Think about the oldest and most familiar principles of American law, property and proportional liability, in a new and surprising way, and learn to apply economic reasoning to an especially important and interesting aspect of life.
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Property and Liability: An Introduction to Law and Economics
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Externality
Exchange involves both benefit and cost – traders take rights from others, imposing costs on them but creating benefit for themselves, but they must compensate the others for their costs by paying for the rights they've taken. External costs are imposed when one person takes another's rights without paying for them, which leads to the taker taking more rights than efficient allocation would allow and leaves the victim uncompensated for the costs of losing the rights. The law's response to this inefficiency and injustice is liability, forcing those who take rights without payment to compensate those whose rights they have taken for the costs they have borne. Thinking about how the law determines these liability prices, and how people might respond to them, reveals the underlying economic logic of liability.
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Richard AdelsteinProfessor
Department of Economics
Hi, everybody. Welcome back.
Let me conclude our discussion of the steel plant example by talking about the
fourth potential solution to the uncompensated taking of the neighbors
rights to good health by the steel plant. This fourth alternative, I'll refer to as
social norms and I'll describe the solution in this way.
Administering any system of liability or taxation as, as we've seen is costly,
it's cumbersome, it's late,and it often involves intrusions into the lives of all
of the people who are party to the case. They must spend not just their time and
effort, they must reveal a great deal about themselves, reveal a great deal
about what's happened to them, and about the, the situation in which they found
themselves. Wouldn't it be better, generally, to
avoid all of these costs in favor of a kind of internal policing of cost
impulses through social norms. That is, to produce people who don't want
to seize the entitlements of others without compensation.
Notice that the liability system, like the exchange system, attempts to
influence the behavior of cost imposers, by inflicting a particular kind of price
on the activities that they undertake. So, in this view, we sort of assume that
people, cost imposers, already know what they want to do.
And then, they're either deterred from doing it or encouraged to do it by the
level of the price that they'll have to pay if they perform the cost imposition.
If the price of the cost imposition is smaller than the benefits they receive,
they'll impose the costs and pay for them.
But if the cost imposition is worth more then the, if that is if the costs imposed
upon he victims are greater than the benefits to the to the steel plant, to
the cost imposer. Then, of his or her own volition, the
cost imposer will simply not inflict the cost because the price is too high.
In both cases, the cost imposer wanted the same thing which was to impose the
costs. In one case, the imposer was deterred by
a high price, in the second case the imposer might not be deterred because the
price would be too low. Norms, contrarily, attempt to influence
the behavior of cost imposers, not by placing a price on activities that
imposers already know they want to do, but by attacking the preferences of the
cost imposers, directly. That is, by making or persuading the cost
imposers that they get no value out of the cost imposition.
They don't want to impose the cost. If they don't want to impose the costs,
then they won't impose them even if the liability price is very low or even if
it's very unlikely that they will be caught.
The low price won't encourage them to commit the tort to impose the cost.
Because, in fact, their social norm, the social norm that's influenced them has
already persuaded them that they don't want to do that.
Let me illustrate this point with what a great economist, George Akerlof, I'll
show you his picture in a moment, has called the Market for Lemons.
In the United States, as you can see in the picture, there are literally
thousands of places where you can buy a used car.
But it's always very risky to buy a used car, much riskier than buying a new car.
Most car dealers will guarantee that a new car will work exactly as advertised.
And so, most people who buy new cars are very confident that the car that they buy
will in fact be worth what they're paying for.
Because they haven't been lied to by the dealer and sold a car that is not worth
as much as they think it is worth, and as much as they're paying.
This is obviously much more difficult with used cars.
Used cars have been driven around by people that the potential or prospective
buyer doesn't know. And dealers try very hard to persuade
potential buyers of used cars that the cars that they are buying are in terrific
condition and will run beautifully. But some used cars simply don't work and
Americans called used cars that don't work, lemons.
And to distinguish lemons from used cars that do work, Americans sometimes call
the used cars that do work, as they are advertised, cream puffs.
So, the question before the floor is, what will the market for used cars look
like if some of the cars being sold are lemons and some of the cars being sold
are cream puffs? Let's do antother thought experiment.
Suppose that there are a very large number of identical used car dealers in a
particular area. Say, a 100 used car dealers, and each of
the used car dealers, we'll assume sells exactly the same number of cars every
year. Suppose however, that one dealer in 10
sells only lemons, while the other 9 dealers sell only cream puffs, okay?
That is, there are 9 dealers who will sell cars with proper advertising, that
are worth exactly what the sale prices says what they're worth.
But there is one dealer in 10 who won't do this and they'll sell cars that are
worth much, much less than the asking price.
Suppose that the asking price of all used cars is $1,000, that a cream puff is
worth $1,000, but that a lemon is worth nothing.
In this situation, there exists what economists call an information asymmetry,
that is, all the dealers know whether they themselves are selling cream puffs
or lemons. But no dealer has any way to communicate
reliably to any potential buyer whether that dealer is selling a lemon or a cream
puff. Why?
