain what is wrong with the Court’s view.

What is the economic interpretation of the defense of “coming to the nuisance”? Could it be said that Webb, by paying less for the property, was already compensated for the nuisance because the land values reflected the disamenity of the nearby feedlots?

Suppose that the price Webb paid for the land was not lower than the price of comparable land that was free from the stench. Could you argue that Webb knew or should have known about the nuisance so that whether the price of land was lower is irrelevant to resolving this dispute?

Would the result of this dispute have been less efficient if the court had excused Spur on the grounds that Webb had come to the nuisance? If the court had resolved the dispute in that way, what, if any, bargaining might have taken place among the parties afterward? In terms of the Calabresi-Melamed theory of protecting entitlements by property rules or liability rules, who would have received the entitlement and would that entitlement have been protected by a property rule or a liability rule?

How might the behavior of other nuisance-creators be affected by this decision? Would those nuisance-creators behave differently if the court had dismissed Webb’s suit?

Was a cooperative solution to the nuisance possible between Spur and Webb? Between Spur and the residents of Sun City?

If the case against Spur had been dismissed on “coming to the nuisance” grounds, do you think that the residents of Sun City would have had a cause of action against Del Webb? On what grounds?

Suppose that the case against Spur had been dismissed on “coming to the nuisance” grounds. And suppose that Spur had remained where they were and had continued to operate a cattle feedlot. Now suppose that ten years later, the Surgeon General of the United State has announced that persistent exposure to odor and flies is carcinogenic. Several of the residents of Sun City have developed cancer during that ten-year period and can make a plausible claim that the nearby cattle feedlots are responsible. Do the residents now have a cause of action against the feedlot? Is the feedlot now a public nuisance? Use the economic theory of remedies to suggest how a new suit by the residents against Spur can most efficiently be resolved.

◼ Taking and Governmental Regulation We used the following case in the first edition of the text. Many students and instructors found this a very useful way to understand the economic arguments about governmental taking. This excerpt (and some additional material on the case—such as the fact that although the property was taken and the homes and churches and businesses of a part of Poletown destroyed, GM moved its plant out of state anyway) is also available on our website.

Cooter/Ulen • Law & Economics, Sixth Edition

Poletown Neighborhood Council v. City of Detroit, 304 N.W.2d 455, 410 Mich. 616 (1981) PER CURIAM. This case raises a question of paramount importance to the future welfare of this state and its residents: Can a municipality use the power of eminent domain granted to it by the Economic Development Corporations Act . . . to condemn property for transfer to a private corporation to build a plant to promote industry and commerce, thereby adding jobs and taxes to the economic base of the municipality and state? . . . The Economic Development Corporations Act is a part of the comprehensive legislation dealing with planning, housing and zoning whereby the State of Michigan is attempting to provide for the general health, safety, and welfare through alleviating unemployment, providing economic assistance to industry, assisting the rehabilitation of blighted areas, and fostering urban redevelopment. . . . To further the objectives of this act, the legislature has authorized municipalities to acquire property by condemnation in order to provide industrial and commercial sites and the means of transfer from the municipality to private users. What plaintiffs-appellants do challenge is the constitutionality of using the power of eminent domain to condemn one person’s property to convey it to another private person in order to bolster the economy. They argue that whatever incidental benefit may accrue to the public, assembling land to General Motors’ specifications for conveyance to General Motors for its uncontrolled use in profit making is really a taking for private use and not a public use because General Motors is the primary beneficiary of the condemnation. The defendant-appellees contend, on the other hand, that the controlling public purpose in taking this land is to create an industrial site which will be used to alleviate and prevent conditions of unemployment and fiscal distress. The fact that it will be conveyed to and ultimately used by a private manufacturer does not defeat this predominant public purpose. . . . The power of eminent domain is to be used in this instance primarily to accomplish the essential public purposes of alleviating unemployment and revitalizing the economic base of the community. The benefit to a private interest is merely incidental. . . . If the public benefit was not so clear and significant, we would hesitate to sanction approval of such a project. RYAN, Justice (dissenting). This is more than an example of a hard case making bad law [;] it is, in the last analysis, good faith but unwarranted judicial imprimatur upon government action taken under the policy of the end justifying the means. . . . It was, of course, evident to all interested observers that the removal by General Motors of its Cadillac manufacturing operations to a more favorable economic climate would mean the loss to Detroit of at least 6,000 jobs as well as the concomitant loss of literally thousands of allied and supporting automotive design, manufacture, and sales functions. There would necessarily follow, as a result, the loss of millions of dollars in real estate and income tax revenues. [General Motors had announced its intention to close the plant and move to the South unless the site of the Cadillac plant could be significantly improved. GM asked the City of Detroit to make extensive improvements to the freeways, streets, sewers, and other aspects of the site. If those changes were made, GM said that it would keep the Cadillac plant open. The cost of the acquisition of the property and of making these improvements was over $200 million. The City intended to sell the site to General Motors for $8 million.] Faced with the unacceptable prospect of losing two automotive plants and the jobs that go with them, the city chose to march in fast lock-step with General Motors to carve a “green field” out of an urban setting which ultimately required sweeping away a tightly-knit residential enclave of first- and second-generation Americans, for many of whom their home was their most valuable and cherished asset and their stable ethnic neighborhood the unchanging symbol of the security and quality of their lives. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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It is plain, of course, that condemnation of property for transfer to private corporations is not wholly proscribed. For many years, and probably since the date of Michigan’s statehood, an exception to the general rule has been recognized. The exception, which for ease of reference might be denominated the instrumentality of commerce exception, has permitted condemnation for the establishment or improvement of the avenues of commerce—highways, railroads, and canals, for example. . . . It cannot for an instant be maintained, however, nor has anyone suggested, that the case before us falls within the instrumentality of commerce exception. . . . It may be argued, however, that the fact that the case before us lies outside the exception does not end the inquiry if the reasons justifying the existing exception are present here. I turn now to determine whether such reasons exist. Examination of the cases involving the instrumentality of commerce exceptions reveal[s] that three common elements appear in those decisions that go far toward explicating and justifying the use of eminent domain for private corporations: 1) public necessity of the extreme sort, 2) continuing accountability to the public, and 3) selection of land according to facts of independent public significance. . . . With regard to highways, railroads, canals, and other instrumentalities of commerce, it takes little imagination to recognize that without eminent domain these essential improvements, all of which require particular configurations of property—narrow and generally straight ribbons of land—would be “otherwise impracticable”; they would not exist at all. . . . [I]t could hardly be contended that the existence of the automotive industry or the construction of a new General Motors assembly plant requires the use of eminent domain. . . . One of the reasons advanced by the defendants as justification of the taking in this case, and adopted by the majority, is the claim of alleviation of unemployment. Even assuming, arguendo, that employment per se is a “necessity of the extreme sort,” there are no guarantees from General Motors about employment levels at the new assembly plant. . . . But the fact of the matter is that once [the Central Industrial Park or CIP] is sold to General Motors, there will be no public control whatsoever over the management, or operation, or conduct of the plant to be built there. . . . The level of employment at the new GM plant will be determined by private corporate managers primarily with reference, not to the rate of regional unemployment, but to profit. With this case the Court has subordinated a constitutional right to private corporate interests. As demolition of existing structures on the future plant site goes forward, the best that can be hoped for, jurisprudentially, is that the precedential value of this case will be lost in the accumulating rubble.

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Questions

Would you characterize what the City of Detroit intends to do with this land as being the provision of a public good?

Justice Ryan describes the area where the taking is to occur as a “tightly-knit residential enclave of first- and second-generation Americans, for many of whom their home was their most valuable and cherished asset and their stable ethnic neighborhood the unchanging symbol of the security and quality of their lives.” If this description is accurate, does it raise any special efficiency concerns about the government’s taking this property at fair market value? Specifically, is there a particular problem here in undercompensating the residents of Poletown for their large subjective valuation on their homes and community?

Cooter/Ulen • Law & Economics, Sixth Edition

Consider this case as an extension of Boomer, where transaction costs blocked bargaining over a public nuisance. The courts stepped in to move the entitlement to the party whose use was, presumably, more valuable. Is that what is really going on in Poletown? The bargaining costs between GM and the neighbors are so high that, even if the valuation of GM’s desire to use their property were greater than the valuation on the neighbors’ desire to remain where they were, no bargain could have been struck. What the court is sanctioning here is a hypothetical market transaction that would have taken place but for the level of transaction costs. Evaluate this interpretation of Poletown.

There is no question that maximizing employment and minimizing the social dislocation of unemployment when an employer leaves town is a legitimate and worthy governmental goal. What other policies were available to the City of Detroit in pursuing this goal? How else, other than by taking this property, might the City have assisted General Motors to remain in Detroit?

How would you have financed these alternative policies? Would using general tax revenues from all over Detroit or all over Michigan to purchase the neighbors’ property at their reservation prices have been more equitable than taking at fair market value?

What adverse economic incentives might this decision create for future business organizations thinking of leaving Michigan? What adverse economic incentives might it create for municipal governments in Michigan?

Be sure to note that (as we mention in the Web Notes) the Michigan Supreme Court overturned Poletown in County of Wayne v. Hathcock, 684 N.W. 2d 765 (Mich. 2004). Here is an excerpt and some questions about the most famous regulatory takings case. This excerpt, too, may be found on our website. Pennsylvania Coal Co. v. Mahon 260 U.S. 393, 43 S.C. 158, 67 L.Ed. 322 (1922). [Mahon was a property owner whose surface structure was in danger of subsiding because of the subsurface coalmining of the Pennsylvania Coal Company. In 1878 a previous owner of Mahon’s property had sold the Coal Company the right to mine coal under the property, retaining for himself and for subsequent owners the surface and other rights. The company claimed that Mahon bought the property knowing that the coal company had the right to subsurface mining and that he, therefore, willingly assumed the risk that structures on the surface might subside and waived all claims to damages that might occur. After Mahon bought the property the legislature of Pennsylvania in 1921 passed the Kohler Act, which forbade “the mining of anthracite coal in such way as to cause the subsidence of, among other things, any structure used as a human habitation,” unless the structure was the property of the owner of the underlying coal and was more than 150 feet from the improved property of someone else. Relying on that act, Mahon sued the coal company to have the subsurface mining halted. The Pennsylvania Coal Company contended that the statute destroyed its property right to mine under Mahon’s property and asked that it be compensated for this lost property. The court below refused to compensate the Coal Company, and it appealed to the Supreme Court of the United States.] MR. JUSTICE HOLMES. Government hardly could go on if to some extent values incident to property could not be diminished without paying for every such change in the general law. As long recognized, some values are enjoyed under an implied limitation and must yield to the police power. But obviously the implied limitation must have its limits, or the contract and due process clauses are gone. One fact for consideration in determining such limits is the extent of the diminution. When it reaches a certain magnitude, in most if not in all cases there must be an exercise of eminent domain and compensation to sustain the act. So the question depends upon the particular facts. The greatest weight is given to the judgment of the legislature, but it always is open to interested parties to contend that the legislature has gone beyond its constitutional power. … ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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What makes the right to mine coal valuable is that it can be exercised with profit. To make it commercially impracticable to mine certain coal has very nearly the same effect for constitutional purposes as appropriating or destroying it. This we think that we are warranted in assuming that the statute does. . . . The general rule at least is, that while property may be regulated to a certain extent, if regulation goes too far it will be recognized as a taking. It may be doubted how far exceptional cases, like the blowing up of a house to stop a conflagration, go. . . . We are in danger of forgetting that a strong public desire to improve the public condition is not enough to warrant achieving the desire by a shorter cut than the constitutional way of paying for the change. As we already said, this is a question of degree—and therefore cannot be disposed of by general propositions. . . . But the question at bottom is upon whom the loss of the changes desired should fall. So far as private persons or communities have seen fit to take the risk of acquiring only surface rights, we cannot see that the fact that their risk has become a danger warrants the giving to them greater rights than they bought. Decree reversed. MR. JUSTICE BRANDEIS, dissenting. Coal in place is land; and the right of the owner to use his land is not absolute. He may not so use it as to create a public nuisance; and uses once harmless, may, owing to changed conditions, seriously threaten the public welfare. Whenever they do, the legislature has power to prohibit such uses without paying compensation; and the power to prohibit extends alike to the manner, the character and the purpose of the use. . . . Every restriction upon the use of property imposed in the exercise of the police power deprives the owner of some right theretofore enjoyed, and is, in that sense, an abridgment by the States of rights in property without making compensation. But restriction imposed to protect the public health, safety or morals from dangers threatened is not a taking. The restriction here in question is merely the prohibition of a noxious use. The property so restricted remains in the possession of its owner. The State does not appropriate it or make any use of it. The State merely prevents the owner from making a use which interferes with paramount rights of the public. . . .

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Questions

What precisely is the rule proposed by Holmes?

If you had to advise a governmental body or private owner, would you tell him that a 30 percent decline in value was sufficient to constitute a taking? Or would it need to be 70 percent? Is it possible that there is no precise answer? Might this ambiguity introduce inefficient incentives into the behavior of governments and of private owners? If so, would a flat rule about the decline in value that will trigger compensation—for example, a 60 percent reduction in value—minimize those inefficiencies?

How is the reduction in value to be determined? Suppose that a site purchased for the construction of a nuclear power plant can no longer be used for that purpose because the government promulgates a regulation forbidding the construction of nuclear power plants on earthquake fault lines. How much value has the owner lost? What contribution can the concept of “opportunity cost” make?

Cooter/Ulen • Law & Economics, Sixth Edition

Justice Brandeis’ position is, in essence, that to require compensation for property losses that follow from legitimate regulation would reduce the government’s incentive to regulate public nuisances. He says, “If by mining anthracite coal the owner would necessarily unloose poisonous gases, I suppose no one would doubt the power of the State to prevent that mining, without buying his coal fields. And why may not the State, likewise, without paying compensation, prohibit one from digging so deep or excavating so near the surface as to expose the community to like dangers? In the latter case, as in the former, carrying on the business would be a public nuisance.” Is this an apt analogy? Be certain to read the background material on this case from William Fischel’s Regulatory Takings on our website.

◼ Final Thoughts There is some additional material on the website about the possibility of a market in transplantable organs—supplementing the box on that topic in the text. We have found that topic to be an excellent one to use to spur classroom discussion.

