Economics for Lawyers

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"Economics for Lawyers is by far the best book available for lawyers who want to learn the economic concepts that will influence future public policy debates and regulatory decisions. It developed out of Richard Ippolito's immensely popular class at the George Mason University School of Law, where many of the students already work for Congress, the executive branch, or federal regulatory agencies. They, more than most law students, already know that the Washington, DC, policymaking process has become a creative ...

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Overview

"Economics for Lawyers is by far the best book available for lawyers who want to learn the economic concepts that will influence future public policy debates and regulatory decisions. It developed out of Richard Ippolito's immensely popular class at the George Mason University School of Law, where many of the students already work for Congress, the executive branch, or federal regulatory agencies. They, more than most law students, already know that the Washington, DC, policymaking process has become a creative and productive debate between lawyers and economists—one in which it is a distinct advantage to possess both sets of tools."—Mark F. Grady, Professor of Law and Director of the Center for Law and Economics, University of California, Los Angeles

"This book strikes the right balance between rigor and intuition. The tools presented here provide a framework in which the disparate concepts and issues thrown at students in law school can be organized and analyzed systematically. However, Economics for Lawyers also provides the kind of examples that are engaging to even those students who usually shudder when they hear words like 'slope' or 'maximize'."—Jonathan Klick, Assistant Professor of Law and Courtesy Professor of Economics, Florida State University; Associate Director, Liability Project, American Enterprise Institute

"Economics for Lawyers is well and clearly written and well organized, and its examples are quite good. A fine complement to available texts in the area of law and economics, it is a book I would like to teach from; indeed the very thought engendered a feeling of positive anticipation."—Richard O. Zerbe, Jr., University of Washington, author of A Foundation for the Use of Economics Efficiency in Law and in Economics

"This book is well organized and well written, with easy-to-follow main points and a minimum of technical analysis. It will serve its purpose well of introducing economic concepts to law students."—Albert Choi, University of Virginia

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Editorial Reviews

The Federal Lawyer
Economics for Lawyers provides systematic instruction in economic theory relevant to law, starting with indifference curves and working its way through the basics of game theory. . . . [It] is a very good textbook. It is comprehensive, well-organized, clearly written, and very usable. . . . [T]he focus of the book is unique; I know of no other book that attempts to do the same thing.
— G. Thomas Woodward
The Federal Lawyer - G. Thomas Woodward
Economics for Lawyers provides systematic instruction in economic theory relevant to law, starting with indifference curves and working its way through the basics of game theory. . . . [It] is a very good textbook. It is comprehensive, well-organized, clearly written, and very usable. . . . [T]he focus of the book is unique; I know of no other book that attempts to do the same thing.
From the Publisher
"Economics for Lawyers provides systematic instruction in economic theory relevant to law, starting with indifference curves and working its way through the basics of game theory. . . . [It] is a very good textbook. It is comprehensive, well-organized, clearly written, and very usable. . . . [T]he focus of the book is unique; I know of no other book that attempts to do the same thing."—G. Thomas Woodward, The Federal Lawyer
The Federal Lawyer
Economics for Lawyers provides systematic instruction in economic theory relevant to law, starting with indifference curves and working its way through the basics of game theory. . . . [It] is a very good textbook. It is comprehensive, well-organized, clearly written, and very usable. . . . [T]he focus of the book is unique; I know of no other book that attempts to do the same thing.
— G. Thomas Woodward
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Product Details

  • ISBN-13: 9780691146560
  • Publisher: Princeton University Press
  • Publication date: 7/1/2010
  • Pages: 456
  • Product dimensions: 6.10 (w) x 9.10 (h) x 1.00 (d)

Meet the Author

Richard A. Ippolito retired in 2004 as Professor of Law and Economics from the George Mason University School of Law, where he taught the materials that form the basis for this book to more than 1,000 law students over the course of his five-year tenure. He earned his Ph.D. in economics from the University of Chicago in 1974, and spent twenty-five years working with lawyers on policy and regulatory issues. His previous books include "Pension Plans" and "Employee Performance".