Because, well, the dealers who are selling cream puffs will quite honestly
tell perspective buyers that the cars that they're selling for $1,000 are cream
puffs and they are worth the full thousand dollars.
But the dealers who are selling lemons that are worth nothing, won't tell their
perspective customers that they're going to buy a lemon.
They tell their perspective buyers that they're going to buy a cream puff, too.
Except, these dealers are obviously lying in an attempt to deceive their customers
into buying a car that is worth nothing and paying a $1,000 for it.
Since no buyer has any reliable way to determine whether the dealer is telling
him or her the truth. When the dealer says that only cream
puffs are sold on our lot, then the perspective must take into account the
possibility that the car that the buyer buys will be a lemon and not a cream
puff. If 9 10ths of the cars are worth a $1000,
and 1 10th of the cars are worth zero, then, just as we calculated before, the
expected value of every car, cream puff or lemon.
It's 0.9 times a $1000, that is the $1000 value of a cream puff multiplied by the
probability that any given car is a cream puff and that value comes out to $900.
But you'll notice that $900 is not enough to buy a cream puff.
Cream puffs are actually worth a $1000 and therefore, the honest car dealers
can't sell their cream puffs for $1000 because of the existence of the dishonest
car dealers who are selling lemons worth nothing at a price of $1000.
The result of this is that no buyer will be willing to pay more than $900 for any
car and as a result, no cream puffs will be sold.
The only cars that would be sold at $900 would be lemons.
But now, the people will know that the cars that they will be able to buy for
$900 will be lemons. And so, no cars at all are likely to be
sold, and the existence of the dishonest car dealers has essentially eliminated
the market for used cars in this area. Even though buyers want cars worth a
$1000 and are willing to pay a $1000 for those cars and honest sellers want to
sell them, cars worth $1000 for a $1000. The market will fail because of the
dishonesty of the cheating car dealers and the information asymmetry that makes
it impossible for buyers to distinguish those dealers who are selling cream puffs
from those who are selling lemons. So, this problem was first developed in
the way that I've described it by a great economist, as I've said, named George
Akerlof, a teacher at the University of California at Berkeley.
One solution to the problem of the market for lemons, or should we say, the failure
of the market for lemons, is to define selling lemons as a fraud, a crime, or a
tort. And then to use the liability symmetry,
the liability system to limit its incidence.
Again, this would address the problem of fraud by putting a price on the fraud
that might be too high for the potential fraudsters to pay.
So, the attempt of the liability system, again, is to influence the behavior of
the dishonest car dealers by making their behavior costly by forcing them to pay
the costs that their that their deceit would impose upon other people.
But, as we've seen, the liability system is costly and it's imperfect.
Imperfect both in the inaccuracy that sometimes plagues its attempts at cost
estimation and, therefore, the determination of the correct liability
price. And it's imperfect in the sense that not
every cost imposer is actually caught and brought to bear, brought to the bar of
justice and made to pay the compensation costs.
But again, suppose that we attack the problem not through prices but directly
through the preferences of the fraudsters.
That is, suppose that instead, people were persuaded that it is simply wrong to
deceive people in commerce. And as a result of that belief, they
forebear from doing the cost imposition because that's what they want to do and
not because they're deterred by the prospect of paying for the costs that
they imposed. If this were the case, if we could rely
on the cost imposers themselves to solve the problem by deciding not to impose the
costs, we'd get more reliable externality control.
And we'd achieve that externality control at far less costs than the liability
system because norms work invisible as it were, you don't have to produce a
machinery to manifest the law. And then, inflict the law and the cost
imposer, the system of norms if we can call it as such work silently and
invisibly in the minds of the individual who might have imposed the cost but are
persuaded not to. This, in itself, raises a very
interesting kind of question. As we've seen, it's inefficient for there
to be fraud. That is, if there is fraud, Professor
Akerlof's arguments suggest that there will be a lot of exchanges that people
might be willing to undertake. And that would benefit both sides of the
exchange that won't be undertaken at all if there are fraudsters afoot, and the
value of these lost transaction that would have benefited all parties is a
serious inefficeincy. So, one reason to oppose fraud is that it
makes for inefficient allocation of property rights.
But most people think that fraud is simply wrong.
That it's not right to lie to people in commerce and to deceive them for the
purpose of profiting from them, and then sticking them with a car that's worth
much less than they thought they were paying for.
Most people, that is, think that fraud is wrong.
So, an interesting question is whether there's a relationship between what's
efficient and what's right. So, let me suggest, let me close this
part of the course by suggesting yet another thought experiment.
This one being another economist, the Austrian economist Friedrich Hayek and
his thought experiment goes like this. Assume that at the beginning of human
history, there are 100 scattered, isolated societies around the world.
Each of the societies is very small and each of them lives at a sufficient
distance from all of the other societies, that the societies come in absolutely no
contact with one another. Each of the 100 scattered societies will
assume it's self-contained and has no contact with any other society.