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Question

Smith has just moved to a large city to take a job. He has found an affordable apartment. But he is having difficulty finding a reasonably priced storage space for his pride and joy—a very valuable antique automobile that he owns. Smith works on his car every chance he gets, including most weekends. For that reason he would very much like to have his car stored in a secure place near his new apartment. (The apartment complex does not have a secure parking area.) However, the only place that he has been able to find is a 30-minute bus ride away. He’s not happy with this situation, but it seems to be the best he can do. One afternoon while out jogging Smith goes by a very large estate located not far from his apartment. Over the course of the next several days he examines the estate more closely and observes that there is a garage on the edge of the property with a very short drive that opens onto the street. He peers into the garage and sees that there is nothing there. If only he could rent this garage and place his antique car there, his problems would be over. Smith inquires in the neighborhood and learns that the owner of the estate is a single, older man named Jones. He has almost nothing to do with people in the neighborhood, preferring to keep to himself. So, Smith approaches Jones and offers to rent his garage. Jones summarily refuses. Smith offers a higher price. Jones angrily says that the property is not for rent and slams the door. There can be no further negotiation. Smith is disappointed, but he’s not one to give up easily. On his runs he notices that the garage remains empty and that the doors to the garage have only a very light padlock on them. Suppose that Smith breaks into the garage and stores his antique car there, replacing the flimsy padlock with a more secure one. And suppose that he gets away with this trespass undetected by Jones for several months. Eventually, Smith is discovered to be using Jones’ property without his consent. Jones, through his lawyer, brings an action against Smith and asks for compensation for Smith’s previous, and unauthorized use of his garage. You can explore this situation with the students, getting most of them to see that here the reason for the failure to transact is that there is no cooperative surplus. It cannot be that the transaction costs are high: there are only two people involved, and the scope of the contemplated transaction is simple. So, Smith’s argument, although it sounds as if it might be sophisticated, is wrong. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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But you can push the students even further. Ask them how they would feel about this situation if the reason that Jones refuses to rent to Smith is that Jones is a racist and dislikes people of Smith’s race. Many students respond that racism means that the transaction costs are high. But does it? Might it not be better to reserve the category of transaction costs for the situations we’ve imagined—many people, a complex transaction, the passage of time, difficult-to-define attributes of the resource, and so on—and explain racism as something different? Might it not be better to say that a racist appears to derive utility or well-being from failing to transact with certain people? And why shouldn’t Jones be allowed to derive utility or well-being from that source? These issues can lead to remarkably instructive classroom discussions.

Chapter 6 An Economic Theory of Tort Law The economic analysis of tort liability is one of the greatest topics with which to capture the interest of the students. There are several reasons for this. First, for law students the economic analysis is so obviously and clearly at variance with the standard doctrinal analysis with which they are familiar that this topic may teach them more about the entire field of law and economics than anything else in the semester. For instance, the standard doctrinal course focuses on cases in which there has been an injury, and the central issue is who ought to pay for it. Law professors help the students mine the principles of corrective justice to see if there are organizing ideas for deciding who should bear liability for accidental injuries. By contrast, the economic focus is not on what to do after an accident has occurred but rather on what rules for apportioning liability ought to be so as to induce pre-accident precaution that will minimize the likelihood and severity of accidents. Second, the material may serve to illustrate some earlier points that have been made. For instance, one of the principles that we stress in the text is that transaction costs prevent parties from reaching a deal with all potential injurers or all potential victims about who should take care or pay for an accident if one should occur. Notice that tort law is all about affecting behavior “behind a veil of ignorance”—specifically, ignorance about whether you will be injured or an injurer. Third, this may be the first time during the semester in which the law students have to wrestle with graphs. (For those of you teaching economics and business students, you may have been using graphs and mathematical tools all along. Bear with us.) Law students get a little twitchy when we start putting equations and graphs on the board, but in dealing with this subject they ought to welcome it. The underlying logic of the argument is much clearer because of the mathematical presentation than it would be if merely made verbally. An investment on the law students’ part in trying to become comfortable with the graphical treatment of the economics of tort liability is well worth their time. You can facilitate this learning by asking the students to do some exercises based on the graphs. For instance, you might ask them to indicate the effects on the social optimum level of care of a change in technology that lowers the perunit cost of precaution or of an advance in medical technology that makes treatment of injuries more effective. You might also ask them if they can use the graphs to indicate the effect on precaution-taking of the courts’ getting the damages calculation wrong or of only a fraction of the victims’ suing those who injured them. An additional point that you might wish to make in discussing negligence and strict liability is this: why would the law ever hold out the possibility (as does negligence) that a wrongdoer will not be held liable for the harm that he has caused? This, we think, is the central question that any theory that compares negligence and strict liability must answer. And the answer, we believe, for negligence’s holding out the possibility of exonerating a wrongdoer is that it is the only conceivable way to induce the potential victim to take care, too. For many accidents the ex ante identity of victim and injurer is not at all clear. Consider automobile accidents. One simply does not know which role he will take when the next accident occurs. In view of that uncertainty as to role, strict liability simply will not work. Only negligence will induce both potential participants in an accident to take care.

Chapter 6

An Economic Theory of Tort Law

What is frequently troubling to the students about this view is that if they have not thought of negligence in this way before, how will the great mill run of people who know next to nothing about the law be affected appropriately by a rule about which they know nothing? This is a good question, one that we first raised in Chapter 1. If law is a device for inducing people to behave in a socially optimal (or at least, acceptable) manner but people do not know what the law is, how can law have its desired effect?

◼ Changes in the Level of the Legal Duty of Care Suppose that you have walked the students through the graphical analysis of the various changes that can occur if the price of precaution changes or the technology of precaution leads to lower expected accident costs. A very revealing discussion question is this. Suppose that the legal duty of care is set at x, which is equal to the social-cost-minimizing level of care. Now, suppose that the technology of precaution improves or the cost of precaution falls so that the social-cost-minimizing level of care increases from x to, say, x+. There may be a danger that potential injurers will continue to adhere to x, instead of increasing their levels of precaution to x+. Are there forces that will induce potential injurers to increase their level of care to the new optimum? Would one’s lawyer have to advise one to increase one’s precaution? Why or why not? Would there be a competitive advantage to those firms that increased their precaution to the new level? Must a court hear a new dispute in order to be induced to raise the level of care, or do parties do this in anticipation of what the court might do? Can industries be relied upon to set industry safety standards that increase when the precaution technology improves or when the cost of precaution falls? Our experience, amazingly, is that law students have never thought very much about their advisory role. That is, they know what the law teaches them about doctrine, but they have not so clearly grasped that there are implications of what we are saying in this chapter for their role as counselors. The students may think that only a court, legislature, or administrative agency can change the legal standard of care. True in a sense. But ask them to work through what would happen if a new technology comes into play that, if adopted, would lower the expected accident losses and the likelihood of an accident occurring. If you were the lawyer for a manufacturer and such a superior precautionary device became available, would you advise your client to adopt it?

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Activity Levels

One of the most important but difficult ideas to convey to students in a short time is the idea of the activitylevel effect in accidents. The idea is that there are some activities—such as automobile driving and serving restaurant meals—in which there is an independent positive effect on the probability of harm arising from the quantity of the underlying activity in which the potential tortfeasor is engaging. To give a stark example, if you do not drive a car, then there is a zero probability that you will injure someone in an automobile accident. However, the more miles you drive, the more likely it is that you will injure (or be injured by) someone. The efficiency idea involved is that negligence does not take appropriate account of the activity-level effect but that strict liability does. The reason is that negligence simply establishes a list of identifiable behaviors, compliance with which will exonerate the decisionmaker. But the activity-level effect does not—some say that it could not—figure into a negligence calculation. By contrast, strict liability simply delegates to the potential wrongdoer the responsibility for minimizing the costs of accidents in whatever manner he is able. Because the responsibility for accident losses lies entirely on the wrongdoer and because there is no way in which to escape that responsibility (there being no exonerating level of care), the potential tortfeasor subject to strict liability has every incentive to find every means he can of reducing his expected accident costs. If there is an activity-level effect, he has an incentive to discover it and to take it into account in determining how much of the underlying activity to do. For that reason, strict liability is superior to negligence as a means of getting potential tortfeasors to take account of activity levels. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

We give a brief summary of the article (“The Accident Externality from Driving” from the Journal of Political Economy) by Professor Aaron Edlin and Pinar Karaca-Mandic in which they calculated the cost of ignoring the activity-level effect in automobile driving.

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Error Costs

The law-and-economics literature’s finding is that the circumstances in which negligence and strict liability are appropriate are different. There are other factors mentioned in the text, but the central one is that negligence is more appropriate for situations of bilateral precaution and strict liability for situations of unilateral precaution. The matching, on the ground of efficiency, of liability standards with certain types of accidents raises the interesting question of legal error. What if tort law uses an inappropriate standard? That is, what if the law seeks to determine liability according to a negligence standard when it should have used a strict liability standard or according to a strict liability standard when it should have used a negligence standard? This could happen simply through inattention or because a court, even one well informed in economics, was not sure whether a particular accident type was one of bilateral or unilateral precaution. In that latter case the court should presumably want to know what costs it might be imposing on future parties and society if it guesses wrong. Consideration of these possibilities can make for an interesting class discussion or moot court problem or exam question. Consider the case in which the law inappropriately uses strict liability when it should, if it were pursuing only efficiency, have used negligence. If the potential parties know that the court will make this mistake (which they may not know), there may be inefficient consequences. Potential injurers will know that there is nothing that they can do to evade liability, but, as we have seen in the text, this fact alone should not cause inefficiency. Potential injurers will take the same amount of precaution whether the liability standard is negligence or strict liability. But potential victims will recognize that they will not bear residual liability, even though there are actions they can take to reduce the probability or severity of this accident. What are the results of the fact that potential victims will fail to take precautionary actions? Some scholars have suggested that modern products liability law is an example of this particular error—namely, using strict liability where some form of negligence is more appropriate. Now consider the other possible error—the law uses negligence where it should have used strict liability. This might occur where there is, say, unilateral precaution—only the potential injurer can realistically take action to reduce the probability or severity of an accident. Potential injurers will take the exonerating level of care and thereby escape liability, shifting the responsibility for the accident losses onto potential victims. Those victims cannot, by assumption, take precautionary actions to reduce this residual liability. They must simply bear those losses. One might argue that this is not necessarily inefficient in the sense that there will not be a greater likelihood of accidents, nor will those that occur be any more severe than they would have been had the liability standard been correct. But there may be a distributive injustice. What if potential victims could purchase first-party insurance? How would they respond to this legal error? Will the common law process be able to correct this legal error? Does anyone involved in the process (lawyers for potential injurers and potential victims, potential victims and injurers themselves, common law judges, appellate judges) have an incentive to correct this legal error? Or will it take action outside the common law process to set this right? What if we invoke the possibility that potential victims could approach the legislature to set this injustice straight? There are other issues that discussion can develop: whether the inefficiency of the misuse of strict liability can somehow be corrected by imposing duties on potential victims, whether societal efficiency or compensation of victims is the more desirable goal, whether the flawed decisionmaking noted early in Chapter 9 would alter any of these conclusions, and so on. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 6

An Economic Theory of Tort Law

◼ Rules and Standards The distinction between negligence liability and strict liability illustrates a recurring theme in the law—that between a standard and a rule. (We now have, in the fifth edition, a box on this issue. But here we want to extend that material.) Negligence or fault is a standard: “behave reasonably,” with the determination of what is “reasonable” to be made on a case-by-case basis. A standard delegates a great deal of discretion to the decisionmaker and requires him or her to make a guess as to what the court will deem to be acceptable (or exonerating behavior). It also puts a burden on the parties, if there is an accident and a trial, of presenting facts to a court to establish whether the behavior prior to the accident was reasonable. In Chapter 9 we suggest that this uncertainty about how a court will evaluate the decisionmaker’s behavior may induce risk-averse parties to take more precaution than is strictly necessary to minimize accident costs. In contrast, a rule establishes a much brighter and clearer guideline (a “bright-line rule”) as to the duties of the parties. An example is a posted speed limit. A rule tends to have two virtues. First, it relieves the decisionmaker whose behavior the law seeks to affect of having to guess about what the law will deem appropriate. A rule economizes on the decisionmaker’s knowledge requirements. She knows what the law expects of her, and, therefore, her ability to comply with that requirement should not be much in question. Second, a rule makes it much easier for legal decisionmakers (courts or other governmental agents) to evaluate whether parties have complied with the law. The question before the legal decisionmaker is not whether the parties’ behavior reasonable but whether it was within the bounds set by the rule. (Of course, there is the question that the legal decisionmaker may have to evaluate whether the rule was appropriate. Although that is a complicating question, it is one that can be ignored for the moment.) A good discussion question for getting at this issue is automobile speed limits. Why do these tend to be rules rather than standards? In 1995 the federal government abolished the 55-miles-per-hour speed limit that it had imposed on the states in an attempt to save oil consumption and to reduce traffic fatalities. In addition, the federal government allowed the states to choose their own speed limits for federal highways within the state boundaries.1 Until the summer of 1999 every state but one in the United States had posted speed limits. The exception was Montana, which had a standard. During the daylight hours Montana, which is very sparsely populated, had a standard that said “drive at a speed that is reasonable under the circumstances.” Only at night did Montana revert to a rule. In mid-1999 Montana decided to replace its standard with a rule—that is, with a posted speed limit. One explanation that was given was that police did not have any idea how to enforce the standard. When should they stop a car? How should they present a complaint to the court about noncompliance with the standard? You might discuss in class what predictions the class would make about the difference between Montana’s experience under a standard and those of comparable states that had a rule. You might also discuss what changes, if any, they would predict to occur in Montana after its switch to a rule. Would there be a change in the average speed driven? In the number of accidents? In the number of tickets given? In the number of tickets contested? And so on. This issue is related to the topic of this chapter in the sense that negligence is clearly a standard and strict liability is much more like a rule. (Extending the idea even further, a governmental regulation—an ex ante safety regulation—is clearly a rule.) You might ask the class to evaluate the economic arguments for the different liability standards in light of this bigger question of rules versus standards. 1

The National Highway Traffic Safety Administration estimated that there would be an additional 6,400 deaths per year because of the higher speeds. That estimate turned out to be wrong. 1997 was the lowest rate of automobile traffic accidents and of deaths in U.S. history. Since 1995 21 states have raised their maximum speed limit to 65 mph; 17 have gone to 70 mph; and 10, to 75 mph. Most highway fatalities occur at speeds of 45 mph or less. See Eric Peters, “Highways Are Safe at Any Speed,” Wall Street Journal, Nov. 24, 1998.

Cooter/Ulen • Law & Economics, Sixth Edition

Another good discussion question regarding rules and standards is whether the abilities and sophistication of the judiciary ought to influence the form of a legal command. Judge Posner once made an argument to this effect with respect to the evolution of legal commands as a country develops. The gist of the contention was this: when a country is relatively poor and has relatively poor governmental institutions, rules are to be preferred to standards. The reason is that the governmental institutions, such as the judiciary, are probably staffed by talented but unsophisticated people and the legal profession in the country may be at an early stage of sophistication, too. In those circumstances, compliance with rules is much easier than compliance with standards because the informational burden on all parties of standard-based law are so much greater. There are many other good issues that you and the students can explore using this distinction between a rule and a standard. The difference is one that, like that between property rules and liability rules, runs across many areas of the law. So, please bear it in mind when reviewing property and contract and as you go through the remaining chapters of the book.

Chapter 7 Topics in the Economics of Tort Liability This chapter looks at extensions of the material that Chapter 6 introduced. The focus is on new topics to which the theory of the previous chapter may be applied. In previous editions we included case studies of products liability and medical malpractice as a means of demonstrating the importance of looking at empirical work in a complete assessment of the efficiency of the tort liability system. We have moved some of that material to our website. In this edition of the text we have significantly updated the empirical material that was in earlier editions. In addition, we mention at the end of this chapter of the Instructor’s Manual some other empirical work that we very highly recommend that you read and discuss with the class.