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Read an Excerpt

Economics for Lawyers


By Richard A. Ippolito

Princeton University Press

Copyright © 2005 Princeton University Press
All right reserved.

ISBN: 978-0-691-12177-2


Chapter One

Finding the Optimal Use of a Limited Income

Main Economic Concepts

1. More is better.

2. Free choice is a valuable commodity.

3. Freedom to trade can make everyone better off.

New Terms

1. Indifference curve

2. Diminishing marginal utility

3. Budget constraint

4. Optimal use of a limited income

5. Pareto efficiency

6. Pareto optimal allocation

7. Pareto efficient allocation

8. Edgeworth box diagram

9. Contract curve

10. Compensation principle

11. Substitution effect

12. Price effect

13. Income effect

14. Corner solution

The best place to start the study of economics is with a model of consumer decisions. Each of us has a limited income and must make choices about how best to allocate it among competing uses. Compared to a bundle of goods and services that are given to us with a market value of $20,000, most of us would prefer to have a $20,000 income to spend as we want. Why? Because each of us has different preferences for different goods and services, and thus, the "value" of a dollar is higher if we have the opportunity to spend it as we please. The value of free choice is a central tenet in economics and provides the basisto understanding the concept of a demand curve.

I. Indifference Curves

I am going to pursue this problem in a simplified way. There are two goods, clothing and housing. There are no other uses of income, no savings and no taxes.

A. THE MAIN QUESTION

A person has $100 to spend during some period. Using the assumptions below, how much does he spend on clothing and housing?

To answer this question, I need to introduce the concept of an indifference curve. An indifference curve merely tells us the various combinations of goods that make a particular consumer indifferent. Consider figure 1-1, panel (a). I assume that we can create a homogeneous unit of clothing, like yards of quality-adjusted material. This measure is shown on the horizontal axis. I also assume that we can create a homogeneous unit of housing, like number of quality-adjusted square feet, which I show along the vertical axis. Suppose we consider some combination of clothing and housing labeled B, which corresponds to 25 units of clothing and 50 units of housing. What other combinations of clothing and housing would make this consumer indifferent to this particular allocation?

B. INDIFFERENCE CURVES SLOPE DOWNWARD

We know that any bundle that has both more housing and more clothing must be superior to B, and thus, any such bundle cannot be on the same indifference curve. This inference follows from the axiom "More is better." The combinations of housing and clothing labeled II in the figure denote superior bundles as compared to B. Likewise, our consumer cannot be indifferent between the bundle labeled B and any combination of both less housing and less clothing, denoted by area IV in the figure. This means that the indifference curve passing though point B must pass through areas I and III. In other words, the indifference curve must be downsloping from left to right. Panel (b) in figure 1-1 shows one such indifference curve that satisfies this criterion.

This particular indifference curve is unique to some hypothetical person that we are considering. To be concrete, suppose that we are drawing an indifference curve for Jane Smith, who in fact possesses the bundle of goods labeled A. This bundle comprises 100 units of housing and 12.5 units of clothing. And suppose that we quiz her as follows: if we take away some units of housing, leaving her with only 50 instead of 100, how many additional units of clothing would she require in order to be indifferent to bundle A? We suppose that she answers, 12.5 units, which I show in the diagram. This corresponds to bundle B. Thus, we know that bundles A and B must lie on the indifference curve. Note that over the relevant range, Jane is willing to give up an average of 4 units of housing for each unit of clothing she obtains.

Assuming that we continue asking her questions like this, we could draw a line through all the points of her indifference curve, which I label as [U.sub.1] in panel (b). That is, [U.sub.1] describes all the combinations of clothing and housing that make Jane indifferent to bundle A; we can think of all these combinations as yielding the same utility to her, which is why I use the letter U to denote the indifference curve.

