Econ 200, Foldvary, Lectures Notes

Law’s Order, by David Friedman

6. Burning houses and exploding coke bottles

The economics of insurance

Suppose one chance in 100 that a house will burn down in a year.

Cost $100,000. Average cost: $1000. Plus overhead.

Insurance priced at $1100. Why buy?

People pay to get insurance because a large loss hurts more than a small one.

Dollars are worth more when you are poor than when you are richer.

Risk: a known probability of loss.

Uncertainty: the possibility of loss, with no known probability

Individual uncertainty, but for the company, risk.

Risk aversion: the preference for less risk.

Insurance reduces uncertainty and risk, replacing a possible large loss with a known small loss.

As Friedman says, it is really about a taste for outcomes.

Moral hazard: the tendency of insured persons to take on more possibility of loss,

or to use more of a service, raising the costs for others, an example of institutional failure.

A failure of the insured party to take cost-justified precautions.

That increases insurance costs.

Increasing co-payments reduces the hazard, as does obtaining more information on the user.

Insurance companies may specify precautions to take,

or provide discounts for safety measures such as fire alarms.

Coinsurance: insuring only part of the value.

Adverse selection

The problem that those buying insurance are those most likely to receive payouts.

Insurance costs are therefore higher.

Same problem with used cars.

Ask the seller if he is willing to also sell a guarantee.

General rule: put the incentive where it does the most good.

Problem of genetic medical conditions.

Require parents to buy genetic insurance for their children.

7. Ex post and ex ante

Which laws are better.

Ex ante: punish people for acts that increase the probability of accidents.

E.g. drunk driving. Reckless driving.

Ex post: punish actual damage. e.g. collisions.

Why do we punish attempted murder?

It prevents murders by reducing the probability of actual murder.

The threat of harm is itself actual harm.

Ex ante and also ex post punishment for murder.

Ex post punishment gets the actor to use his private information.

The driver knows best what his weakness it.

Ex ante fines have to be observable.

Ex ante is efficient with small fines imposed with high probability.

Ex post punishment takes into account non-observable information.

Similar to why a pollution charge is better than regulation.

Regulation: one mandate for all regardless of costs.

Regulation controls inputs. Ex ante.

Effluent charges punish producing the bad output.

A speeding ticket is ex post.

Speed limits are ex ante as a bright line.

California 65 mph.

Lower speed limits are prima facie.

Prima facie is a Latin expression meaning on its first encounter, first face, or at first sight.

A "prima facie speed limit" may be exceeded by a driver.

However, if the driver is detected and cited by police for exceeding the limit,

the onus of proof is on the driver to show that the speed at which the driver was traveling

was safe under the circumstances.

A driver can receive a traffic citation for violating the Basic Speed Law even if their speed is below the "maximum speed limit" if road, weather, or traffic conditions make that speed unsafe.

However, because the Basic Speed Law establishes prima facie limits, not absolute ones, they can also defend against a citation for speeding "by competent evidence that the speed in excess of said limits did not constitute a violation of the basic speed law at the time, place and under the conditions then existing," per section 22351(b) of the California Vehicle Code.

As attorney David Brown says in his book Fight Your Ticket & Win in California,

"a person traveling over the speed limit–but less than the usual 65 mph maximum speed (55 mph for two-lane undivided highways)–isn't necessarily violating the law"

and that "you can defend against a charge of violating the Basic Speed Law not only by showing you weren't exceeding the speed limit, but also by establishing that even if you were over the limit, your speed was nevertheless 'safe' under the circumstances."

If drivers overestimate their ability,

ex ante speed limits have an advantage.

But the state has an incentive to use traffic fines for revenue.

Fines were raised after Prop. 13.

But they are often set below actually safe levels,

wasting time and causing drivers to look behind rather than ahead.

Photo-enforcement of red lights;

some cities have reduced the time for yellow lights.

Criminal law uses costly punishments.

Many criminals cannot pay large fines.

If you pay a fine, there is little net social cost.