◼ Relaxing the Assumptions of the Basic Model The first topic that we discuss is the relaxation of some of the simplifying assumptions that we made to develop the economic theory of tort liability. For example, we had assumed that there was no insurance. As the text explains, this turns out not to be a distorting assumption: when relaxed, so that potential injurers have liability insurance and potential victims have medical and disability insurance, the conclusions of the simple model still hold. This would be a great point at which to ask the students to discuss subrogation, the practice by which the insurer agrees to stand in the shoes of the insured party in the event that the insured has a legal claim. Suppose that A’s insurance policy with the XYZ Insurance Company contains a subrogation clause. Suppose that A is injured in an accident by B. The XYZ Insurance Co., following the subrogation clause, may compensate A for his injuries and then proceed against B for indemnification. Is subrogation efficient? One of the most important arguments in this regard is to note the possibly distorting effect that insurance has—the plaintiff may be disinclined to sue because he or she has already received compensation from his or her insurance company. That would make the injurer less likely to take care in the future because he had not had to compensate those whom he injured. But if the plaintiff’s insurance company proceeds against the injurer (or her insurance company), then the incentives to take care are maintained. Note that when we relax the assumption of zero litigation costs, matters do become a little bit more complicated because costly litigation points in different directions for potential injurers and potential victims. How might that impact the situation where a potential precaution-taker does not know whether he will injure or be injured? One of the most troubling topics—one with which traditional legal scholarship has only glancingly dealt— is the appropriate relationship between tort liability and administrative agency regulation. This is frequently discussed as the distinction between ex post safety regulation (tort liability) and ex ante safety regulation (administrative agency). (This is a potentially confusing topic for the students. Even though we refer to tort liability as a method of ex post safety regulation and even though tort liability is invoked only after an accident takes place, our take on tort liability [as we emphasized at the beginning of Chapter 8’s entry in this manual] is that it works by inducing people to take care so as to minimize the social costs of accidents. One of the

Cooter/Ulen • Law & Economics, Sixth Edition

puzzling aspects of this view, if we were to try to measure it empirically, is that we would be eager to measure the accidents that did not happen, whereas the only evidence we’ve got is on accidents that did take place.) There is no clear, settled learning on the subject of the appropriate relationship between tort liability and administrative agency regulation. Among legal scholars there seems to be an unspoken feeling that whatever else the tort liability system does, it does not necessarily induce precaution against accidents. There are various reasons given for this view—among them that not every victim brings an action against her injurer and that the tort liability system is quirky in its compensation of victims who do bring actions (with some getting vast sums for seemingly trivial injuries, such as the famous McDonald’s coffee cup case). In light of these feelings, many legal scholars seem to prefer to minimize accident costs through governmental regulation—as, for example, that of the federal Consumer Product Safety Commission requiring that fireretardant material be used in children’s clothing. But there are problems with administrative agency regulation of safety, too. Administrative agencies are part of the political process (in a way that the courts are not or are but to a far lesser extent), and so, politics may taint the ability of the administrative agencies to accomplish their social goals. For example, it is often alleged that the agencies are sometimes captured by those they seek to regulate. (The capture can be subtle or blatant. If it is subtle, it could just be that the regulators and the regulated industries become familiar with and deferential to one another. For instance, the regulated industries could be the principal source of information for the agency, and if the agency comes to believe in the completeness and accuracy of the information provided to them, then they may defer to the regulated industries on many more matters than those having to do with information submission. But the connection could be blatant. The regulated industries may be eager to employ former regulators—at far higher salaries than the regulators made in their governmental employment. If so, then regulators may be eager to preserve those future employment options by treating the regulated industries very gently while they are regulators. Federal and state laws recognize these possibilities and through conflict-of-interest laws make it difficult for regulators to be hired by firms they once regulated.) Here is the discussion question: should Congress make compliance with federal regulations a complete defense in product-related accidents? Many producers’ groups have tried to get Congress to pass legislation to that effect in the 1990s, but, thus far, they have not been successful. One view of the issue is that the political process that generates administrative agency safety regulations is subject to inefficiency-producing pressures leading to standards for precaution that are too low. By contrast, tort liability is inexact in its ability to signal to potential victims and injurers what precaution to take because such a small fraction of those who are injured actually bring an action against their injurers. Allowing both systems to work together—that is, allowing private causes of action even when there is a safety standard—may serve to correct the shortcomings that either system would have if it were to work alone.

◼ Damages There is a relatively short section on the topic of computing compensatory money damages for tortious injury. The text discusses the risk-equivalence method of computation and a particular method of computing punitive damages. There are several excellent discussion topics surrounding the issues of computing damages. One has to do with computation of damages for harms to nonmarket values. (We discuss this very briefly with respect to the loss of life.) This issue has arisen most forcefully with respect to environmental damages— as in the Exxon Valdez case. (For an excellent discussion of the facts in that case, see Bruce Owen et al., The Economics of a Disaster (1995).) There were some damages in that disaster to clearly identifiable interests, such as resort owners and commercial fishermen, but there were substantial injuries to the “environment”— i.e., to wildlife populations, scenery, the amenity of public beaches, and so on. Because those interests are ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 7

Topics in the Economics of Tort Liability

not easily represented in a civil action, there needs to be some clever ways of seeing to it that wrongdoers face these nonmarket damages. (Clearly, unless tortfeasors incorporate these damages into their cost considerations they will take too little precaution.) The technique that is gaining the most currency for computing damages for nonmarket values is “contingent valuation.” The technique involves sophisticated methods of discovering the price that people would be willing to attach to nontraded resources, such as air quality and scenic views. (There is a superb description of the strengths and weaknesses of contingent valuation in Paul Portney, “The Contingent Valuation Debate: Why Economists Should Care,” 8 J. Econ. Persp. 3 (1994).) You might ask someone in the class to read the Portney article and give the class a brief report. Or you might base a law-and-economics moot court problem around the issue of damages to a nontraded good. In addition to discussing contingent valuation, you might discuss punitive damages. In a recent Georgetown Law Journal article, Professor W. Kip Viscusi of Harvard Law School argued for the abolition of punitive damages, particularly with respect to environmental and toxic harms, but the argument seems to apply with equal force to all torts. And you should supplement the material in the text with a reading of a recent article by Jonathan Karpoff and John R. Lott, Jr. in the Journal of Law and Economics on punitive damages. They study nearly 2,000 lawsuits in which plaintiffs sought punitive damages from publicly traded companies and find that there is an adverse impact on share values of those (and other) companies that follows an announcement of punitive damages awards. You should also take a look at Cass Sunstein, Reid Hastie, John W. Payne, David A. Schkade, and W. Kip Viscusi, Punitive Damages: How Juries Decide (2002). We also highly recommend Jonathan Harr, A Civil Action, as supplemental reading for this section of the course. The book has been made into an enjoyable movie starring John Travolta.

◼

Empirical Work on the Deterrent Effect of Exposure to Tort Liability

We have made an attempt in this chapter to bring some empirical work to bear on the theoretical issues raised in Chapter 8. There is an increasing amount of empirical work about the social-cost-minimizing aspects of tort liability, and we review some of that toward the end of the chapter. Students do not need to be adept at statistics and econometrics to read that material. Here let us take just a moment to point out the very grave problems that exist in doing empirical work designed to demonstrate the deterrent effect of tort law. (This is precisely the same problem that will exist with respect to showing the deterrent effect of criminal sanctions.) If fear of liability or of bearing the costs of accidents induces potential victims and injurers respectively to take care, then there are accidents that might have taken place that do not take place or the accidents that do occur are less severe than they would otherwise be. It is extremely difficult to measure either of these quantities—either the accidents that did not occur or the degree to which those that did occur were less severe than they could have been. (Even though there are great difficulties in measuring these quantities, we all have a sense that, to a degree, some accidents are not going to take place because of fear of liability. We all rely upon the deterrent aspect of tort law in walking on designated footpaths rather than in the street.) The most accessible introduction to the empirical literature on tort liability is Gary T. Schwartz, Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter?, 42 UCLA L. REV. 377 (1994). Professor Schwartz reaches a cautious conclusion that tort liability deters wrongdoing but not as completely or as forcefully as one might have hoped.

Cooter/Ulen • Law & Economics, Sixth Edition

Another highly commendable empirical study of tort law is Dewees, Duff, and Trebilcock, Exploring the Domain of Accident Law (1996). These distinguished Canadian scholars look at evidence on automobile accidents, medical malpractice, product-related accidents, environmental harms, and workplace injuries to evaluate the extent to which tort law, administrative agency regulation, and criminal law achieve the goals of deterrence, distributive justice, and corrective justice. One point that these authors stress (and one that is well worth emphasizing to students) is that the tort law system does not work in a vacuum. Its strengths and weaknesses must be judged by comparison to the other social tools that society can bring to bear on the issue of the minimization of the social costs of accidents. There is a new section in the empirical summary at the end of the chapter on mass torts. That is a fascinating topic that strays into some of the areas—such as class actions—dealt with in the next chapter.

Chapter 8 An Economic Theory of Contract Law This may be the most challenging chapter in the text. One way of preparing the students for the material is to review the material in Chapter 2 on game theory. Here is a very effective way to introduce that subject. Imagine (or even play with the students) a game in which there are two players. Each player receives two cards—one saying “Give me $1”; the other saying, “Give my opponent $5.” Tell the players not to communicate with one another. They must choose one of the two cards and return it to you. You will then do what the cards instruct you to do. So, if Player 1 returns “Give me $1” and Player 2 returns “Give my opponent $5,” you will give Player 1 $6, and Player 2 will receive nothing. Let the students play the game or have them draw up the payoff matrix for the game. They should see that this is a prisoner’s dilemma game in which the players would do better to cooperate but are driven, by a dominant strategy, not to cooperate— that is, to play the “Give me $1” card. You might even let the students communicate so as to show that there may be defection (because “Give me $1” is still a dominant strategy). Finally, you might ask the students to think how players who recognize that a game is a prisoner’s dilemma might change the payoffs so as to induce themselves to cooperate. Familiarity with game theory—perhaps through this introductory game—will greatly enhance the students’ understanding of the chapter. A central theme of the chapter is the extent to which the law can help to solve the coordination problem between potential contracting parties. They may want to make mutually beneficial promises that bind themselves to certain actions and induce reliance by the other party, but, in the absence of an inexpensive method of allowing parties to make a credible commitment, it may not be easy to achieve this commitment and reliance. Another important theme of the chapter is that the law can assist parties to form these consensual agreements by providing a set of default and mandatory rules that greatly reduce the costs of achieving an agreement. This distinction between default rules and mandatory rules is very useful and a rich explanatory tool. When you come to examine the set of rules that constitute contract law, be sure to ask the students if each of them is a default rule or a mandatory rule. Note that there are two general kinds of default rules—majoritarian and penalty. Majoritarian are the starting points that most people would want. By denominating those as the default rules, the law saves most people the costs of changing to something more desirable. Rather, the minority who prefers some other arrangement to that of the default rule will have to incur the costs of contracting around the default. A penalty default is a default rule that will, unless changed, impose a penalty on one of the parties if he withholds pertinent information. Mandatory rules may not be changed, even by mutual consent. A principal justification for them is paternalism. A good example of a potential problem that mandatory rules create is the mandatory rule that (in almost all cases) minor children cannot make a binding contractual promise. (There is an exception that we will come to in a moment.) That means that not even a competent minor child can waive this rule. Why? The exception to the mandatory rule regarding minor children is that they can make binding promises with respect to necessities such as food, shelter, and clothing. Why should there be this exception?

Cooter/Ulen • Law & Economics, Sixth Edition

One last thing to bear in mind. Efficiency in contract law requires efficiency at three different stages of the contractual relationship: at the time the agreement is formed, during the time between formation and performance when the parties need to rely upon one another, and, finally, at the time that the parties must choose to perform or to breach. We find that one of the most challenging aspects of the theory presented in this chapter is the economic theory of reliance. That is, we believe, a very subtle and powerful theory.

◼

Additional Topics

Third-party effects are sometimes at issue when a commercial contract threatens harm to a business rival of one of the parties to the contract. Such a rival may be led to take action interfering with the performance of the contract. Such actions are often discussed under the doctrine of “inducement to breach.” Third-party effects of this sort also form part of what is known as an “economic tort.” A recent example comes from the world of professional sports. The professional baseball team in San Francisco, the Giants, plays their home games in a stadium, CandlestickPark, that is frequently cold and rainy, which discourages paying customers from coming to the games. The City of San Francisco owns Candlestick and has leased it to the Giants under a long-term contract. The Giants considered moving to a different city, which would involve breaching their lease with the City of San Francisco. For the Giants to move, three-quarters of the owners of National League baseball teams have to approve the change. The City Attorney of San Francisco wrote to all the other owners of National League baseball teams to tell them that if they voted to approve the Giants’ move from San Francisco, the City might sue them for inducement to breach the Candlestick lease. Another example comes from labor law. Unions wish to assist each other through “secondary boycotts.” To illustrate such a contract, the teamsters might promise to boycott any steel factory struck by the steel workers, and the steel workers might promise to boycott any trucking company struck by the teamsters. Even before secondary boycotts were forbidden by statute, the courts were reluctant to enforce such contracts that “derogate public policy.” Is this the right stance? Question: Suppose that a computer company exchanges the following letters with a potential client. On May 10 the computer company mails a “firm offer” to sell a particular machine to the client at a specified price. On May 11 the computer company sells the machine to someone else and mails a letter to the original client withdrawing the firm offer. On May 12 the original client receives the firm offer, decides to accept, and mails back his check. On May 13 the client receives the notice of withdrawal and sues the computer company, alleging breach of contract. Should the court interpret the “firm offer” as an enforceable promise? How would the bargain theory answer this question? When the offer was first made, would the parties—the computer company and the client—both want it to be enforceable?

