Prof. Dr. Friedrich Schneider
Institut für Volkswirtschaftslehre
http://www.econ.jku.at/schneider
Recht und Ökonomie
(Law and Economics)
LVA-Nr.: 239.203
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(2) The Coase Theorem and Behavioral Economics
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1. Assumptions and premises
 People respond to incentives.
 Law is a method of ordering society to further social
goals.
– Law creates incentives for people to behave in
certain ways.
– Law can help people by facilitating
achievement of their legitimate goals.
their
 Economics provides both theoretical and empirical
techniques for examining law’s likely and actual effects
in the world.
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1. Assumptions and premises (cont.)
 So, to discourage a particular activity, law should
increase the “price” for engaging in that activity.
– E.g., by increasing the sanction for engaging in
undesirable behavior.
– Or by increasing monitoring and enforcement of the
undesirable activity.
– If legal sanctions increase or become more likely,
people will “consume” less of the sanctiontriggering activity.
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2. Coase Theorem
 Ronald A. Coase, “The Problem of Social Cost,” 3 J.L.
& Econ. 1 (1960).
 If transaction costs are zero, bargaining will lead to an
efficient allocation of resources, regardless of the law.
 Law is only necessary to induce efficient behavior
when transaction costs are positive.
 An implication: assign legal entitlements to the party
who would have ended up with the entitlement
(that is, to the person who values it the most).
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3. The Economics of Contract Law
 Law should seek to reduce the costs of concluding and
enforcing consensual agreements.
 Law does so by providing a set of default and
mandatory rules that contracting parties can use as a
template for concluding an agreement.
– Default rules.
– Mandatory rules.
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3. The Economics of Contract Law (cont.)
 Why do private parties need help in forming, relying
upon, and completing consensual agreements?
– Time-intensive transactions (i.e., those that take
time to complete).
– Coordination, commitment, and cooperation.
– Risk allocation.
– Information exchange.
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4. The Economics of Tort Law
 Minimize the social costs of accidents.
– Precaution costs.
– Accident losses.
– Administrative costs.
 Continue to assume that potential victims and injurers
are rational decision-makers.
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4. The Economics of Tort Law (cont.)
 Tort law holds out the prospect of liability for accident
losses so as to:
– create incentives for parties to choose levels of
precaution and activities in which to participate in
order to minimize their liability, and
– thereby to minimize the social costs of accidents.
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5. Precaution costs
 How does a rational potential injurer decide how much
precaution to purchase?
– Assume provisionally that the injurer will be liable
for the victim’s losses if there is an accident.
o But recognize that most parties are acting
“behind a veil of ignorance” - they do not know if
they will be a victim or an injurer.
– A rational potential injurer takes all cost-justified
precaution - i.e., precaution for which the cost of the
last unit of precaution taken is just equal to the
benefit provided by that precaution.
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5. Precaution costs (cont.)
 The expected benefit of a unit of precaution equals the probability
of an accident’s occurring times the anticipated accident losses.
 Suppose that one more unit of care will reduce the probability of
an accident’s occurring by 0.005 and that if an accident occurs,
given that amount of precaution, the losses are likely to be
100,000$.
 The expected benefit of that unit of precaution is (0.005) x
100,000$ = 500$.
 So, if that unit of precaution costs less than 500$, society would
like a potential injurer to purchase the precaution because the
cost is less than the expected benefit.
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6. Additional topics in the economics
of tort liability
 Different tort liability standards.
 The relationship between administrative agency safety
regulation and tort liability.
– Should regulatory compliance be a defense in a
private tort action?
 “Who are these rational people you’re talking about?”
– If injurers and victims are not fully rational, then a
situation that might seem to be one of bilateral
precaution may be, instead, one of unilateral
precaution.
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7. Crime and Punishment
 Becker’s rational-choice theory of the decision to
commit a crime:
– Criminal compares the expected costs (EC) and
expected benefits (EB) of a crime.
– Expected costs (EC) include the probability of
detection, arrest, and conviction times the value of
the sanction imposed.
– Expected benefits (EB) include the monetary value
of the crime plus any non-monetary satisfaction the
criminal receives.
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7. Crime and Punishment (cont.)
 A rational potential criminal commits the crime if
EB > EC and refrains if EB < EC.
 Society can reduce crime by raising the expected
costs of crime.
– Raise the probability of detection, arrest and
conviction, or
– increase the criminal sanction, or
– do both.