If you are falsely executed or imprisoned, there is a social cost.

If the damage done by accidents is small,

people can pay the ex post fine or tort claim,

and ex ante laws are not warranted.

We should never observe systems of pure ex-ante punishment.

8. Game theory

Game theory explains decision making with incomplete information.

A “game” consists of players, rules, and payoffs for each player.

A game can be cooperative or rival (non-cooperative)

Game outcomes can be positive sum, negative sum, or zero sum.

A game can be one-time or repeated.

Economic games involve strategies.

“Strategic” means each player takes into account the likely reactions of other players.

A dominant strategy is one that is the best for a player.

Bilateral monopoly. E.g. marriage, child. USSR and USA.

Legal rules that lead to bilateral monopolies with high stakes should be avoided.

Damage awards are favored rather than requiring specific performance of contract.

One basic game is called the prisoners’ dilemma.

The story is that there are two thieves who get caught.

They are partners in crime, but they don’t love each other.

They are questioned in separate rooms.

If one confesses and the other does not, the confessor goes free and the other 20 years in prison.

If they both confess they get 8 years.

If neither confesses, they get a lesser charge, and only 1 year in prison.

The incentive is for both to confess, unless they are in love.

Confessing is the dominant strategy.

(Not really a dilemma if the choice is clear.)

During the Cold War, the arms race was also a prisoners’ dilemma.

Advertising another example.

Also, common resources.

An oligopoly is like the prisoners’ dilemma.

In repeated games, there is communication, and the outcome can be different.

Tit-for-tat strategy in repeated games is: cooperate with others who do so, otherwise, not.

This is a successful long-term strategy.

Government policy to increase competition has to be weighed against possible government failure, including the abuse of power, ignorance, and policy that ends up reducing productivity.

In a duopoly without collusion, each firm might maximize profit at a lower price and greater quantity than is the case with a monopoly. But the price is higher than in atomistic competition.

When neither firm has an incentive to change its price, this stable outcome is called a “Nash equilibrium.”

It is named after John Nash, the mathematician who worked on economic game theory and won the Nobel prize in economics. He developed the concept of the Nash Equilibrium for his dissertation.

The movie “A Beautiful Mind” tells the story of his life.

A Nash equilibrium is the outcome where the players choose their best strategy given the strategies chosen by the others.

The lower the concentration of the industry, the less is the impact of other individual firms.

In repeated games, there is communication, and the outcome can be different.

Tit-for-tat strategy in repeated games is: cooperate with others who do so, otherwise, not.

This is a successful long-term strategy.

Plea bargaining can make punishment greater.

All defendants are better off if they all refuse, but each is in a prisoner’s dilemma.

Chapter 9: As Much as Your Life is Worth

We have to value human life because it takes resources to reduce the risk of death.

How does one price a life?

A few million dollars.

If life has infinite value, then we avoid any risks to life.

Drive 20 miles per hour.

The law requires a price on life in order to compensate the family.

Value of human life for premium for riskier work.

Also, how much people pay for equipment that reduces risk.

Inchoate tort claim

inchoate: A legal right or entitlement that is in progress and is neither ripe, vested nor perfected.

Inchoate legal interests are those which are in their beginning or preliminary stages and which will mature or develop into a full property right.

David Friedman proposes a market for inchoate tort claims.

You could sell your right to damages to someone else.

Suppose there is a 1/10 of a percent chance that you will die in an accident,

and the courts will award $1,000,000 to a successful claimant.

In expected value, the right to make this claim is $1000,

minus some administrative and legal costs.

An insurance company could buy a "tort future" from you,

paying you $900 for the right to make a legal claim in the event of your death.

The law could use this method for injuries in general.

Common law does not treat tort claims as transferrable property.

Generally, torts would be more efficient if they were transferrable.

An injured person is worse off in 3 ways:

1. Pecuniary costs: medical, lost wages during the recovery.

2. Suffering and less enjoyment.

3. Reduction of future wages.


First issue of Journal of Law and Economics in 1958.