◼

Gift Promises

To see the evidentiary argument against the enforceability of gift promises, we must return to the issue of consideration. Why did the classical theory require consideration as a necessary condition for the enforceability of a promise? It has been argued that consideration in and of itself is not really that important. Rather, its principal function is to serve as a reasonably reliable signal for distinguishing those promises that both parties want enforced from those that they do not. That is, consideration is a formal indicator of serious intent. Presumably, some other such indicator—say, a notary public’s seal or some public ritual— could serve the same distinguishing function just as well. How does this apply to the enforceability of gift promises? The argument is that there is no obvious formal indicator of serious intent on the part of the

Chapter 8

An Economic Theory of Contract Law

promisor who truly wants to give a gift in the future and to be bound to that promise. Thus, it is difficult for the law to distinguish between a donor who truly desires to be held to his desire to give a gift and one who is merely masquerading as a generous donor. We might characterize this argument in economic terms as saying that the costs of distinguishing between serious and nonserious gifts are so high that, in general, gift promises should not be enforceable, so as to save society the costs of drawing this distinction. But is this argument against the enforceability of promises to give a gift persuasive? No. The argument presumes, without proof, that the costs of drawing the distinction between gifts that the donor truly wants to make and those that he does not really want to make (but wishes to be seen as wanting to make) are high when, in fact, they may be trivial. Indeed, some legal systems have developed an inexpensive procedure for making the distinction. The continental civil law countries typically allow gift promises to be enforceable if they have been formalized by a notary public’s seal. A second argument that is sometimes made for nonenforceability of promises to give a gift is that the losses that result from nonenforceability are relatively slight. Because the resources of courts are scarce, they ought to be relieved of the burden of trying to distinguish good from bad gift promises so that they can focus their attention on more serious issues where the potential benefits are larger. Moreover, the argument continues, those donors who truly want to be bound to their promise to give a gift will find ways to formalize their intent—in essence, they will find a way to convert an unenforceable gift promise into an enforceable promise. (How might that be done?) The first part of this argument sounds a little hollow. There is no compelling reason to believe that the benefits that parties realize or anticipate from the completion of a promise to give a gift are trivial. Indeed, it is easy to imagine promises to give millions of dollars where the anticipated benefits to both donor and donee are immense. Additionally, the bargain theory does not reserve enforceability to those reciprocal promises for which the benefits are large. Rather, it argues for the routine enforcement of trivial bargains, just so long as they are bargains. If this justification for not enforcing gift promises were to be consistent, then we should also exclude from enforcement those bargain promises where the benefits are very small. A third argument for the general nonenforceability of gift promises is that those who promise gifts are frequently operating under an impulse that, upon reflection, they might wish to renounce. For example, the uncle who promised his nephew the trip might have done so in an ebullient mood at a family gathering; the alumna who promises to giver her alma mater a large sum of money might have done so in an emotional and vulnerable moment at a class reunion. Later, both donors might not wish to be held to these impulsive acts. The general nonenforceability of gift promises, the argument goes, protects parties from being held to complete impulsive acts. But, again, this argument does not seem persuasive. Bargains can also be impulsive, and yet we routinely enforce them whether impulsive or not. We are led to conclude that the rule proposed in §90 of the Restatement is a sound one. That is, the economic theory of contracts argues for the general enforceability of promises to give a gift where the donee reasonably relied to her detriment on the donor’s intention to fulfill the promise. Let us make one last economic argument for the enforceability of gift promises according to the rules of §90 of the Restatement. (See box below.) The argument is that enforceability according to those terms encourages efficient behavior by both donor and donee. Suppose, first, that gift promises are not, as under the bargain theory, enforceable. A donor who really wants to be taken seriously by a donee must incur extraordinary costs of convincing the donee of his intent to be bound so that the donee may rely upon his fulfilling the promise. For example, she might put the money she intends to give to the donee in the hands of a third party with irrevocable instructions to give it to the donee at some future date. These extra costs of giving a gift would not be necessary if the promise were enforceable. For his part, a donee who cannot be certain that a promise to give a gift is enforceable may not be able to take action in reliance upon the gift. The direct and indirect costs of this inability to rely may be substantial and constitute a further inefficiency of the nonenforceability of gift promises. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

Now suppose that all gift promises are enforceable. This, too, would be inefficient. Donors would be excessively careful about what they say—perhaps ending each statement with a disclaimer that they make no promise, express or implied. Donees might over-rely—that is, undertake too many or too expensive decisions in reliance upon the promise’s being performed. Neither of these extremes—never enforce or always enforce a gift promise—is efficient; each involves inefficiencies by donors or donees. The virtue of the enforceability criteria of § 90 of the Restatement is that they create efficient incentives for promising by donors and for reliance by donees. Those donors who would like to be taken seriously can do so without incurring extraordinary costs, and frivolous donors are discouraged. Those donees who would like to rely are encouraged to do so but only up to a reasonable amount, thus discouraging overreliance. Question: Can you argue that the §90 rule for the enforceability of gift promises efficiently allocates the risk of performance and nonperformance between the donor and the donee? What might be the effect of proposing general enforceability but not requiring that the donee detrimentally rely? Would you expect donees to over-rely on a gift promise, relative to what a donor wishes? The following problem and solutions are used with the permission of Professor Gillian Hadfield, now of the University of Southern California Gould School of Law. Efficient Breach Example Spud Co. is a dealer in potatoes. Chip Co. makes potato chips. On Monday, Spud and Chip enter into a contract in which Spud agrees to deliver 100 bushels of potatoes to Chip on Friday; Chip agrees to pay Spud $2.00 per bushel. Spud’s cost of growing and delivering potatoes = $100. Chip’s cost of converting potatoes into chips = $100, $25 of which must be spent on Friday morning before the potatoes are delivered and which cannot be recovered if no potatoes arrive. If no potatoes arrive on Friday, Chip must wait until Monday to call around to alternative suppliers to purchase potatoes. The price of potatoes on this “spot” market is $3.00 per bushel. The price of potato chips is $4.00 per bushel. Variation 1: Assume for this variation that Chip paid for the potatoes at the time the contract was signed. Just before delivering the potatoes to Chip at noon on Friday, Spud receives a frantic phone call from Babette, the chef at Chez Babette. She has discovered that the potatoes she bought from someone else are rotten and she needs 100 bushels immediately to make her famous vichyssoise (a fancy name for cold potato soup) that weekend. She is willing to pay $5.00 per bushel as she cannot wait till Monday to buy potatoes on the spot market. Is breach efficient? Under what measures of damages will efficient breach be achieved? Variation 1A: Same as 1 but Babette offers $3.00/bushel.

Chapter 8

An Economic Theory of Contract Law

Variation 2: Assume for this variation that Chip agreed to pay for the potatoes C.O.D. On Thursday, Chip is shut down for health code violations and will not be able to reopen for two months while it renovates its production facilities to bring them up to code. It therefore has no use for the potatoes to be delivered on Friday. If Chip performs by taking delivery of the potatoes, they will go to waste. If Chip breaches, it will refuse to accept delivery. Spud, as dealer, can sell the potatoes to someone else for $1.50 a bushel. Is breach efficient? Under what measures of damages will efficient breach be achieved? Efficient Precaution/Efficient Reliance Example Spud Co. v. Chip Co. continued Variation 3: This variation is the same as Variation (2), in which Chip Co. is shut down for health violations but now Spud Co. spends money in reliance on the contract. Suppose that Chip Co. is in a location that is hard to find. Of Spud’s delivery costs, $10 is spent getting precise directions over the phone from Spud and communicating these to the delivery person. The remaining costs of production and delivery are $90. The total cost of production and delivery is therefore $100. In this variation, Chip Co. can take the following steps to minimize or eliminate the risk of being shut down for health code violations. Level of Precaution

Prob. of Shut Down

Cost of Precaution

50%

$ 0

10%

$50

$75

If Chip gets shut down by the health officials, Chip will breach the contract, in which case Chip’s cost will equal expenditure on precaution plus damages to Spud. If Chip breaches, Spud will lose the $10 invested in specific directions to reach Chip and then Spud will pay $100 in production and delivery costs for potatoes selling for $150. Under which measure of damages (restitution, reliance, expectation) will Chip Co. engage in efficient precaution? Variation 4: This variation is the same as Variation (3) except now Spud Co. has a choice about how much money to spend in reliance on the contract. To guarantee that the driver doesn’t get lost, Spud Co. can send someone out to test the directions taken down over the phone and to make additional notes about the landmarks, confusing parts of the route, etc. This person’s time costs Spud an additional $20, so that the total amount invested in finding the route to Chip Co. is $30. However, since this person’s time is less expensive than the driver’s time plus the truck rental time, eliminating any risk the driver will get lost reduces the remaining costs of delivery to $60. Total delivery cost is therefore $90. Is it efficient for Spud Co. to invest the additional $20 in reliance? Under which measures of damages (if any) will Spud Co. engage in efficient reliance?

Cooter/Ulen • Law & Economics, Sixth Edition

Answers to Spud v. Chip Variation 1:

Spud profit = 200 − 100 Chip = 400 − 200 − 100 = 100 Joint = 200

Perform:

Spud: 500 − 100 + 200 = 600 Chip: 400 − 300 − 100 − 25 − 200 = −225 Joint: 375

Breach:

Breach is efficient Restitution = $200 Reliance = $225 Expectation = $325

Damages:

Perform profit = 100 Breach profit = 600 − D

Spud’s breach decision: Breach under all measures—efficient

Joint Profit = $200 Spud profit = $400 Chip profit = −$225 Joint = $175

Variation 1A: Perform: Breach:

Breach not efficient Damages as in 1 Perform profit = $100 Breach profit = $400 − D

Spud’s breach decision:

Efficient breach only under expectation damages Variation 2: Perform:

Spud profit = $100 = [−100 + 200] Chip profit = $−200 Joint = $−100

Breach:

Spud profit = $50 = [−100 + 150] Chip profit = $0 Joint = $50

Breach efficient Restitution = 0 Reliance = 0 Expectation = $50

Damages:

Perform profit = −$200 Breach profit = −$D

Chip’s breach decision: Efficient breach under all measures

Chapter 8

An Economic Theory of Contract Law

Variation 3: Perform (no shutdown) −100 + 200 = 100

Spud Chip

Breach

Expected Profit

−10 − 10 + 150 = 40

−100 − 200 − 0 + 400 = 100

120 = 0.5(200) + 0.5(40)

−100 − 200 −50 + 400 = 50

−50

134 = 0.9(150) = 0.1(−10)

−100 − 200 −75 + 400 = 25

Expected joint profit

Level 1 Level 2 Level 3

125 = 100 + 25 = 120 1/2(200) + 1/2 (40) = 139 0.9(150) + 0.1(4) = 139 = 125

Level 2 is optimal level of precaution Chip’s precaution decision:

Damages:

Variation 4:

Level 1 profit Level 2 profit Level 3 profit

= 50 − D/2 = 40 − D/10 = 25

Restitution Reliance Expectation

= $0; Level 1 (also excuse result) = $10; Level 1 = $60; Level 2—efficiency

Discretionary reliance investment = $20 Suppose Level 1 precaution taken, expected return from increased investment = 0.5  $30 (savings) = $15 increased investment inefficient

Spud’s reliance decision: Invest profit Don’t invest

= 0.5(110) + 0.5(20 + DI) = 65 + DI/2 = 0.5(110) + 0.5(40 + DDI) = 75 + DDI/2

Restitution = 0; Don’t invest; efficient Any fixed DI = DDI efficient Reliance: DI = $30 DDI = $10 Invest inefficiently (guaranteed I) Expectation: DI = $90 DDI = $60 Invest inefficiently (guaranteed I) Damages:

Chapter 9 Topics in the Economics of Contract Law The central purpose of this chapter is to elaborate, through lots of examples, the theory laid out in the previous chapter. Here we can confine ourselves to highlighting several points and to introducing only a few more examples. Our impression is that the main thing that we have done in the sixth edition is to tighten up the exposition, add a few new topics (as in our discussion of information), and clarify the treatment of some topics. Note that there are cases on the website that you might find useful, either as classroom discussion exercises or for a law-and-economics moot court.

◼ Remedies In evaluating the efficiency of various contract remedies, the efficiency should apply to formation, reliance, and performance. We, and many others, have an unfortunate tendency to focus only on the efficiency of the decision whether to breach or perform. But there is more involved in inducing efficient contractual behavior than that important decision. You can have a great discussion with your class to show them that the anticipated remedy for breach of contract can influence the decision to enter or form a contractual relationship and to rely on that relationship (by, for example, making pre-performance expenditures in anticipation of enjoying the benefits of contractual performance). Here is a good discussion question: should courts award punitive damages for breach of contract? The standard American rule is not to allow punitives in contract cases. However, Professor William S. Dodge (“The Case for Punitive Damages in Contracts,” in the 48 Duke L. J. 629 (1999)) argues that punitives should be available for willful breach of contract (as opposed to involuntary breach of contract). Dodge makes a persuasive case. For some facts that might serve as the basis for a law-and-economics moot court problem on this topic, see Patton v. Mid-Continent Systems, Inc., 841 F.2d 742 (7th Cir. 1988) (Posner, J.). Here is another good topic for discussion, based on a real British case: X contracted to have a builder construct a swimming pool for him that was to be exactly 2 meters, 50 centimeters deep. After completion of the pool X discovered that the pool was only 2 meters, 30 centimeters deep. He sues the builder for specific performance. What is the efficient result?

Chapter 9

Topics in the Economics of Contract Law

◼ Information in Contracts The issue of what information to compel the parties to divulge and what they may keep secret is an especially difficult one. The 2  2 matrix shown in Table 9.4, is meant to highlight the fact that there are two aspects of information associated with a contract—the nature of the information (whether it is productive or redistributive) and how someone acquired that information (whether deliberately or by chance). The only combination for which there is a clear efficiency reason for protecting the information-holder from having to disclose his information is the combination (deliberately acquired productive information).1 The combination in the upper left-hand corner (productive information that has been deliberately acquired) is clearly one in which contract law should enforce the bargain and not compel the party with deliberately acquired productive information to divulge that information to the other party. The reason is that protecting the deliberate acquisition of productive information will create an incentive for others to make that investment—an investment from which society, not just the individual investor, will prosper. The cell on the lower left-hand side (deliberately acquired redistributive information) is one where there is a fairly strong case for not enforcing a contract and for compelling a party to divulge information. The reason is that if contracts premised on deliberately acquired redistributive information were to be enforced, then there would be an inefficient incentive for future parties to invest in the acquisition of such information. An example might be investing in establishing a relationship with political powers so as to be the first to learn where a new governmental business will be located. We would all be better off if people made investments in productive information gathering rather than in information whose only benefit is to enrich the holder at someone else’s expense. As one of our students once said of those who seek to curry favor in order merely to be the first to learn valuable information, “They should get a job!” The two cells involving fortuitously acquired information present more subtle problems. There is no strong efficiency argument in favor of enforcing a contract premised on fortuitously acquired productive information. But there is no strong efficiency argument for not enforcing it either. Because there is a strong line-drawing problem in deciding what information is fortuitously acquired and what is deliberately acquired but a strong social interest in acting on productive information, we lean in favor of enforcing contracts based on fortuitously acquired productive information and of not compelling parties to divulge productive information, however it has been acquired. We would, of course, reserve for the court the ability to back away from this in extreme cases. As to the fortuitous acquisition of redistributive information, we think that the case for enforcement is weak. Note that it seems to us less troubling to have fortuitously acquired redistributive information than to have deliberately acquired fortuitous information. Professor Michael Trebilcock in The Limits of Freedom of Contract (1993) gives this wonderful discussion question on mistake. Suppose that A sells a piece of her farm to you and that you intend to construct a country home on that parcel. Unknown to either you or A, the farm contains an old toxic waste dump that long predates A’s ownership of the farm and that makes the site hazardous for residential use. This fact is subsequently discovered in the course of drilling foundations for your home; as a result, the market value of the land drops to 10 percent of the purchase price. You seek to rescind the contract with A on the ground of mutual mistake. What result?

We have already excluded from consideration the situation in which there is destructive information. In that circumstance there is an efficiency argument in favor of no enforcement and in compelling the party with the information to divulge the information to the other party.