C. OTHER THINGS TO KNOW ABOUT INDIFFERENCE CURVES

A few other features of indifference curves are important to know: they (a) are convex to the origin, (b) are infinite in number, (c) never cross each other, and (d) different consumers have different indifference curves.

Indifference curves are convex from the origin. This phenomenon is due to the concept of diminishing marginal utility, meaning that consumers attach a higher value to the first units of consumption of clothing or housing, and less value to marginal units of clothing or housing once they have an abundance of them. Thus, if Jane has lots of housing and little clothing, as for example at point A in the figure, she is willing to trade 50 units of housing for 12.5 units of clothing to form bundle B. But once she attains this bundle, she attaches less value to obtaining still more clothing and is more reluctant to give up more units of housing.

For example, starting at point B, suppose that we take 25 units of housing from Jane, say from 50 to 25 units in the figure. She requires 25 more units of clothing to make her indifferent to bundle B. Bundle ITLITL denotes the new allocation. Over the range B to ITLITL, she is willing to sacrifice only 1 unit of housing to receive 1 unit of clothing, on average. Compare this to the move from point A to point B, where she was willing to give up four times as much housing for each unit of additional clothing, on average. The difference is that at point B, she already has a fair amount of clothing and thus is not willing to give up as much housing to obtain even more clothing.

There are an infinite number of indifference curves. Panel (b) in figure 1-1 depicts a single indifference curve for Jane. That is, I started with bundle A and then drew an indifference curve through all the other bundles like B and ITLITL that yield the same utility to her. But suppose that Jane started with an allocation of goods labeled D. We know that this bundle of goods cannot be on indifference curve [U.sub.1] because in comparison to bundle B, for example, bundle D has both more clothing and more housing. Since more is better, then it follows that D must be on a higher indifference curve than B. Following the same reasoning, bundle E must be on a lower indifference curve.

If we pursued the same experiment with Jane starting from bundle D as we did when she had bundle A, we could draw a second indifference curve running through bundle D in the figure. If we do, then we have an indifference curve labeled [U.sub.2]. Similarly, we could draw an indifference curve passing through point E, labeled [U.sub.0]. I show these indifference curves in figure 1-2, panel (a). [U.sub.2] is a higher indifference curve than [U.sub.1], and therefore any combination of housing and clothing on this curve is preferred to [U.sub.1]. Similarly, [U.sub.0] is a lower indifference curve than [U.sub.1], and therefore any combination of clothing and housing on this curve is inferior to [U.sub.1]. In reality, there are an infinite number of indifference curves. To keep the figures simple, we normally portray only two or three in the relevant range to illustrate a problem.

Indifference curves do not cross. Each indifference curve is uniformly higher than the one below. Why? If they were not depicted this way, they would violate the rule of consistency. Consider panel (b) in figure 1-2. In this figure, I have drawn indifference curve [U.sub.1] and show points labeled F and G. I also portray indifference curve [U.sub.2] passing through point G. In drawing it this way, I am saying that bundle G yields the same amount of utility as bundle F. I also am saying that bundle G is the same as bundle H. But how can this be true, since bundle H has more housing and clothing than bundle F? This conundrum violates the consistency rule. We avoid this problem as long as we ensure that indifference curves never cross.

Note that we can use this same idea to remind ourselves that any bundle on a higher indifference curve is superior to any bundle on a lower indifference curve. Consider panel (a) in figure 1-2. How can we be sure that bundle ITLITL is inferior to bundle D? We know this because bundle ITLITL offers the same utility as bundle B because they are on the same indifference curve. But bundle B clearly is inferior to bundle D because there are fewer units of housing and clothing in bundle B compared to D. Since ITLITL is the same as B, it follows that ITLITL also must be inferior to D. This is another application of the principle that more is better.

