Econ 200, Lectures Notes, Foldvary

Law’s Order, by David Friedman


Because of scarcity, there is a possibility of conflict as people want the same good.

Two ways to resolve conflict: force and agreement.

Law is created when a group of people agree on rules and leaders.

But to be effective, rules need to be enforced.

A voluntary club can enforce rules by expelling a member

or by calling on a higher authority to enforce the rules.

If the group claims to have a monopoly on the ultimate use of force,

its rules become the laws of a government.

What the law does is to make the use of force predictable.

If any governmental official can use force without any legal constraints,

there is the rule of men rather than of law.

Elements of law and economics:

An economic way of analyzing law.

1. Examining the consequences of laws. Example: rent control.

Laws have unintended consequences.

Predicting the effects and consequences of rules.

2. Examining the economic reasoning behind law.

Explaining why particular rules exist.

This involves the field of economics called “public choice”.

3. Judging what rules should exist, and how to reform the current system.

Much of our law is created by judges in precedents; common law.

Much of law creation and enforcement is by private parties.

A contract creates a private law among the parties.

The enforcement is by lawsuits;

the government provides the courts,

the parties do most of the work.

There are also rules in organizations and families.

Many legal rules enforce cultural norms.

Our law today was not designed but mostly evolved.

Chapter 1. What does economics have to do with law?

The science of economics presumes that people make rational choices.

What does “rational” mean in economics?

Different from the meaning in psychology or sociology.

(the following is not in the book)

Economic rationality consists of two propositions:

1. People’s goals are logically consistent.

If A is preferred to B, and B to C, then A is preferred to C.

2. People economize in their pursuit of goals:

they maximize benefits given some cost, and minimize cost given some benefit.

Economizing implies that people respond to incentives:

They do more if there is a greater benefit, and less if there is a greater cost.

Criminals are rational; they just have different goals and values than non-criminals.

Friedman says people are not always rational, and gives as an example,

his eating a third helping of spaghetti.

But is that really irrational?

Not really. He has short-run and long-run ends or goals, and sometimes the rankings change,

especially when he gets stimuli such as seeing a bag of potato chips.

Question of standard of proof in legal cases.

Two errors: convicting an innocent person, and failure to convict a guilty one.

Higher standard in criminal law vs. civil law.

Civil cases involve money or other assets.

There is no social cost if the payment is reasonably based on damages.

Punishment in criminal cases with prison sentences does impose a social cost.

If an innocent person is convicted,

it is a loss of labor and even life to society as well as the convicted person.

Example: nonwaivable warranty of habitability.

The California Supreme Court adopted the implied warrantee of habitability

            in Green V. Superior Court.

Long-run economic effect: more costly dwellings for lower-income people.

But also perhaps better health, lower illness costs.

If medical services paid from taxes, the warranty may be efficient.

But if medical services are private, low-income tenants are worse off,

because they would have chosen contracts providing the warranty.

Legal rules are to be judged by the structure of incentives they establish

and the consequences of people altering their behavior in response to those incentives.

Ownership of property, especially real estate, is a complex matter.

Property is anything that can be controlled by human action.

Ownership is a bundle of rights. Moral or legal.

Much of real estate law concerns effects on others, and remedies.

2. Efficiency

Generally, efficiency is calculated as outputs / inputs.

The output of law should be social well being,

and since that is subjective, it is whatever folks want the outcomes to be.

Generally, people prefer more wealth to less.

Alfred Marshall: ask people how much they would pay to get a benefit or prevent a loss.

We accept each person’s judgment of what is best for him.

But people may not tell the truth.

Can use demand revelation.

Economists use data on preferences from actual purchases: revealed preferences.

Economic freedom is efficient. Freedom to produce, exchange, consume.

Because it lets people act on their choices.

Resources get allocated to where they are most wanted.

Efficiency is not the highest value.

Morality trumps efficiency.

But in fact, usually, what is efficient is also what is ethical, thus, a free market.

Thou shalt not steal. All transactions are voluntary.

Goods belong to the producers.

Pareto improvement: a law that benefits some without reducing the welfare of others.

Unanimity works at the constitutional level rather than the operational level.

Market exchange are not Pareto improvements,

since switching from being a customer of X to a customer of Y leaves Y worse off.

3. What’s wrong with the World, Part I.

External effects; externalities. Uncompensated effects on others.

Pecuniary or purely financial are not harms. The social effect is neutral.

Suppose I sell my house, and therefore my neighbor has to sell his house for less.

He loses, but the buyer gains. The two cancel out. There is no social cost.

Competition is not a tort. The loss is an incidental injury, not a coercive harm.

In a free and competitive market, the price of a good is based both on the marginal costs of production and the marginal values of the buyers.

Competitive markets produce efficient outcomes.

Market prices are not just what we pay for goods.

Prices reflect the costs and benefits of goods.

When a producer does not also pay the cost to others of his pollution,

he sells his product below its real cost.

Customers therefore buy too much of it.

Solutions include either command-and-control regulation

or a payment of the social cost.

A problem with command regulations is that it forces everybody to do the same thing

regardless of individual costs and benefits, which differ.

Example: smog tests.

Secondly, the government may lack the knowledge of the most efficient way to minimize pollution.

The second approach is to charge firms and car owners for their pollution damage.

This can be done privately by tort law.

A tort is a wrongful act which can be legally remedied by a law suit.

Or it can be done with permits that trade.

Or it can be done by emission fines, fees, Pigovian taxes.

Two types of law: civil and criminal.

Two origins of law: common and statute.

Also constitutional law and international law.

And private law.

When there are many victims, the government can do this with effluent fees or pollution taxes.