Cooter/Ulen • Law & Economics, Sixth Edition

This is an excerpt from a poem by Professor Brainerd Currie about the cow in the famous case of Sherwood v. Walker. For the full poem see 10 The Student Lawyer 4 (1965). For a law review article on the case see Robert Birmingham, A Rose by Any Other Word: Mutual Mistake in Sherwood v. Walker, 21 U.C.D.L. REV. 197 (1987). (2) Aberlone, Rose of. ‘T is the middle of night on the Greenfield farm And the creatures are huddled to keep them from harm. Ah me!—Ah moo! Respectively their quidsome balm How mournfully they chew! And one there is who stands apart With hanging head and heavy heart, Have pity on her sore distress This norm of bovine loveliness, Her gentle limbs, her hornless brow Proclaim no ordinary cow: Fair as a pasture sweet with hay Mown in the very month of May! Nay, fairer yet! And yet more fair! She stands alone, the short black hair Heaving sometimes on her breast. Shunned and despised by all the rest. If one should ask her why she doth grieve She would answer sadly, “I can’t conceive.” Her shame is a weary weight like stone For Rose the Second of Aberlone. Her sire is of a noble line Of most aristocratic kine: Angus of Aberdeen, black and polled; Their name is proud and their get pure gold. Their procreation hath won renown, But Rose the Second hath let them down. Her forbears have labored for bitter meed, For Rose is barren and will not breed. Now the gate that is strait and the way that is narrow Call for a cow to forgo being farrow. In a cow one condones a trifle of loose Morality if she will just reproduce, The stars in their courses deliver us From the cow that is non-frugiferous! If a heifer aspires to a niche on high She must certainly plan to fructify, And when she reaches puberty Must concentrate on uberty. No honor is there for the boss of that ilk That produceth no young and giveth no milk;

Chapter 9

Topics in the Economics of Contract Law

And this is the reason her kith make moan For Rose the Second of Aberlone ‘T is the middle of night before the exam, And there’s nothing to eat but a cold bit of ham, Ah me!—Ah moo! Mark how the eager students cram, What coffee black they brew! A dismal specter haunts this wakeThe law of mutual mistake; And even the reluctant drone Must cope with Rose of Aberlone. She rules the cases, she stalks the page Even in this atomic age. In radioactive tracts of land, In hardly collectible notes of hand, In fiddles of dubious pedigree, In releases of liability, In zoning rules unknown to lessors, In weird conceits of law professors, In printers’ bids and ailing kings, In all mutations and sorts of things, In many a hypothetical With characters alphabetical, In many a subtle and sly disguise There lurks the ghost of her sad brown eyes. That she will turn up in some set of facts is Almost as certain as death and taxes: For students of law must still atone For the shame of Rose of Aberlone.

◼

Allocating Risks: Now (at Formation) or Later

One of the topics to which we give short shrift but that you might want to discuss with your students is the extent to which parties ought to spend time and effort allocating risks in the course of forming their contractual relations. We say in the text, correctly, we believe, that the relevant consideration is a comparison of the costs of allocating the risks at formation time with the costs of dealing with those risks later, should they arise. If parties postpone risk allocation until later, then they may not have to incur those costs at all if the risk doesn’t materialize. So, those future costs of negotiating about risk allocation need to be discounted by the probability of the risk’s materializing (as, of course, they will be if you deal with them at formation time) and further discounted to present value. The problem with this commonsensical rule is that it may be difficult to imagine what the costs of renegotiation will be. If everything else about the relationship is going well, then those costs might be low. But if things are not going well or if one of the parties has acquired a situational monopoly, then the renegotiation may be inequitable. We explore the implication of this in the following section. In a recent article that we discuss in one of the PowerPoint presentations, Alan Schwartz and Robert Scott— “Contract Theory and the Limits of Contract Law,” 113 Yale L.J. 541 (2003)—argue in favor of allowing sophisticated business parties to leave gaps in their contracts and to rely on the parties to fill those gaps as they need filling through renegotiation, not by having courts fill them for the parties. See also Robert Scott, “A Theory of Self-Enforcing Indefinite Agreements,” 103 Colum. L. Rev. 1641 (2003). ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

◼ Contract Modification and Renegotiation An excellent discussion question has to do with the efficiency of contract modification. Should parties be allowed to modify their contract after it has been formed but before it has been performed? One’s first instinct is to suggest that, of course, they should: if the change is mutually acceptable, then it must be valueenhancing. But there are other defensible possibilities. One, recently abrogated in British law, is not to allow any modification. The justification for this rule—a mandatory rule—is presumably that it induces the parties to concentrate their efforts at getting the terms of the contract just right in its original formation. But notice that the original contract could include a clause allowing modification under certain circumstances. The traditional American rule (and the older British rule) for contract modification is to allow it only if there is fresh consideration—that is, in essence, a new bargain. The theory is that the same formation defenses would apply to this new bargain as applied to the original bargain and that these defenses would serve as protection against exploitation of one party by the other. There is an economic reason to be skeptical of modification: it may be coercive or unconscionable. The parties may be so deep into the performance of the contract that they might agree to modification rather than lose everything that they have thus far committed to the completion of the contract. Dean Hein Kötz, former Director of the Max Planck Institute on Comparative Law in Hamburg, Germany, and founding dean of the first private law school in Germany, Bucerius, told us of this example: A buyer contracts with a British shipbuilder to build a tanker for the transportation of oil. The parties agree on a price for the tanker, denominated in dollars, and on a delivery date. However, before the construction can be completed but well after it has begun, the exchange value of the dollar against the British pound or Euro changes so much that the completion of the construction would be much less valuable to the shipbuilder than before. He approaches the buyer and asks for contract modification. In fact, he says that he wants the buyer to pay 10 percent more than the previously agreed-upon dollar price. And he says that failure to agree to this may cause him to delay delivery or to reduce the quality of the product delivered. Should this modification be enforced? See Eric L. Talley, “Contract Negotiation, Mechanism Design, and the Liquidated Damages Rule,” 46 Stan. L. Rev. 1195 (1994).

◼ Unconscionability The unifying economic theme in cases of unconscionability appears to be the notion of a “situational monopoly.” This is a monopoly that no one set out to create. It simply happened, and once it has come into being, one party has taken advantage of the situation. Suppose that two ships come across a third ship, which is foundering. The foundering ship contains a cargo of valuable whale oil that will be lost in the event that the ship sinks. The two captains of the seaworthy vessels hold an auction to see who will pay more for the cargo of whale oil. The higher bidder, whose bid is still far below the market value of the oil, saves the cargo (and the crew). Back in harbor, the rescued captain seeks to void the sale of the whale oil on the ground that the terms and conditions were unconscionable. (He might also claim duress.) The following further example comes from Matthew Braham of Hamburg. Two English tourists in Nepal hire a guide to take them into the Himalayas for a day-long hike. They agree upon a price for the day’s services. However, about halfway through the hike, at an altitude of 5,000 meters and at a lonely and difficult place, the guide insisted that he would leave them unless they agreed to a much higher price for his completion of his services. If the tourists agree, should they be held to the contract when they return?

Chapter 9

Topics in the Economics of Contract Law

Professor Michael Trebilcock gives this example in his wonderful The Limits of Freedom of Contract (1993): In a remote rural area there is a terrible drought. Suppose that all the wells but that of Smith dry up. Smith auctions off drinking water to his desperate neighbors for large percentages of their present and future wealth. Is the auction objectionable on the ground of efficiency, even though Smith did not create the life-threatening situation but is merely exploiting it? The website has some cases that are interesting to discuss in class.

◼ Final Thoughts You are probably aware of three new strands in the literature on contracts—that on relational contracts, incomplete contracts, and social norms. Although we mention both subjects, our mention is very brief. Here are some thoughts to mull over with your students. Relational contracts involve two parties agreeing to establish a relationship—typically a commercial relationship—and leaving the details of that relationship for later elaboration. “I agree to supply you with natural gas for the next three years, and you agree to purchase it at a price to be determined later.” Relational contracts by their nature contain many gaps that the parties fill in as the relationship goes on. The issue that the law faces in this regard is what to do when the relationship comes apart because of an inability to fill in the gap. You will find a hard-headed but persuasive view of these matters in Robert E. Scott, “The Case for Formalism in Relational Contract,” 94 Nw. U. L. Rev. 847 (2000). In some ways the incomplete contracts literature (principally the work of economists) is simply a more formal treatment of the relational contracts literature. For a wonderful summary of the literature on incomplete contracts as it applies to contract law, see Eric Posner’s article, “Economic Analysis of Contract Law After Three Decades: Success or Failure?”, 112 Yale L.J. 829 (2003). There is a marvelously interesting literature appearing on the use of social norms within communities as substitutes for formal contractual rules enforced by public courts. Be certain to see Lisa Bernstein, “Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry,” 21 J. Legal Stud. 115 (1992) and “Merchant Law in a Merchant Court: Rethinking the Code’s Search for Immanent Business Norms,” 144 U. Pa. L. Rev. 1765 (1996).

Chapter 10 An Economic Theory of the Legal Process This chapter, like Chapters 8 and 9, contains some advanced material that law students and some undergraduates may find challenging. The material itself is not beyond their ken, but because of its mathematical presentation, some students will find that it requires special attention. We recommend that if time allows, you go through the mathematical exercises. Another challenge at this point in the semester or quarter is that you are probably running out of time and wondering how you are going to be able to get through this chapter and the remaining two in the time left to you. Our suggestion is that you focus in this chapter on just a couple of issues, such as the economics of the decision to sue or the process by which the common law process might generate efficient rules. You will find some additional topics covered in the Web Notes and PowerPoint presentations at the Addison Wesley Longman website. These include material about the legal profession (for example, how many lawyers per capita there are in different countries, why lawyering is being “offshored” in the United States, whether lawyers in the United States are a happy or unhappy group, the attraction of alternative dispute resolution (ADR, mediation and arbitration), and more. If you have used this text before, you will find that the arrangement of material is a bit different. We have divided the old Chapter 10 into two chapters so as to preserve the structure that we established in the other chapters—namely, a theoretical chapter (this one) and a topics chapter, including empirical evidence on the theoretical matters (Chapter 11). Our colleague and friend Endre Stavang of the Faculty of Law at the University of Oslo, Norway, has pointed out to us that we shift gears in this chapter. Heretofore we have been focusing on the economic analysis of rules and institutions. In this chapter we switch to an analysis of behavior. We think that’s correct.

◼ Lawyers and the Litigation Process The text and mathematical exercises designed to illustrate the rationality of the decision to sue or to defend and the choice between suit and settlement are, we think, self-explanatory and straightforward, although challenging. Some interesting discussion questions about these matters relate to the role that lawyers can play in the decisionmaking process. Specifically, are the relative costs and benefits of suit and settlement fully evident to private parties? Or do they need the experience of lawyers to recognize the various costs and benefits? And if parties hire attorneys to represent their legal interests, does that not raise a principalagent problem like what we dealt with in the agency game of Chapter 8? In an important article—“Disputing Through Agents: Cooperation and Conflict Between Lawyers in Litigation,” 94 Colum. L. Rev. 509 (1994)—Ronald Gilson and Robert H. Mnookin ask, “Do lawyers facilitate dispute resolution or do they instead exacerbate conflict and pose a barrier to the efficient resolution of disputes?” Part of the motivation for their inquiry is the fact that most of the literature on suit versus settlement looks at the choice as a two-person game played by the principals, whereas, in fact,

Chapter 10

An Economic Theory of the Legal Process

it is a game in which the principals use lawyers as their agents. Another important motivation for the article is the attempt to deal with the widespread view that there has been a significant and secular increase in the contentiousness of civil litigation. (“Whether this is, in fact, true” and, if so, “why it should have occurred” are interesting questions for class discussion or for a group of students to give a brief oral or e-mail report to the class. But be sure to see the discussion of Professor Marc Galanter’s “Vanishing Trial” in Chapter 11.) Gilson has, in previous work, referred to lawyers as “transaction cost engineers,” a felicitous phrase that captures a great deal of the sense of this text’s message about the legal system. You might suspect from this phrase that they take a generally favorable view of what lawyers do. Here’s what they say: “Over a century ago, Abraham Lincoln suggested that lawyers can play an extraordinarily constructive role in disputes—as peacemakers who facilitate efficient and fair resolution of conflict when their clients could not do so for themselves. From this perspective, a central characteristic of the formal legal system—that clients carry on their dispute through lawyers who are their agents—has the potential for damping rather than exacerbating the conflictual character of litigation.” (p.512) The evidence on an increase in contentiousness is compelling. For example, studies have found an increase in the amount of commercial litigation since 1970. Through the 1960s there was a relatively constant level of contract dispute filings in federal courts of about 14,000 per year. The number of filings began to increase in the 1970s and reached a peak of 47,000 in 1986. (See the work of Marc Galanter cited in Gilson and Mnookin.) Moreover, a study of breach-of-contract filings in the Southern District of New York—a court that Gilson and Mnookin characterize as having the largest commercial caseload in the country and certainly the largest commercial bar—found that the number of such cases rose from an average of about 400 per year in the 1960s to an average of almost 1,300 cases per year in the 1973–1979 period. (Gilson and Mnookin cite William E. Nelson, 39 Emory L.J. 413 (1990).) Gilson and Mnookin suggest that part of the reason that there has been an increase in the amount of litigation and a decline in the civility among lawyers is that the returns to developing a reputation for cooperation have fallen. Part of the reason that lawyers may help to reduce conflict is that they are repeat players, and, as the summary of game theory in Chapter 2 suggested, in a repeat game, a player has an incentive to develop a reputation. In particular, lawyers can establish a reputation as skillful at finding a cooperative surplus and dividing it equitably. Alternatively, an attorney can develop a reputation as a ferocious battler (what is called more politely in legal circles, a “zealous advocate”) who burns the bridges of retreat behind her as she advances. Presumably, clients can determine the reputation of various attorneys and retain those who have the particular reputation that will be valuable in each particular setting. Gilson and Mnookin suggest that the secular trend has been away from developing a reputation for cooperative behavior. (And, as we will shortly see, they further argue that this trend has been accompanied [and perhaps caused] by the rise of very large law firms.) Another question that Gilson and Mnookin address (and that is worth class discussion) is whether reputations are better developed by individual lawyers or by a firm of lawyers. They suggest that the rise of large law firms has helped to decrease the returns for developing a reputation for cooperative behavior. “In the late 1950s only 38 law firms had more than 50 lawyers. By 1985, 508 firms had reached that size. Fewer than a dozen firms exceeded 100 lawyers in 1960; by 1986, there were 251 such firms. In 1968 the largest law firms had 169 lawyers; in 1993 the largest firms had 1,662 lawyers and 84 firms were larger than the 1968 leader.” (p.538) It is generally argued that the rise of very large firms is due to the need to provide comprehensive service over long geographical distances to large multinational clients. Why should there be a connection between the growth of very large law firms and the decline in the incentive to develop a reputation for cooperative behavior? ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Cooter/Ulen • Law & Economics, Sixth Edition

Gilson and Mnookin say that lawyers in some specialties recognize that there is a decline in the incentive to be cooperative with other lawyers and that they are taking steps to reverse this decline. They show that the development of a professional organization—such as the American Academy of Matrimonial Lawyers (AAML), an organization of those practicing family law—helps to create an incentive for developing a reputation for cooperation. For some interesting additional material on the state of modern lawyering, see the following articles: David Wilkins and Mitu Gulati, “Black Lawyers,” 84 Cal. L. Rev. 493 (1996); Wilkins and Gulati, “Reconceiving the Tournament of Lawyers,” 84 Va. L. Rev. 1581 (1998); Marc Galanter and Thomas Palay, Tournament of Lawyers: The Transformation of the Big Law Firm (1991); and the article on which that book was based, “Why the Big Get Bigger,” 76 Va. L. Rev. 747 (1990). Be sure to see Web Note 11.3 on the Companion Website for more about lawyers and “big law.” There is some emerging evidence that the nature of the legal services market has been changing dramatically in the past decade. There is also vigorous debate about whether the 2008–2010 Great Recession has had a passing or a profound and lasting impact on the market for legal services.