Different consumers have different indifference curves. The indifference curves drawn for Jane are specific to her tastes. Ken Jones would have a different set of indifference curves depending on his tastes for clothing and housing. The basic look of his indifference curves would be similar to Jane's (downsloping, convex, etc.), but his trade-off of clothing and housing very likely would be somewhat different.

II. Gains from Trade Using the Edgeworth Box Diagram

With this small amount of modeling, we already can illustrate an important principle of economics-namely, the gains that result from trade. I demonstrate this concept in the simplest possible way. I assume that there are only two people, Jane and Ken. I have [ITLITL.sub.max] units of clothing and [H.sub.max] units of housing. I want to demonstrate the proposition that if I allocate these units in any arbitrary way to Ken and Jane, they almost always will make each other better off by trading. To do this, I need to show Jane and Ken's indifference curves on the same picture. This is done through the use of an Edgeworth box diagram.

As a first step, I write Jane's indifference curves in figure 1-3, panel (a). I label [ITLITL.sub.max] and [H.sub.max] on the vertical and horizontal axis to remind myself that this is the maximum amount of clothing and housing available in the problem. In panel (b), I write Ken's indifference curves, but I do it in an odd way: I rotate it 180 degrees, so that his origin is diagonal to Jane's. In this picture, Ken has more clothing and housing as he moves away from his origin, as depicted by the arrows. Note that I also show [ITLITL.sub.max] and [H.sub.max] as the limits in this chart, so that the horizontal and vertical lengths of the axes are the same as Jane's.

A. CONSTRUCTION OF THE BOX

To create the "box," simply slide Ken's indifference curve map until it is superimposed onto Jane's. Note that the charts exactly fit together because the lengths of the axes are the same on Jane's and Ken's figures. I show these charts superimposed in figure 1-4. I label Ken's indifference curves [K.sub.i] and Jane's [J.sub.i]. Larger subscripts denote higher levels of utility. (Note that it is OK that Ken's and Jane's indifference curves cross each other, as long as Jane's and Ken's own indifference curves do not cross.)

I want to illustrate the initial amount of clothing and housing that Ken and Jane have to start with. I could portray this allocation anywhere in the box, because the axes have been drawn so that no matter where I plot a point, the total amount of clothing and housing must add to the maximum amounts. For illustration, I arbitrarily allocate these goods as described by point A as shown in panel (a) of figure 1-5. Jane has lots of housing and not much clothing, while Ken has lots of clothing and not much housing.

To solve the problem, I reintroduce some indifference curves. Recall that there are an infinite number of indifference curves for both Ken and Jane, and so by definition, we know that each has one curve passing through point A; and so I draw these curves as illustrated in panel (b), figure 1-5. Notice that these curves, when superimposed, look like a cigar. Ken's indifference curve is [K.sub.1] and Jane's is [J.sub.1].

B. PARETO SUPERIOR TRADES

It is immediately apparent that a trade could make either Ken or Jane or both better off without making either worse off. This trade involves Jane giving some housing to Ken, and Ken giving some clothing to Jane, meaning that the allocation moves in a southeast direction in the figure-that is, toward the fat part of the "cigar."

For example, suppose that Ken and Jane trade in a way that moves their allocation from A to B. In this case, Ken is no worse off than at A, because he is on the same indifference curve; but Jane is clearly better off because at B she is on a higher indifference curve compared to point A (compare [J.sub.4] to [J.sub.1]). When a trade makes at least one participant better off and no participant is worse off, then it is said to be Pareto superior. Similarly, they could trade so that Jane is no worse off but Ken is better off. Ken gets the best deal without reducing Jane's utility at point ITLITL. The move from A to ITLITL also is Pareto superior. Many moves starting from A are Pareto superior.

It is not possible to know exactly who is going to get the better deal in a trade. It depends on Jane's and Ken's relative bargaining power. Most likely, however, both will gain, and we can characterize the range of outcomes in which both can be better off compared to point A.