Then, let's assume that completely randomly, 50 of these societies live by
the norm that stealing is wrong. We won't inquire why they believe
stealing is wrong, how they came to that belief, we'll just assume that in those
50 societies, people don't steal because they believe that stealing is wrong.
Completely randomly, the other 50 societies, we'll assume, live by the
opposite norm. Not so much that stealing is right and
everybody should do it, but that stealing is not wrong.
And therefore, if it's convenient for you and you think you have a good reason to
do it, then you can go ahead and steal and it won't be a problem with anybody
else in the society. So, we have these hundred societies.
50 of them live in one way with one moral code, and the other 50 live in a
different way with the opposite moral code, and the two societies don't come
into contact with one another. So, let's see what will happen as life
proceeds in these two societies. In the former society, the one that
believes that stealing is wrong, let's suppose that the farmers go out in the
spring, and plant a crop of corn for food for the entire society over the next
year. The farmers invest something in the land.
They invest something in the seed. And they invest substantial labor over
the course of the summer to produce the corn.
And sure enough, at the end of the summer, the fields are rich with corn and
the farmers are ready to harvest. And they're able to harvest the corn
because all of the people in the society obey the norm that stealing is wrong.
It may well be that somebody will walk by the cornfield in September or October and
say, gee, that corn looks great, I'd like to have some of it for myself, maybe I
should just take it. But in this society, that individual will
not take the corn, because the corn would be stolen, and stealing is wrong.
As a result of this norm, the corn is left on the stalk for the farmer himself
to harvest. He harvests the corn, he sells the crop,
he earns the money that the crop has, has been sold for, the people in the society
have the corn to eat. And the farmer has his payment, his
compensation, for all the labor and investment that he's made.
And so, when the next spring rolls around, that same farmer will confidently
plant another crop of corn. Confident that he can again plant the
corn, invest his money and effort in the production of the corn, and be confident
that when the corn is ready to be harvested, it will be left on the stalk
for him. Because there is no stealing, his
incentive to invest is high, and because his incentive to invest is high, the
people in this society eat corn. Now, consider the 50 societies that live
by the norm, stealing is not wrong. Here, too, the farmers in the spring
begin to invest a great deal of money and a great deal of labor in the production
of corn to feed their fellows in the society.
They, too, are blessed with the good crop, and as the fall approaches, it's
time for this good crop to be harvested. But in the second group of societies,
people now walk passed the corn and they say, just as did in the first societies,
boy, that corn looks good, I'd like to have some of it for myself.
And since the norm is that stealing is not wrong, they cheerfully walk up to the
stalks of corn, pick the stalks and take the stalks of corn away.
Pretty soon, all of the corn is gone. And when the farmer comes to harvest his
crop, he discovers that there is no crop to harvest.
Therefore, he can not sell the crop that he has harvested because it doesn't
exist. And therefore, the people won't get to
eat that corn, at least from the farmer. The people who have stolen the corn will
get to eat it, at least for that winter. But people who haven't stolen it, won't
get to eat it unless they purchase it from the others.
The real problem comes next spring. Now, in these societies the farmer
remembers what happened to him the following fall.
After investing all that cost and all of that labor in producing a crop of corn,
the farmer has found the value of that crop to him completely destroyed.
Because his fellow citizens are comfortable in simply stealing the corn
from him before he gets a chance to harvest it.
So, all of his investment of cost and labor at the end has been a waste.
And so, the next spring, he says to himself, am I going to plant corn again?
Am I going to invest in the labor, invest in the seed, invest in the land to
produce a crop that's simply going to be stolen from me in the fall so I can
realize no compensation for the costs that I've incurred in growing the corn?
Not on your life, he says. I'll just sit back and not grow corn at
all. And, of course, the result of that is
that nobody has any corn to steal, nobody has any corn to eat, and the members of
the society starve. After enough time, after several years of
this, only the societies who don't steal are left surviving, because all the
people in the other societies have died of starvation.
And so, the only people who are left are people who think that stealing is wrong.
Everyone thinks that stealing is wrong, it's a universal norm.
But whether it's right or wrong, it's obviously inefficient.
And so the question then arises, one indeed, which no one really knows the
answer to. And the question is are important,
widely-observed norms, norms like don't lie, don't cheat, don't steal.
Norms that are obeyed by and large everywhere on the planet Earth, all
societies, all modern societies certainly have a norm against stealing, have a norm
against obvious forms of cheating, have a norm against lying.
It doesn't mean that people never do these things, it's that when people do
these things, they get a pang of conscience and they know that it's wrong.
Again, the question is are these important, widely-observed social norms,
what they are because they express universal moral truths or because more
simply, they allow the societies that observe them to prosper.
Whereas, societies that don't observe them fail.
We finished our discussion of externality and the steel plant.
And in the lectures that follow, I'll be talking about crime as distinct from
tort, and speak about the criminal justice system as a liability system.
See you next time.
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