◼ The Effect of Lawyers on Societal Economic Growth The topic of the effect of the legal profession on the legal process can be extended to a discussion of the effect of lawyers on society as a whole. Recently several articles have appeared on this topic with opposing views clearly articulated and even some empirical work reported in an effort to support the opposing views. Frank B. Cross of the University of Texas has argued that lawyers reduce the Gross Domestic Product (GDP). In “The First Thing We Do, Let’s Kill All the Economists: An Empirical Evaluation of the Effect of Lawyers on the United States Economy and the Political System,” 70 Tex. L. Rev. 645 (1992), Cross posits that lawyers can have three effects on the economy: (1) they can foster redistributive or rent-seeking activities; (2) they can foster productive, economically facilitating activities; and (3) they can help in the creation of valuable nonmarketed social goods, such as individual rights to free speech and due process of law. The latter two of these effects enhance social product, but the first reduces it (as we showed at the end of Chapter 4). Whether, on net, these three activities result in an increase or a decrease of GDP depends on careful empirical work and might vary across time and geography. The only clear effect that Cross finds is a strong correlation between the number of lawyers per capita and the amount of political freedom. He concludes, “The uncertain and relatively insignificant monetary costs of lawyering are more than justified by the nonmarketed social goods (including human rights and democracy) that lawyers help supply.” (pp.678–679). (This is, of course, a conclusion worth trumpeting if you are in the business of educating lawyers. Remember that the United States has three times as many lawyers per capita as any other comparable society.) Several studies have found a negative correlation between the number of lawyers and the rate of economic growth. See, for example, Stephen P. Magee, William Brock, and Leslie Young, Black Hole Tariffs and Endogenous Policy Theory; Political Economy in General Equilibrium (1989). They simply compared lawyers per capita with economic growth rates in various countries. Magee contends that each lawyer in the United States costs the nation $1 million in lost GDP. Another study reached a similar conclusion: Kevin Murphy, Andrei Schleifer, and Robert Vishny, “The Allocation of Talent: Implications for Growth,” 106 Q. J. Econ. 503 (1991), republished in Schleifer and Vishny, The Grabbing Hand (1999). They compared total enrollment in law schools versus total enrollment in schools of engineering and compared changes in those enrollments with changes in GDP. They report that a 10 percent increase in law school enrollment caused a 0.3 percent decline in economic growth. Finally, David Laband and John Sophocleus, “The Social Cost of Rent-Seeking: First Estimates,” 58 Pub. Choice 269 (1988), used the number of lawyers in society as a proxy for the amount of rent-seeking and found that each lawyer costs the society about $2.6 million in 1982 dollars. Law & Social Inquiry published a symposium issue in fall 1992 (v. 17, n. 4) entitled “Do Lawyers Impair Economic Growth?” The lead article was Charles R. Epp, “Do Lawyers Impair Economic Growth?” with ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 10

An Economic Theory of the Legal Process

commentaries by Mancur Olson, Ronald Gilson, Philip Keefer, Frank Cross, Richard Sander, and Stephen P. Magee. Epp finds that there is no significant negative correlation between the number of lawyers and the rate of economic growth. The topic of the effects of lawyers on societal well-being is of particular importance to the developing economies. The contention could be made that what the developing economies need is more law—in the sense of rule-abiding behavior, enforceability of property and contractual rights, and so on—and that more lawyers will facilitate this law-abiding behavior. That recommendation presumes that lawyers cause rather than hinder growth. There is some evidence—principally by Edgar Buscaglia—that suggests that more law (if not necessarily more lawyers) assists in the growth of the developing economies. And it must count for something important that the People’s Republic of China (which has been growing at nearly 10 percent per year for almost three decades) has had until recently few lawyers and that the country’s leaders have now determined that the next phase of the nation’s growth requires many more lawyers. For an even broader look at the relationship between a legal system’s efficiency and a country’s economic growth, see Professor Cross’s summary article, “Law and Economic Growth,” 80 Tex. L. Rev. 1737 (2002), and the now classic Rafael La Porta, Florencio Lopez-De-Silanes, Andrei Schleifer, and Robert W. Vishny, “Law and Finance,” NBER Working Paper W5661 (1996) (subsequently published as “Law and Finance,” 106 Journal of Political Economy 1113 (1998).)

◼ Frivolous Law Suits We deal with this topic briefly in this chapter and again, briefly, in Chapter 11 (in the first section). We should probably give more space than we currently do to the topic of frivolous law suits. There is such a current of criticism of lawyers in the United States today that this is a great topic for class discussion. If you are going to take up this topic, we very highly recommend that you do things in preparation. First, read the empirical summary that constitutes the second half of Chapter 11, particularly the material on “vanishing trials.” It is difficult to maintain, after you read the summary of Galanter’s marvelous article, that there are too many trials in the United States. Second, you should read Robert Bone’s wonderful article, “Modeling Frivolous Suits,” 145 U. Penn. L. Rev. 519 (1997) and the related chapter in his wonderful short book, The Economics of Civil Procedure (2002). The article develops the notion that we and others have used to discuss frivolity—the “negative expected value” suit, one where the plaintiff has reason to know that the probability of winning is so low and the costs of proceeding so high that there is a net loss from proceeding to trial. Professor Bone adds an analysis of the problem of the plaintiff who proceeds without adequately investigating the merits of her claim and proposes a policy for dealing with that situation.

◼ The Efficiency of the Common Law Process One of the most significant claims in the law-and-economics literature is that the common law process generates efficient legal commands. As the text shows, the novelty of that claim lies in the contention that the behavior of private parties—not of judges, lawyers, legislators, or others—generates these efficient laws. To paraphrase Adam Smith, the claim holds that private parties are led, as if by an invisible hand, to litigate inefficient law and not to litigate efficient law. We (and the literature) speak of the “common law process” here and in the text, but what we really mean is “private adjudication.” The broader term is one that should be borne in mind in the discussion of this material because the forces that the literature identifies as pushing private law toward efficiency would seem to apply to both the civil law and common law systems. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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There are many interesting discussion questions that arise from this important claim. Are there any impediments to the process? What if some parties do not bring an action against an inefficient law? Under what circumstances would that happen, or would every inefficient law be challenged? Why might it not be the case that private bargaining between affected parties would get around an inefficient law? Do parties have to have a continuing interest in the matter covered by the inefficient law in order to have a strong incentive to litigate? For instance, would you expect an individual renter to be willing to incur the costs of correcting an inefficient aspect of landlord-tenant law? Wouldn’t you anticipate that a lifelong landlord or an association of landlords would have a stronger interest in litigating an inefficient landlord-tenant law than would someone who just happens to own one rental property? What if some parties choose to fight inefficiency by appealing to the legislature, not to private causes of action? Is the legislative process or the common law process more flexible in dealing with changed circumstances—for example, when tastes or technology change so as to make an existing, efficient law inefficient? Are there any circumstances under which private law will remain in an inefficient state and may, therefore, need external forces to move it to an efficient state? What is the interaction between social norms and private adjudication? We have not really dealt with the comparative efficiencies of private adjudication and legislation so this topic will open up issues that are beyond the text.

Chapter 11 Topics in the Economics of the Legal Process This chapter takes up some new topics first developed in the previous chapter and introduces the empirical literature on the legal process. As noted at the beginning of the last chapter of this manual, we recognize that time may be growing short in the semester and that you may be looking for topics to cut or to treat very lightly. You can, of course, pick and choose the topics you would like to cover. We particularly commend to you a consideration of the material on class actions on pages 425 and 426, the material on nuisance suits on pages 429–431, the consideration of unitary versus segmented trials on pages 433–434, and the material in Section II, “An Empirical Assessment of the Legal Process.” The material contained in the three Web Notes for this chapter might also serve as material to spur class discussion. For instance, the first Web Note has a brief comparison of the different systems for education lawyers throughout the world. The United States has been, until recently, unique in making legal education a post-baccalaureate or graduate form of education. (Japan and South Korea have recently changed their legal education systems to allow some of those who desire to become licensed lawyers to receive their first instruction in law as graduate students. At the same time, both countries have continued to offer law as an undergraduate course of specialization. It will be interesting to see, over time, if there are any discernible differences between the attorneys in Japan and Korea who get their legal degrees as undergraduates and as graduates—as in prestige of private appointments or as judges, lifetime income, satisfaction with the job, and so on.) Another topic to which we allude at the end of Web Note 11.1 but that we do not discuss in the text is the governmental regulation of the legal profession. That is a fascinating but complex topic that is well worth classroom discussion. (There are some reading suggestions on this topic provided at the end of that Web Note.) In the United States the legal profession is largely self-regulated with rules for admission to the practice of law and regulation of conduct being promulgated by state supreme courts, state bar associations, and the American Bar Association (which also has an important role in accrediting law schools in the United States). Most disciplinary actions are imposed on attorneys in the United States through the profession itself, not through an external regulatory agency or through private causes of action brought against the attorney (although, of course, such private causes of action—for example, for malpractice, fraud, breach of a fiduciary duty, and the like—are possible and not uncommon). We simply do not know enough about the legal regulatory mechanisms of other countries to make any comparative statements about those systems vis-à-vis the U.S. system. You might also note if this comes to a discussion that other professions—doctors and accountants, for instance—are also self-regulating. Can you think of some reasons why some professions or industries are self-regulated and others are externally regulated?

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◼ Contingent Fees There are only a few countries that allow lawyers to structure their payment contract with their clients on a conditional or contingent basis. The condition is typically that the client wins the pending litigation or a settlement. (Herbert Kritzer reports that the following countries currently allow contingent or conditional fees: the United States, the United Kingdom, Australia, Belgium, Brazil, Canada, the Dominican Republic, France, Greece, Ireland, Japan, Lithuania, and New Zealand. The European Union is considering allowing contingent fees in a limited number of circumstances.) For years most legal systems made it illegal for an attorney to make his fee conditional on the outcome of litigation or other legal resolution. Whatever the moral reasons for this restriction, it is not a practice that meets with economic favor. We hope that this section explains that contingent fees are efficient. At any rate, this is a very stimulating topic for classroom discussion.

◼ Further Behavioral Considerations In Chapter 10 we inserted a box on prospect theory or loss aversion and its possible connection to the decision to sue or settle. We did not have space to insert some material on the “hindsight bias” in the text. So, what we have to say about that bias’ effect on the legal process is largely contained in Web Note 11.3, the last Web Note for this chapter. This bias is worth some classroom discussion if you have time at this late hour in the semester. As the Web Note points out, one of the possibly bad effects of the hindsight bias is that if a complaint is brought to a trial—whether before a judge or a jury—the fact-finder is likely to think that the injury should have been more clearly foreseen than he or she might have thought had they considered the possibility of injury in foresight. So, for example, if a fact-finder is asked to determine whether Company A took sufficient care against a particular accident’s occurring, the appropriate method by which to make that determination is by checking to see if the ex ante considerations that the company actually took were reasonable. However, the hindsight bias suggests that if someone is asked to make that determination knowing that an accident has, in fact, occurred and that someone was injured, it proves impossible for the determiner to put him- or herself back into the same position that Company A was in prior to the accident’s occurring. Instead, the facts that an accident has happened, that someone was injured, and that the victim has initiated a lawsuit are significant enough to cause anyone trying to look at A’s ex ante behavior to revise upward their prior (ex ante) of an accident’s taking place, given any level of precaution. As the Web Note indicates, this hindsight bias may make it difficult for an injurer to have his or her precaution evaluated reasonably if an accident should occur and a victim sustain injuries. The most troubling implication of the hindsight bias may be that it may be impossible for defendants who were, in fact, complying with their legal duty of care to get a fair reading of their precautionary behavior in private tort actions. We also note in the Web Note that there may be more to the story. Suppose that when he was in school, the in-house counsel of Company B took a law-and-economics course in which he learned about the hindsight bias. Should his legal advice to the company be this: “We cannot and will not get a fair evaluation of our precautionary behavior if our products should happen to cause injury to one of our customers and that customer sues us for compensatory money damages. That is, if we identify the exonerating level of care— in our circumstances, the appropriately designed and manufactured product with sufficient warning to consumers—and comply with it, that will not be enough for us to avoid liability. Juries and judges will find close compliance with the legal duty of care to be insufficient. As a result, if we really want to avoid liability, we must take more care than we think we should.” ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 11

Topics in the Economics of the Legal Process

Suppose someone in the audience asks, “How much more care?” An honest answer might be, “I don’t know. 10 percent more? 20 percent more? It’s hard to say.” One exercise that you might work on with your class is devising a test—a survey or an experiment—that seeks to discover how much more precaution than is contained in the legal standard of care is required in order to overcome the hindsight bias.

◼

Empirical Evidence on Dispute Resolution

We included this section on empirical studies for the first time in the fifth edition. It contains a lot of information, not all of which you may wish to cover. We would strongly suggest that you at least bring to the students’ attention the following parts of the section: (1) the notion of selective litigation, the PriestKlein model, the 50-percent rule, and the empirical literature that seeks to identify the characteristics of the relatively small fraction of disputes that actually go to trial; and (2) the summary of Professor Marc Galanter’s article, “The Vanishing Trial.” The latter article is tremendously important in that it shows that the number of trials that are occurring in the United States is much lower today (at least in 2003, the time of the end of the study) than it was in the early 1960s—not just proportionally lower but absolutely lower. That is contrary to a widespread view that we are a very highly litigious society. But apparently that isn’t true. Professor Galanter walks through a number of possible explanations for the decline, such as the rise of alternative dispute resolution (ADR) and the rising relative cost of litigation versus alternatives. But none of these works particularly well. One possibility, which we wish that someone would undertake empirical work to measure, is that litigation is becoming rarer because transactional lawyering is becoming better. In a real sense, litigation is the result of poor planning (for example, with regard to the anticipation of unfortunate contingencies and what might be done if they eventuate), and poor planning is often the result of sloppy lawyering. If it could be shown that during the period 1962–2003 (Galanter’s time period), transactional lawyering became more adept at anticipating unfortunate contingencies and at renegotiating agreements when those contingencies occurred, then one would have the beginning of a possible explanation for the decline of litigation in the United States. We would like to think that the rise of law and economics might be shown to have a role in this improved lawyering. And that is not that implausible. Judges in the United States (and other common law countries) tend to be older; as a result, it may be a while before a new cadre of judges who are familiar with law and economics begins to assume positions on the state and federal benches. That is, we should not necessarily expect the behavior of judges to have changed in the recent past so as to reduce the amount of litigation. And, in fact, some empirical attempts to find evidence of the use of law and economics on judicial behavior of the past 20–30 years have generally found that there has been relatively little evidence of such an effect. But law and economics has become such a routine part of the legal curriculum of the past 20–30 years that it may be that its impact, if any, is to be found in how lawyers advise their clients, draw up agreements, and the like—not in how judges dispose of cases. Because U.S. legal education focuses on appellate opinions in teaching students the law, we may have been looking in the wrong place for evidence of the impact of law and economics. There is an old joke about these matters: a person comes across a drunk crawling around under a streetlight in the dark and asks him if he’s lost something. “Yes,” says the drunk. “I dropped my car keys.” “Right around here?” asks the intervener. “No,” says the drunk. “I dropped them back there.” “Well, then, why aren’t you looking back there?” “Because the light’s over here,” answers the drunk. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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In looking for evidence of an effect of law and economics on the legal system or the practice of law, we may have been like the drunk looking for his keys not where they were lost but where there’s light. Demonstrating this potential explanation for the decline of litigation would be a remarkably difficult but highly rewarding research project. You might discuss with our students what data they might need to gather or what sorts of experiments or surveys they might run in order to try to purse this explanation.