To do this, I add a few more indifference curves in the relevant range in panel (a) of figure 1-6. Consider a move from point A to point D. In comparison to point A, both Ken and Jane each are on a higher indifference curve, and thus both have benefited from the trade. Clearly, the move from A to D represents a Pareto superior move. But at point D, both can trade again to further increase their utility. In general, as long as a "smaller cigar" can fit inside a "larger cigar" then in an Edgeworth box diagram, both consumers can be made better off by further trading. When does this process stop?

C. THE CONTRACT CURVE: PARETO OPTIMAL ALLOCATIONS

Once they reach a point where their indifference curves no longer form a "cigar" but are just tangent, then it is not possible for one to gain by further trade without making the other person worse off. One such outcome is depicted by point E. In general, this condition defines a Pareto optimal allocation. A Pareto optimal allocation exists when any possible move reduces the welfare of at least one person. Sometimes, a Pareto optimal solution is referred to as a Pareto efficient allocation. Likewise, a Pareto superior move sometimes is referred to as a Pareto efficient trade.

So far, I have portrayed a solution for one arbitrary initial allocation of clothing and housing, namely A. For this allocation, I have shown at least three possible trading outcomes, namely B, ITLITL, and E in panel (a), figure 1-6, whereby at least one consumer is better off and none is worse off. Depending on how Jane and Ken bargain, we could have a solution anywhere along the segment CB in the figure. Any point along this segment has the characteristic that Jane's and Ken's indifference curves are tangent.

What if the allocation we started with was not A but some other point in the Edgeworth box, for example, point G in panel (a)? Repeating the exercise for this allocation would lead us to some solution along the segment IH, which also is a segment along the contract curve.

(Continues...)



Excerpted from Economics for Lawyers by Richard A. Ippolito Copyright © 2005 by Princeton University Press. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Introduction xv
What Makes This Book Different xvii
Recommended Supplementary Reading xviii

Chapter 1: Finding the Optimal Use of a Limited Income 1
I. INDIFFERENCE CURVES 1
A. The Main Question 1
B. Indifference Curves Slope Downward 2
C. Other Things to Know about Indifference Curves 4
II. GAINS FROM TRADE USING THE EDGEWORTH BOX DIAGRAM 6
A. Construction of the Box 8
B. Pareto Superior Trades 10
C. The Contract Curve: Pareto Optimal Allocations 12
III. THE BUDGET LINE: THE ESSENCE OF THE ECONOMIC PROBLEM 14
A. Impact of Income Changes 16
B. Impact of Price Changes 16
IV. CONSUMER CHOICE: THE OPTIMUM USE OF A LIMITED INCOME 16
A. Determining the Optimal Solution 16
B. Portraying an Exact Solution 18
C. How a Change in Income Affects Choice 19
D. The Impact of a Price Change on the Optimum Solution 20
V. THE COMPENSATION PRINCIPLE: THE DOLLAR VALUE OF CHANGES IN UTILITY 20
A. Valuing the Utility Change from a Price Reduction 20
B. Anatomy of a Price Change: Income and ''Price'' Effects 23
VI. APPLICATIONS OF THE COMPENSATION PRINCIPLE 24
A. Buckley’s Tulips and Mums Problem 24
B. Dominic’s Report Card and Computer Games 33

Chapter 2: Demand Curves and Consumer Surplus 41
I. FROM INDIFFERENCE CURVES TO DEMAND CURVE 41
II. CONSUMER SURPLUS 46
A. An Intuitive Way to Understand Consumer Surplus 47
B. Using the Compensation Principle 49
C. Checking Back with the Indifference Curve Map 51
III. MARKET DEMAND CURVE 52
A. Consumer Surplus When Demand Curves Are Linear 55
B. Complements and Substitutes 57
C. Changes in Income 59
IV. DEMAND ELASTICITY 59
A. Calculating the Elasticity for a Linear Demand Curve 60
B. Relation of Elasticity to Total Revenue 63
C. Long-run versus Short-run Elasticity 67
V. APPLICATION: IMPOSITION OF A TAX 68
A. Showing the Distortion on Indifference Curves 68
B. Efficiency in a Kaldor-Hicks Sense 70
C. Showing the Distortion on the Demand Curve 73
D. Tax Burden: Application of Demand Elasticity 76
APPENDIX: CONSUMER SURPLUS AND UNCOMPENSATED
DEMAND CURVES 80