Competition itself should not be, and is not, a tort.

Transfer seeking: obtaining subsidies and privileges from government at the expense of the public.

Also called “rent seeking” because economic rent is any surplus gain.

Excessive litigation has social costs: resources on lawyers, experts, court costs.

Chapter 4, What’s wrong with the World, Part 2

Ronald Coase, economist, famous article on social cost.

External effects are the result of actions of all parties.

Transaction costs.

If property rights are complete and there are no transaction costs, then negotiation eliminates externalities efficiently.

Example of a steel mill that does $200,000 / year damage.

It costs $100,000 / year to eliminate the damage.

The cost of shifting the affected land to other uses not affected by pollution is $50,000.

Regardless of where the property rights are regarding pollution, the parties will likely negotiate a change in the land use for a payment of $50,000, the least costly alternative.

With a pollution tax, the still mill would offer the same payment.

Charging for damage is not always the most efficient solution.

Example of a bombing range next to a camp site.

The less costly option is to keep campers out.

The “coming to the nuisance” rule.

It is less expensive to change the location of a development before it is built.

Ownership is a bundle of rights.

If transaction costs are low, the Coasian solution leads to the most efficient outcome,

as rights move to those to whom they are of greatest value.

When harmed, victims should be compensated.

Example: bee keepers and farmers.

Standards require a case-by-case application,

e.g. drivers license requirement.

Bright-line rules: yield easily predictable results

Example: drinking age of 21, voting age of 18.

5. Defining and enforcing property rights

A right is a correlative of a wrong.

The right to do or have X implies that the negation of X is wrong, ethically or legally.

A property right: you may prohibit others from doing any trespass or damage.

What objects do you have a property right to?

house, car, body

If your property is taken, the taker is punished as a criminal.

The penalty should be high enough to deter.

A liability right: you may not stop someone from doing something, but if he does,

he owes compensation for damages. E.g.

The right to performance of a contract

The right not to have your property accidentally damaged

If your property is damaged, you get compensated.

A model:

Railroads in 19th century threw sparks that started fires.

Suppose farmers have two alternatives: wheat which burns, clover which does not burn.

Clover is less profitable.

Railroad has 2 alternatives: install or not, a spark arrester.

One railroad, 100 farmers.

2 Questions:

Who decides whether the railroad may throw sparks?

Who bears the cost of the decision?

Four legal rules:

1. Property right by the railroad. Railroad decides, farmers bear cost.

2. Property right by the farmer. Farmers decide, railroad bears cost.

3. Liability right by the farmer. Railroad decides, railroad bears.

4. Liability right by the railroad. Farmers decide, farmers bear (Incomplete privilege)

Four outcomes:

A. Sparks + Wheat = Fires

B. Sparks + Clover = No fires

C. Spark arrester + Wheat = No fires

D. Spark arrester + Clover = No fires Does not happen.


Cost of            Cost of                        a                      b                      c                      d


Outcome A     Fires                             $400               $800             $800                 $600

Outcome B     Clover                          $800               $400              $400                 $800

Outcome C     Spark Arrester           $1000              $1000              $200                $1000

Rule 1: Property right by the railroad. Railroad decides, farmers bear cost.

suppose column a. Efficient outcome is A, fires. No need to negotiate.

suppose column b. Efficient outcome is B, clover No need to negotiate.

suppose column c. Efficient outcome is C, Spark arrester.

But it may not happen if there can be free riders.

Farmers could have a mutual contract.

Rule 2. Property right by the farmer. Farmers decide, railroad bears cost.

Suppose column a. Efficient outcome is A, fires. Railroad would offer farmers compensation.

            But there can be a holdout problem. Some farmers could demand an extra payment.

Suppose column b. Efficient outcome is B, clover. Railroad would offer farmers the extra cost.

            same problem

Suppose column c. Efficient outcome is C, Spark arrester. No need for negotiation.

Rule 3 Liability right by the farmer. Railroad decides, railroad bears.

suppose column a. Efficient outcome is A, fires.

The farmers could sue for damages, with a litigation cost.

The competence of the courts is an important element of determining the most efficient rule.

Courts do not always know the true costs of actions.

Railroad would offer farmers compensation. No holdout problem.

Suppose column b. Efficient outcome is B, clover

Railroad would offer farmers the extra cost of clover. No holdout problem.

Suppose column c. Efficient outcome is C, Spark arrester. No need for negotiation.

Rule 4. Liability right by the railroad. Farmers decide, farmers bear (Incomplete privilege)

Outcomes A & B at lowest cost.

C: farmers must agree.

Choosing the most efficient rule

If outcome A is always efficient, choose legal rule 1: let them make sparks.

Rule 1: Property right by the railroad. Railroad decides, farmers bear cost.

Friedman’s example: breathing. No tort liability for adding CO2.

lex non curat de minimis.

other Latin moto:

lex non cogit ad impossibilia.

Suppose outcome C is always efficient.

Spark arrester has lowest cost.

We have a property right to not get attacked.

Generally, pick the rule with the least social cost.

Property rules are less costly when the cost of allocating rights by market transactions is low.

Liability rules are attractive when the cost of allocating rights by litigation is low.

Example: trespass by people and trespass by cattle.

If a person trespasses, he violates the law even if he does no physical damage.

If a cow trespasses, the owner is liable only for the damage.

Liability rules versus fines

Property right in a car.

Liability rule for contracts and accidents.

When efficient, treat pollution as a tort.

Current US law treats it as violations of regulations, and fined.

The two approaches have different effects on incentives.

The fine does not go to the victims.

With torts, the victim has a greater incentive to report a violation.

On the other hand, if there are many victims, fines are better.

Example: auto exhaust.