Governmental law comes from legislatures and judges.

Judges interpret legislation and resolve ambiguities.

"Stare decisis": Latin for "to stand by a decision."

From the Latin maxim: Stare decisis et non quieta movere:

"to stand by decisions and not disturb the undisturbed."

Decisions of one court are binding on another court.

A decision creates precedents.

The general principle in common law legal systems is that similar cases should be decided so as to give similar and predictable outcomes.

Common law precedent is a third kind of law,

on equal footing with statutory law (statutes and codes enacted by legislative bodies),

and regulatory law (regulations promulgated by executive branch agencies).

This is understood to mean that courts should generally abide by precedent and not disturb settled matters.

The Supreme Court of California's explanation of this principle is that

[u]nder the doctrine of stare decisis, all tribunals exercising inferior jurisdiction are required to follow decisions of courts exercising superior jurisdiction.

Otherwise, the doctrine of stare decisis makes no sense.

The decisions of the California Supreme Court are binding upon and must be followed by all the state courts of California.

Decisions of every division of the District Courts of Appeal are binding upon all the justice and municipal courts and upon all the superior courts of this state, and this is so whether or not the superior court is acting as a trial or appellate court.

Courts exercising inferior jurisdiction must accept the law declared by courts of superior jurisdiction. It is not their function to attempt to overrule decisions of a higher court.

Judges go beyond interpreting statutory law, and actually create new law by filling in voids in existing law, or by voiding law as unconstitutional.

In judging the law for its justice, a court may use natural moral law, or ignore it.

Most of the decisions that law students study are by appeals courts.

The structure of law

Criminal law

Plaintiff is the government.

Fines are paid to government.

The victim is not a party to the case.

Punishment can include prison and execution.

Standard of proof: beyond a reasonable doubt.

Driving under the influence of alcohol is usually a crime.

Proof beyond a reasonable doubt

Civil law

Plaintiff is a private person, corporation, or a government

Government can prosecute cases under civil law.

Penalties paid to the victim, who is suing.

There is no imprisonment or execution.

Infractions may be fined without a jury.

Standard of proof, preponderance of evidence

Tort law involves wrongs for which victims can sue to recover damages.

Traffic law

The right to drive is a privilege, which is mainly governed by the individual states.

There is an increasing trend among states to "decriminalize" ordinary traffic violations.

These states call traffic violations "civil infractions," or similar terms.

Although this may sound good, in some instances it can make it harder to fight a ticket. Typically, where tickets are treated as civil offenses, states make it easier to be convicted

Parking tickets are not criminal offenses. They involve civil penalties only.

Because defendants in civil traffic infraction cases are not subject to imprisonment, they are not constitutionally entitled to all the procedural safeguards associated with a criminal trial, such as the right to a jury trial or the right to court-appointed counsel.

Additionally, because traffic infractions are not "crimes," a judgment determining that a defendant committed an infraction is not reported on the defendant's criminal record

Some traffic violations are considered criminal matters, and are handled as criminal law cases.

The sentence imposed is an obligation that the offender has towards the state for violation of law. The law violator can be ordered to forfeit his/her personal freedom,

rather than just being ordered to pay a money judgment,

which is the typical civil law outcome.

Unless you've committed a major violation or the violation is otherwise dangerous or life-threatening to other motorists, the officer will simply issue you a traffic ticket.

Because you are actually being charged with a violation of law, the officer could take you into custody if you refuse to sign the ticket.

Misdemeanors are more serious offenses with a punishment of up to a specific monetary fine and up to one year in jail.

Felonies are the most serious crimes of which you have monetary fines and a minimum of one year and a day to life imprisonment.

Constitutional law

Especially the Bill of Rights. But also ex post facto, habeus corpus.

Commerce among the states. The general welfare.

Natural law

9th Amendment: The enumeration in the Constitution, of certain rights,

shall not be construed to deny or disparage others retained by the people.

California constitution: Section 24 of Article I:

"This declaration of rights may not be construed to impair or deny others retained by the people."