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8. Recent U.S. Statistics on Crime
 Since mid- and late 1980s a decline in non-violent
crime. There is now less auto theft in the U.S. than in
much of Western Europe.
– Property crimes down 30 percent in the 1990s.
 Since 1991 a precipitous decline in violent crime, with
homicide at the lowest level since the 1930s.
– Homicide rates down 40 percent in the 1990s.
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9. Why the Decline in Crime?
 “Deterrence works”.
– Increasing incarceration rates.
– More police and improved policing strategies.
 Decline in crack cocaine.
 A robust economy.
 Increased victim precaution.
– Alarms and security procedures.
– Faster and more effective trauma treatment.
 The legalization of abortion?
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime”
 Donohue and Levitt attribute half of the decline in
crime since 1991 to the legalization of abortion in 1973.
– Roe vs. Wade led to a significant increase in the
number of abortions. (1.6 million per year by 1980;
1 abortion per 2 live births.) Therefore, relatively
fewer 18 year-olds in the population beginning in
1991.
– All the other factors together account for the other
half of the decline.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
 What’s the evidence for legalized abortion’s effect on
crime?
(1) Broad consistency with the prevailing pattern namely, most crime is committed by 18-24 year-old
males; because of legalized abortion, there are
fewer 18 year-olds exactly 18 years after Roe, and
that’s when the downturn in crime began.
(2) Five states legalized abortion in 1970 (before Roe v.
Wade), and they experienced a decline in crime
before the rest of the country did.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
(3) Higher rates of abortion in a state in the late 1970s
and early 1980s are strongly linked to lower crime
(in that state) for the period from 1985 to 1997.
(4) There is no relationship between abortion rates in
the mid-1970s and crime changes between 1972 and
1985.
(5) Almost all of the decline in crime in the 1990s can
be attributed to reduction in crime among the
cohorts born after abortion legislation; there is little
change in crime among older cohorts (over the last
30 years).
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
 The other hypotheses are unlikely to explain the drop
in crime in the 1990s:
(6) The greater use of imprisonment, more police, and
changes in police strategies have been going on for
a long time. It’s unlikely that they could cause a
sudden and sharp drop in crime just in the 1990s.
And the drop occurred in places, such as Los
Angeles,
where
there
was
no
particular
improvement in the police force.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
(7) Similarly for the decline in the crack cocaine trade.
That was largely a phenomenon of major urban
areas. But the crime drop occurred not just in major
urban areas but everywhere.
(8) The robust economy has been with us since the
early 1980s, not just in the 1990s. And, moreover,
there is a relatively weak correlation between
macroeconomic activity and crime levels. Indeed,
there is some evidence that much crime is anticyclical, increasing when the economy is doing well
and declining when it is doing poorly.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
 Donohue and Levitt identify two components that make
up the total effect that legalized abortion had on crime:
(1) The “cohort size” effect:
When the cohort reaches the late teens - the prime
years for committing crimes, there are fewer of them
and, therefore, less crime.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
(2) The “cohort quality” effect:
Children born after abortion legalization may on
average have lower subsequent rates of criminality.
o Women who have abortions are those most at risk
to give birth to children who would engage in
criminal activity. Teenagers, unmarried women,
and the economically disadvantaged.
o Women may use abortion to optimize the timing of
childbearing. Through abortion women may delay
childbearing till later if their current conditions are
suboptimal. Children tend to be born into better
environments.
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10. Donohue & Levitt: “The Impact of Legalized
Abortion on Crime” (cont.)
 Of the half of the drop in crime in the 1990s that
Donohue & Levitt attribute to the legalization of
abortion:
– about half of that total effect is attributable to the
“cohort size” effect, and
– about half to the “cohort quality” effect.
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11. New developments in law and economics
New developments:
(1) Empirical research.
(2) Behavioral law and economics.
(3) The impact of law and economics on the legal
academy.
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12. Law and empirical economics:
Ellickson and Social Norms
 Natural experiment: damage done to property by
unsupervised cattle in Shasta County, California.
– In part of the county the owners of cattle were
responsible for damage done by their unsupervised
cattle.
– In the other half of the county, owners were not
responsible.
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12. Law and empirical economics:
Ellickson and Social Norms (cont.)
 Should there be a difference between the two halves of
the county in terms of the number of cattle and other
indicators of efficiency?