◼

Empirical Methods in Law

There is no question that one of the most important developments in legal scholarship today is the increasing amount of empirical scholarship. Unfortunately, there is no routine or common knowledge among many law-and-economics students—law students, in particular—about empirical methods. As a result, many of the readers of this edition and future editions of Law and Economics may not be in a position to be intelligent, probing readers of empirical literature. We mentioned, in an earlier bibliography, some introductions to empirical methods in law, including Lawless, Robbennolt, and Ulen, Empirical Methods in Law (2010). But there are relatively few law schools offering full-semester courses in that topic. In economics departments, students may not be much better placed to read this new literature. They may have had a course in econometrics. But there the focus will have been on statistics and on only one empirical method—regression analysis. Other methods, such as surveys and experiments, do not typically receive much attention in an undergraduate economics curriculum. To the extent that those alternative methods are not part of the toolkit of economics undergraduates, they, too, may have difficulty evaluating much of the new empirical literature in law, which often uses surveys and experiments. We hope to include, in a future edition of this book, a brief introduction to empirical methods that will equip both law and economics students to read the empirical legal studies literature more adeptly.

Chapter 12 An Economic Theory of Crime and Punishment The last two chapters of the text present some of the most famous material in law and economics. Professor Gary Becker won the Nobel Memorial Prize in Economic Science in part for his 1967 article, “Crime and Punishment: An Economic Approach,” and we discuss that article in this chapter. Another important aspect of these two chapters is that they discuss, for the first time in this text, a public law area. Everything heretofore has concerned private law—disputes between two private citizens. But with crime we stray for the first time into the area of law in which one of the parties to a dispute is society as a whole, not just another private individual. That is, as we will shortly stress, one of the most significant points to bring out in class discussion of these two chapters. Another theme that we sound here is the importance of empirical work. Law-and-economics, especially in the areas of private law covered in Chapters 4 through 10, has been especially short on doing the hard statistical and econometric work that is necessary to test its hypotheses. But, as Chapter 12 will show, this has not been the case with respect to criminal law—and arguably not the case with respect to the broad area of public law to the same extent as with private law. There are three extremely important issues to deal with in this chapter. First, we try to use economics to explain why there is an aspect of social behavior that private law will not deal with in a socially optimal fashion. That is, property law, contract law, and tort law are not entirely able to deal with the wrongdoing that is at the heart of criminal law. Be certain to bring up in class discussion why it might be the case that private law actions cannot fully deter all wrongdoing. For instance, we show that private law is inadequate for dealing with inchoate wrongs—things that are dangerous but have no victim. Society will surely want people to refrain from doing some activities that could be very dangerous. Could tort law be invoked— through, say, actions for probabilistic harm—to deter these wrongs? Why or why not? Could punitive damages assessed against those who actually succeed in harming another adequately deter dangerous activities? We have raised similar issues in Chapter 9 in our discussion of the appropriate relationship between tort law and ex ante safety regulation. The first part of Chapter 11 could serve as an occasion for reviewing some of the arguments raised earlier. You can also use the discussion of the inadequacy of private law for deterring all forms of wrongdoing to go beyond criminal law to consider some or all of the other areas of public law. Why do we need a constitution? Why is labor law necessary, rather than being nothing more than a particular example of contract law? Why is there a necessity for corporation law? For bankruptcy law? For antidiscrimination law? Dealing with these and other issues will necessitate bringing up the important role of the legislature in law and of the appropriate relationship between private adjudication and regulation by public law. The second topic that is at the core of the chapter is the Becker theory of the decision to commit a crime. Our experience has been that this theory is one of the hardest aspects of law and economics for non-economists. There is a widespread view among well-educated people that crime is largely attributable to social or personal conditions that are beyond the scope of law to affect. For instance, many non-economists believe that many, if not most, crime is committed by those who are simply irrational—that is, beyond the standard economic theory of rational choice. Thus, some violent crime is seen as the result of the perpetrator’s being in the grip of an overpowering and uncontrollable emotion—as when someone murders his or her partner

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during a wild argument. Alternatively, many consider crime to be the result of compelling social conditions—as, for example, when hunger or the boredom or lack of meaningful future opportunities drives someone to commit a petty crime against another’s property. The heart of the Becker theory is the contention that the decision to commit a crime is the result of the same sort of cost-benefit analysis that economics presumes to characterize consumer choice. The implications of the Becker theory are extremely practical and profound—namely, that society can deter crime by adjusting the perceived costs and benefits of committing crime, relative to legal activity. The response of many to this contention is that “people simply do not calculate that way with respect to crime.” But why should they not? If the theory of rational choice is acceptable with respect to lots of other decisions with which the law is concerned—as we have argued in this text with respect to decisions regarding property, contracts, and safety for others—why should it not be acceptable with respect to the decision to commit a crime? Rather than simply argue about the suitability of the rationality assumption, you can defer some (but not all) criticism till the discussion of empirical work in Chapter 12 on the ground that it really is a matter of looking to the data to see what theory best explains and predicts the data. One of the interesting things to raise in discussion is whether the socio-economic theory or the Becker theory is more likely to be able to explain geographical and chronological variations in the rate and types of crime. If there are year-to-year or decade-to-decade fluctuations in the amount of crime, can those really be explained by appeal to changes in culture and socio-economic conditions? (One of the startling empirical findings that we examine in Chapter 12 is that there is no statistically significant correlation between fluctuations in the economy and fluctuations in the level of crime. The one exception to this is auto theft, which appears to move, slightly, procyclically. That is, auto theft increases as the economy picks up speed and then drops off as the economy slips into a recession.) It seems inherently more probable that fluctuations in the levels and types of crime (both across jurisdictions and time) are to be explained using the factors that Becker identified. Be mindful, too, of the fact that in Chapter 12 we report on some work by Wilson and Abrahamse that seeks to test the rationality of criminals’ calculations and finds evidence that criminals make systematic mistakes in judging the costs and benefits of illegal versus legal activities. The heart of Becker’s theory can be summarized as saying that a rational potential criminal might commit a crime if the expected benefits of doing so exceed the expected costs and might be deterred if the expected costs of committing a crime are greater than the expected benefits. We have been asked repeatedly by our law-school colleagues (many of whom think, on the basis of scanty information, that they do not like law and economics) if the Becker model implies that a rational person ought to break the law if the expected benefits of noncompliance exceed the expected costs. This is a terrific discussion question to put before your class. You might want, first, to distinguish between serious crimes, such as rape and murder, and relatively low-level felonies such as embezzlement and tax evasion. Second, you might want to draw the students’ attention to the difference between a descriptive theory and a normative theory. We do not believe that there are many who are familiar with law and economics who would read the Becker model as a normative account of behavior—that is, of suggesting that one ought to break that law or that it would be rational or efficient or optimal to break the law when you could get away with it, more likely than not. But as a descriptive matter, one could hypothesize that when the expected costs of crime are less than the expected benefits, there will be an incentive for some to commit crime. And, moreover, one could say that the greater the discrepancy between costs and benefits, the greater the incentive to commit crime. These would be positive statements with testable consequences. The third core topic is how to allocate society’s scarce resources so as to minimize the social costs of crime. There is a famous implication of the Becker theory that is worth stressing here. Becker showed that the expected costs of crime to the calculating criminal are the probability of detection, arrest, and conviction times the monetary value of the sanctions imposed in the event of detection, arrest, and conviction. Presumably, society can achieve the same expected cost through a wide variety of combinations of these ©2012 Pearson Education, Inc. Publishing as Addison Wesley

Chapter 12

An Economic Theory of Crime and Punishment

probabilities and sanctions. For example, a very low probability of detection, arrest, and conviction might be combined with a very stiff monetary sanction or a very high probability of detection, arrest, and conviction might be combined with a very low level sanction to generate the same expected cost of committing a particular crime. Because altering the probabilities typically involves committing real societal resources—more police, more courts, more prosecutors, and so on—while altering the monetary sanction typically involves simply (a freighted word) changing the level of the legal sanction and no particular commitment of real resources, society should generally prefer to achieve a given level of deterrence by means of altering the level of sanctions. Another method of deterring crime, according to the Becker model, is to raise the opportunity cost of crime. One method of doing that is to make legitimate employment more certain and more rewarding. Ultimately it is an empirical question as to whether society gets more deterrence from making it more certain that a criminal will be caught and punished or from making it more certain and rewarding to be legally employed. An interesting discussion question on these matters concerns the social necessity of scaling the expected costs of crime so as to indicate to potential criminals the relative social undesirability of various actions. For example, the expected cost of purse-snatching has got to be lower than the expected cost of homicide. For this to matter it must be the case that criminals are aware of the scale and conform their behavior to it. And that raises, again, the matter of the rationality of criminals. Related to this is the practical issue of how best to convey to potential criminals the relative badness of various crimes. Should we do that by ranking the sanctions or by ranking the expected costs of different crimes? To which do potential criminals pay more attention—the level of sanction or the level of expected cost? That is, do they discount the sanction by the probability of detection, arrest, and conviction or not? Professors Mitch Polinsky and Steve Shavell published an important survey article on some of these matters in the Journal of Economic Literature in 1999—“The Economic Theory of Public Enforcement of Law.” On one important topic discussed in this chapter of the text, they say: “A difficulty with reliance on private enforcement [to deter criminal wrongdoing] is that if a reward is available to everyone, there might be wasteful effort devoted to finding violators (akin to excessive effort to catch fish from a common pool). Another problem is that private parties may find it hard to capture fully the benefits of developing expensive, but socially worthwhile, information systems (such as computerized databases of fingerprint records), such enforcement technologies may constitute natural monopolies.” On another theme of this chapter, Polinsky and Shavell had shown—in “The Optimal Use of Fines and Imprisonment,” 24 J. Pol. Econ. 89 (1984)—that the optimal enforcement of criminal law may generally involve underdeterrence. In the 1999 survey article they write, “Optimal enforcement tends to be characterized by some degree of underdeterrence relative to first-best behavior, because allowing some underdeterrence conserves enforcement resources. More precisely, by lowering the probability of detection from a level that would lead to first-best behavior, the state reduces enforcement costs, and although more individuals commit the harmful act, these individuals do not cause social welfare to decline substantially because their gains are approximately equal to the harm.” Something to bear in mind as you work through the material in this chapter is that these are theoretically defensible hypotheses about crime and criminal behavior but that they are subject, like all hypotheses, to confrontation with real-world data to see whether they explain those phenomena well or ill. You can promise the students that the material in Chapter 12 will cover such empirical evidence as there is on many of the hypotheses raised in this chapter. There are several other topics that are likely to come up in this theoretical discussion. One is the obvious point that if punishment can deter crime, then can’t capital punishment deter first-degree homicide? We shall discuss that topic extensively in the next chapter. But the students ought to recognize that this is, indeed, a natural extension of the Becker model. ©2012 Pearson Education, Inc. Publishing as Addison Wesley

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Second, you might draw a distinction between specific and general deterrence—a standard distinction in the criminological literature. A crime will be “specifically deterred” if the person who has just committed the crime is deterred from committing it again by the sanction imposed upon him. For instance, a criminal sentenced to prison is not going to commit the crime again while in prison. A crime will be “generally deterred” if the punishment of a criminal deters others from committing the same crime. Perhaps they observe the punishment inflicted on their acquaintance and decide that they do not want that inflicted upon them and, so, do not commit the crime. Third, and related to the last point, how would one tell the difference between specific and general deterrence? Put somewhat differently, can we tell, when we incarcerate or otherwise punish someone, the extent to which the subsequent drop in crime, if any, is due to the criminal’s being incarcerated or to the extent that the criminal is incarcerated and others are deterred? Part of the answer has to do with the elasticity of supply of criminals. If that supply is high, then new criminals and expanding activity by existing criminals could completely replace the lack of criminal activity by the person now incarcerated. If the elasticity of supply is low, then almost all of the reduction in crime could be due to lack of activity by the incarcerated criminal. Some might be due to a general deterrent effect, but it’s very difficult to say. Steve Levitt thought of a wonderful, innovative way to measure this difference. We report on that in the next chapter. We also commend the new section F on diminished rationality and its connection to crime and deterrence. (We note above the fact that we deal with this matter empirically in our discussion of the Wilson and Abrahamse article in Chapter 12.)

Chapter 13 Topics in the Economics of Crime and Punishment This chapter focuses on the empirical literature that addresses the hypotheses discussed in the previous chapter. You may well have run out of time in the semester or quarter to go over even some of the material in Chapter 12. But if it is at all possible, you should try to create an incentive for the students to read through this chapter. At a minimum, have them read the final section, which summarizes Steve Levitt’s wonderful summary article, “Understanding Why Crime Fell in the 1990s: Four Factors that Explain the Decline and Six That Do Not,” 18 J. ECON. PERSP. 163 (2004). Their failure to read the entire chapter will not constitute educational malpractice on your part, but it will have them miss such important topics as a summary of the empirical literature on the deterrent effect of criminal sanctions, including the deterrent effect of the death penalty. We have raised the issues of the importance of empirical work throughout the book but particularly in the last chapter.