– Not necessarily, if the Coase Theorem is true.
 There was no difference in behavior between the two
halves, even though the liability rules were different.
Why?
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12. Law and empirical economics:
Ellickson and Social Norms (cont.)
 Not because neighbors were bargaining to the most
efficient result, regardless of the law.
 Rather, because neighbors were not paying attention
to the law.
 They sought to conform their behavior to the prevailing
social norms, not to the law.
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13. Behavioral law and economics
 Recall the close connection between rational choice
theory (RCT) and traditional law and economics.
 Social and cognitive psychologists have found some
systematic deviations from the predictions of RCT.
 Taking these deviations into account in analyzing law
leads to changes in the economic analysis of that
flowed from RCT.
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13. Behavioral law and economics (cont.)
 Consider four examples:
(1) Endowment effect / status quo bias.
(2) The ultimatum bargaining
(results, implications).
game
experiments
(3) Loss aversion.
(4) Difficulties with probabilistic reasoning.
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13.1. Endowment effect / status quo bias
 People seem to place a very high value on the things
they have and the way things are.
 Systematic difference between:
 the willingness-to-pay (WTP): price to acquire
something one doesn’t have, and
 the willingness-to-accept (WTA): price to give up
that same thing if one already possesses it.
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13.1. Endowment effect / status quo bias (cont.)
 WTA ≈ 2 WTP.
 Not experience-related.
 Applies to pens, coffee mugs, and other trivially
valuable items.
 Implication:
– Far more difficult to change the way things are than
one might anticipate.
– Change may not just be a matter of transaction
costs.
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13.1. Endowment effect / status quo bias (cont.)
WTA
WTP
Person A
8$
6$
Person B
10$
4$
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13.2. The ultimatum bargaining game
 Two parties are to split 20$.
– This is a pure cooperative surplus.
– The players are not allowed to talk or meet.
 Player 1 makes an offer for division of the 20$.
 Player 2 can accept the offer, in which case they each
get the proposed division, or reject the offer, in which
case neither player receives anything.
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13.2.1. The ultimatum bargaining game:
results of the game
Result of the ultimatum bargaining game:
 The game has been played in over 100 countries with
thousands of players of all ages and socio-economic
circumstances.
 The modal result is a 50-50 split.
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13.2.1. The ultimatum bargaining game:
results of the game (cont.)
 An unexpected finding (although not necessarily
inconsistent with rational choice theory) is that if
Player 1 proposes a split that gives him or her more
than 70 percent of the surplus, Player 2 almost always
rejects the offer.
– People have a strong sense of what is fair.
– Interestingly, if Player 1 is selected on some
seemingly meritorious criterion, Player 2 will
tolerate Player 1’s receiving more of the surplus
than if Player 1 is selected randomly.
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13.2.2. Implications
 Perhaps we need not worry overly about how parties
divide up cooperative surpluses. They seem to do it
equitably.
 But we need, perhaps, to pay attention to the fact that
overreaching can cause otherwise mutually beneficial
transactions to fail.
– The Normative Hobbes Theorem.
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13.3. Loss aversion
 The standard social science theory of decision-making
under uncertainty is that of subjective expected utility
(SEU):
– Individuals are thought to maximize expected utility
rather than expected value.
– The difference arises from attitudes toward risk:
risk-neutrality, risk-preferring, and risk-aversion.
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13.3. Loss aversion (cont.)
 Kahneman and Tversky found that most people are
risk-averse with respect to gains but risk-seeking with
respect to losses.
– Option A: 50$ with certainty.
– Option B: 100$ with probability 0.5 or 0$ with
probability 0.5:
o Same expected value.
o Most people prefer Option A.
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13.3. Loss aversion (cont.)
 Option C: -50$ with certainty.
 Option D: -100$ with probability 0.5 or 0$ with
probability 0.5:
– Same expected value.
– Most people prefer Option D.
 Implication: In civil actions, defendants may be less
likely to settle than plaintiffs.
– The standard law-and-economics theory of litigation
versus settlement is that trial almost always results from
mistaken and inconsistent estimates of the likelihood of
prevailing at trial.
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13.4. Difficulties with probabilistic reasoning
 Many legal situations imply that decision-makers make
probabilistic calculations.
– Rational criminals are thought to compare expected
costs and expected benefits of crime.
– Tortfeasors and victims are imagined to compare
precaution costs with expected liability.
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