◼ The Amount of Crime One of the fortunate pieces of news that we were able to report in earlier editions was that possibly since the time of the publication of the first edition (1987) and almost certainly since the time of the publication of the second edition (1993), the amount of crime in the United States has declined. Through the 1990s the decline was precipitous—a 40-percent decline in violent crime and a 30-percent decline in nonviolent crime. The trend has continued into this century, although in the last several years the slowdown in crime has ceased in favor of either no change or a statistically insignificant increase. Homicides in the United States are at the lowest level since the 1930s. Naturally, the decline has begun a debate, which we describe very briefly in the text, about the causes of that decline. The alternative theories to explain the decline could not be more starkly different—it’s the robust economy; it’s the fact that we got “tough on crime,” increasing the number of prisoners from about 500,000 in 1980 to over 2 million by 2002 and almost 2.3 million in 2007; it’s the changing demographics of the United States, the aging of the population; it’s the decline in the market for crack cocaine; it’s the legalization of abortion; and so on. We cover all these and more. But the important thing to say to the students is that all of these theories are facially plausible. Only careful empirical work can sort out which of the theories is supported by the facts. And that’s precisely what the Levitt article, summarized at the end of this chapter, does. One of the most thoughtful students of crime, and someone who has made significant contributions to law and economics, is Professor John J. Donohue of the Stanford Law School. In “Understanding the Time Path of Crime,” J. of Crim. L. and Criminology (1998), Donohue considers some of the factors that explain the “long-term trends in crime over the last 50 years” and seeks to distinguish them “from the short-term fluctuations around those trends.” He identifies two long-run trends in crime over the last half century: “one involving sharply rising crime until the late 1970s, followed by a period of slow decline over the next two decades.”

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Within those long-term trends there have been notable fluctuations. For instance, there was a sharp increase in crime in the 1980s and then a drop in the 1990s. Donohue identifies these facts as most relevant: “First, [over the entire period] there has been a steady drop in non-gun homicides and homicides by adults. Second, beginning in the mid-1980s, gun homicides by juveniles skyrocketed, and after about 1993, they fell sharply. . . . From 1967 through 1973 the rates of incarceration were below 100 per 100,000 for the only time in the last half century. The strong anti-incarceration sentiment in the late 1960s and early 1970s succeeded for a time in reducing the prison population at a time of enormous growth in crime. Beginning in 1974, however, a sharp and unrelenting upturn in incarceration began, and we are now at an historically unprecedented level of roughly 450 inmates for every 100,000 individuals in the country.” Those facts would seem to suggest an inverse causal connection between the amount of crime and the willingness to incarcerate. Another possible explanatory variable that Donohue addresses has been fluctuations in the market for crack cocaine. “In the late 1980s, the magnitude of the cocaine market was roughly $60 billion per year. . . . With the growing crack trade needing literally hundreds of thousands of workers and with almost 400,000 adult drug dealers or possible recruits hauled off to prison or jail, and 500,000 previously unemployed young whites now employed in legitimate activities, it is not surprising that a significant percentage of the roughly 1 million African-Americans aged 15-10 were pulled into the crack trade.” Further evidence that there is a connection between the demand for illegitimate drugs and the amount of crime is the fact that demand peaked in the late 1980s and then began to decline in the 1990s, just about the time that the amount of crime also began to decline. However, Donohue says that there are two problems with this story. “First, the drop in total expenditures on cocaine started too early for this factor to explain the sharp downturn in crime that starts in 1993. Most of the decline in the crack trade had come before 1993. Second, while total expenditures on cocaine have fallen, [a figure contained in the Article] shows that the actual volume of cocaine used has been steady from 1990 through 1995. The declining price at a time when total consumption is steady suggests that the supply and demand curves have both shifted in the direction of lowered price (i.e., they both shifted down) with the offsetting effect being that the quantity consumed remained steady. The outward shift in the supply curve seems most plausibly to have resulted from the rationalization of the distribution system. Perhaps the gangs were able to divide the territory in a way that reduced warfare and facilitated lower costs of production.” Donohue concludes that whatever is explaining the long-term trends in crime, the short-term fluctuations do not seem to be amendable to easy explanation.

◼ Regional Variations in U.S. Murder Rates Murder is the crime that gets the most attention and is, by comparison to crimes in other countries, a distinctly U.S. crime. “In 1996 the United States murder rate was 7.4 per 100,000 people. The next closest country was Finland, at 3.2 per 100,000 people, with France at 1.1, Japan at 0.6, and Britain at 0.5.” (See Fox Butterfield, “Why the South’s Murder Rate Is So High,” New York Times (July 26, 1998).) We give some updated (but roughly comparable) figures in the fifth edition. However, one should be aware that there are significant regional variations within the United States in the murder rate. The South has by far the highest murder rate, one that is almost double that in the Northeast. This differential has persisted for at least 100 years. Louisiana has the highest murder rate in the country— 17.5 murders per 100,000 people in 1996. Indeed, the “former slaveholding states of the old Confederacy all rank in the top 20 states for murder.” In contrast, the “10 states with the lowest homicide rates are in New England and the northern Midwest, with South Dakota’s the lowest at 1.2 murders per 100,000 people.”

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What explains these dramatic variations? There does not appear to be any clear explanation. “In analyzing homicide data for whites, [Richard Nisbett, a professor of psychology at the University of Michigan] found there was no difference in murder rates between white males in the largest cities in the South and the rest of the county. . . . But in medium-sized cities, with populations between 50,000 and 200,000, Southern white males commit murder at a rate twice that of their counterparts in the rest of the nation, he said. In small cities, with populations from 10,000 to 50,000, the ratio is 3 to 1 and in rural areas it is 4 to 1. The excess murder in the South he said, comes from crimes ‘where you could plausibly say an insult had been involved.’”

◼ Race and Crime One of the most painful and difficult subjects on which the text touches is the relationship between race and crime. The sad statistics—as quoted in John J. Donohue, III, and Steven D. Levitt, “The Impact of Race on Policing, Arrest Patterns, and Crime,” 44 J. Law & Econ. 367 (2001)—are that “African Americans, who comprise twelve percent of the U.S. population, account for 47 percent of felony convictions and 54 percent of prison admissions. Studies suggest that one-third of African American males aged 20–29 are under the supervision of the criminal justice system on any given day.” Donohue and Levitt are interested in seeing if any part of this can be explained by the fact that, until recently, most police forces were overwhelmingly white. That is, they are interested in seeing if there is any relationship between the amount of crime, arrest patterns, and the race of police officers. There are reasons for believing that if there were more minority police officers, then there might be more cooperation and less hostility between police and minorities, with the result that there might be less crime. “Same-race policy may lead to a greater willingness of victims of crime to report offenses to the police, an increased ability to solve cases due to community cooperation, and a reduction in the number of unjustified arrests or police harassment.” But there are also reasons for believing that if there were more minority police officers, there might be an adverse effect on the amount of crime. “[I]f police are more reluctant to arrest suspects of their own race even when the arrest is justified (as might be predicted from research in social psychology, same-race policing may be less effective in reducing crime than cross-race policing. Furthermore, the possibility of police corruption may increase with same-race policing.” Which of these possibilities is, in fact, the case depends on careful empirical work, which Donohue and Levitt have done. “We find evidence across a wide range of crime categories that own-race policing is associated with lower numbers of arrests than cross-race policing. . . . Own race policing appears more effective in lowering property crime rates, but does not differ systematically from cross-race policing with respect to violent crime. . . . For the mean city in our sample, reallocating police from random assignment by race to an assignment that maximizes own-race policing (holding the number and racial composition of the police constant) is predicted to reduce arrests by more than 10 percent while decreasing property crime by as much as 20 percent. Violent crime is unaffected.” But they also conclude that own-race policing does not appear to increase the crime-reporting behavior of victims.

◼ Deterrence Professor Steven Levitt of the University of Chicago recently wrote the following: “Becker’s well-known economic model of crime is based on deterrence: potential criminals alter their behavior in response to changing incentives. Empirically, however, it is often difficult to distinguish between deterrence, which is a behavioral response, and incapatiation, in which reductions in crime are attributable solely to criminals being unable to commit crimes because they are locked up. Virtually all of the empirical

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work that purportedly supports the economic model of crime is equally consistent with incapacitation. In some cases, such as determining the impact of policies like ‘three strikes and you’re out’ laws, the distinction is critical. If deterrence is the operative force, then ‘three strikes’ laws are likely to be effective; if only incapacitation is at work, then ‘three strikes’ laws will lead to a geriatric, cost-ineffective prison population.” We now discuss this puzzle through the very important article—Daniel Kessler and Steven D. Levitt, “Using Sentence Enhancements to Distinguish Between Incapacitation and Deterrence,” 42 J. LAW & ECON. 343 (1998)—that we discuss on pp. 536 and 537. This is a very complicated issue, and the Kessler and Levitt article does a better job of explaining how important it is than any other article of which we’re aware. You might also look at an article by Levitt, Lawrence Katz, and Ellen Shustorovich in the Fall 2003 American Law and Economics Review that is well worth discussing in class—“Prison Conditions, Capital Punishment, and Deterrence.”

◼ Incarceration The text makes the point that in the United States we may use imprisonment more than is socially optimal and reinforces that point with a brief summary of the work of Donohue and Siegelman showing that imprisonment may have reached the point of diminishing returns. Here are some additional points on incarceration in the United States from a short piece by John J. DiIluio, Jr., “Two Million Prisoners Are Enough,” Wall Street Journal (March 12, 1999). Professor DiIluio notes that in the late 1990s the U.S. incarcerated population is close to 2 million. (As we indicate in the text, that figure was passed in 2002 and is now close to 2.3 million.) DiIluio contends that this is too many prisoners—specifically, that there are too many nonviolent drug offenders in prison. “Between 1980 and 1994, the incarceration rate for drug arrests increased to 80 per 1,000 arrests from 19.” Meanwhile, he argues, those who ought to be in prison, because they committed violent crimes, are outside of prison. “About a third of all people arrested for violent crimes are on probation, parole, or pretrial release at the time of their arrest. A recent study of Texas probationers found that three years after receiving probation, 44 percent of first-time violent offenders with a prior felony history had returned to prison. Likewise, a 1996 New York state study found that within three years of their release, 43 percent of state prison inmates released between 1985 and 1992 had returned to prison—half for a new crime, half for parole violations.”

◼ Drugs and Crime The text reviews what is, among economists, a widespread view that the illegality of some addictive substances may not be the best means of dealing with the personal and social problems of those substances. One of the most common suggestions for dealing with heroin addiction is the free availability of methadone. But will that cure more problems than it creates? Consider these thoughts on methadone from Christopher Wren, “Holding an Uneasy Line in the Long War on Heroin,” New York Times, Oct. 3, 1998, B3. Wren reports that in the United States (as in many Western European countries) the onset of hard drug problems occurred after World War I, when there was an epidemic of heroin use by returning veterans. New York City had 8,000 addicts and treated them by giving them diminishing doses of heroin for free. But that apparently did not cure the long-term problem of addiction: 9 of 10 of the addicts resumed their habit after they were pronounced cured. The personal and social problems associated with hard drug use continued, but at a diminished rate, through the 1930s, 1940s, and 1950s. The next step in assisting those with an addiction was the development and prescription of methadone. That drug had been developed by German scientists during World War II as a

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synthetic painkiller. Its first use in the treatment of heroin addicts occurred in the mid-1960s by Vincent P. Dole and Marie Nyswander of RockefellerUniversity in New York. There was much initial hope for this method of treatment. Methadone “affects the brain’s receptors for 24 hours, blocking heroin’s three-minute euphoric rush [and methadone] can be taken orally and is medically nontoxic.” Because methadone’s effect is slow—in contrast to heroin’s dramatic ups and downs—it eliminates mood swings, allowing users to pursue normal jobs and other life choices. However, methadone creates a physical dependence that can be as strong as heroin’s. Even if addicts pay for their own methadone, it is still much cheaper than being a heroin addict: methadone costs approximately $13 per day, while heroin can cost $200 per day. For addicts methadone does not give them a euphoric high, but it can do so for those not used to taking opiates. This makes it necessary to control the distribution of the drug to prevent its abuse by non-addicts. Despite these factors suggesting that methadone may be a significant tool in combating addiction, there are signs that the initial hopes for methadone’s success have not been fulfilled. In the early 1970s Drs. Dole and Nyswander found that within two years after quitting methadone 70 to 80 percent of addicts were using illegal opiates again. And today there are an estimated 200,000 heroin users in New York City. Of those there are 36,000 people in the City taking methadone. There are also some troubling signs that suggest that methadone will have an even more difficult time at combating heroin addiction in the future. First, 90 percent of heroin addicts also abuse cocaine, and methadone cannot block that drug. And second, the purity of heroin has more than doubled since methadone was introduced, requiring a larger dose of methadone to overcome it.

◼

Gun Control

Our experience has been that the material in the section on handgun control can spur very instructive class discussion. Here are some additional points to bear in mind in that discussion. The position of one of the foremost scholars of the relationship between guns and crime, John Lott, is that guns have costs and benefits. In our public debate we tend to focus only on the costs and to ignore the benefits. Lott has been assiduous at raising what he believes are important benefits that flow from the wider availability of guns—particularly handguns. The strongest benefit is that the possibility that a gun might be present deters criminals from certain kinds of crimes. For example, there is the point, mentioned in the text, that the percentage of “hot” burglaries is higher in jurisdictions that make it difficult or impossible for citizens to possess handguns. Another benefit to which Lott points is that in 98 percent of the cases in which a potential victim merely brandishes a gun, the attacker breaks off the attack and flees. There is a one-tenth of one percent (1/1000) chance of a defender being killed if he or she brandishes a gun. As to the undoubted costs if handguns are more widely available, Lott says that these costs are overstated. Among the points he makes are these: only about 30 children under 5 are killed by accidents involving guns in a given year (for the sake of comparison, 40 children under 5 are killed each year in accidents involving water buckets; 150 children under 5 are killed by fires started by cigarette lighters; and nearly 1,000 children die each year in accidents in home swimming pools); the contention that the United States has such a high murder rate precisely because we have so many guns (80 million people own approximately 240 million guns in the United States) is wrong (other countries, such as Switzerland, Norway, Finland, New Zealand, and Israel have higher gun ownership rates than the United States but much lower murder rates: and in the United States those states with the highest gun ownership rates have the lowest crime rates—even more dramatically, those states with the highest relative increase in gun ownership rates have the relatively greatest decrease in crime rates).

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You might also look at the work by John Lott and William Landes on multiple-victim public shootings. (There is a citation to the article on the webpage.) Lott and Landes investigate whether passage of state statutes allowing wider availability of concealed weapons has a statistically discernible effect on multiplevictim public shootings. They find that it does. In fact, there is an 84-percent drop in multiple-victim public shootings when right-to-carry legislation is passed. Moreover, they investigate whether this deterrent effect on shooting might not divert those bent on public mayhem into more bombings. They conclude that there is no such divergence. Professor Lott said, in a talk to a class that he taught, that the Gun-Free School Zones Act is an invitation to disturbed people to bring guns there, as happened in the tragedy at Columbine High School in Littleton, Colorado, in April 1999. As he asked the class, “Would any of you put a sign in front of your house that said, ‘This is a gun-free house’?” There have been several attempts to criticize Professor Lott’s findings. See the exchange between Professor Lott and Professors Ayres and Donohue in the Spring 2003 Stanford Law Review. The National Research Council appointed a Committee on Law and Justice that did a thorough study of the relationship between firearms and violence and issued its report in December 2004, Firearms and Violence: A Critical Review. You can learn more about the report at http://www.nap.edu/openbook.php?isbn=0309091241. The report does not endorse Lott’s conclusions but, instead, calls for more evidence.