Chapter 3: Supply Curves and the Flow of Resources Also Sunk Cost, Opportunity Cost, and Transactions Cost 82
I. THE WORLD MARKET FOR NICKEL 83
A. The Supply of Nickel with No Fixed Costs 83
B. Producer Surplus 85
C. The World Price for Nickel 86
D. Surpluses in Market Equilibrium 88
II. THE SOLUTION WITH FIXED COSTS AND MANY FIRMS 89
A. Constructing the Cost Curves 90
B. Sustainable Price: Equilibrium in a Long-run Sense 94
III. MARKET EQUILIBRIUM: ENTRY, EXIT, AND COMPETITIVE RETURNS 95
A. How to Evaluate the Sustainability of a Market Price 95
B. The Dynamics of Entry 96
C. The Concept of Long-run Supply 99
IV. PRODUCER SURPLUS, LONG AND SHORT RUN, AND ECONOMIC RENT 100
A. Producer Surplus in a Short-run Sense 100
B. The Concept of ''Rent'' 101
C. The Dynamics of an Increase in Rent 103
D. Portraying the Solution in the Market for Litigation Services 104
E. The Long-run Supply Curve 107
V. BRINGING IT ALL TOGETHER: RECONSIDERING A TAX ON ONE GOOD 111
A. Short-run Impact of the Tax 111
B. Long-run Impact of the Tax 113
VI. A FEW MISCELLANEOUS COST ISSUES 115
A. Sunk Cost 115
B. Opportunity Cost 120
C. Transactions Cost 122
APPENDIX: SHORT- AND LONG-TERM IMPACT OF A SUBSIDY 125

Chapter 4: Using Demand and Supply Curves to Evaluate Policy 127
I. SHIFTS IN DEMAND AND SUPPLY CURVES 128
II. IMPACT OF A MAXIMUM PRICE: THE CASE OF GASOLINE 131
A. Setting Up the Problem 131
B. The Queue for Gasoline 133
C. The Social Cost of the Queue 135
D. A First Lesson in Property Rights 137
E. A Candidate for an Even More Inefficient Solution: Regulation 139
III. THE ECONOMICS OF THE MINIMUM WAGE 140
A. Unskilled Workers Still Employed Gain Rent 141
B. Some Low-rent Workers Displace Some High-rent Workers 142
C. High-rent Workers Outhustle Low-rent Workers 143
D. Rent to Unskilled Workers 146
E. Effort Adds Value, Which Attenuates Job Losses 147
F. A Note on Unions 148 IV. PRICE SUPPORTS 148
A. Restriction on Output 149
B. No Restriction on Supply 151

Chapter 5: The Economics of Monopoly 153
I. THE PRICE DECISION 154
A. The Rule for Finding the Profit-maximizing Price 154
B. Finding the Optimal Price 156
C. Characteristics of the Monopoly Solution 159
II. THE SOCIAL COST OF MONOPOLY 161
A. Deadweight Loss 161
B. Market for Monopoly 163
C. Rent Erosion 164
III. MONOPOLY PRICE DISCRIMINATION 170
A. Two Markets: Ice Cream Monopoly 170
B. Perfect Price Discrimination 173
C. Other Ways to Extract Consumer Surplus 174
IV. PRICE DISCRIMINATION IN COMPETITIVE MARKETS 176
A. Movie Theaters 176
B. Other Examples 180
V. COMPETITION OF THE FEW 183
A. Cheating 184
B. Prisoner’s Dilemma 185
APPENDIX A: PRICE DISCRIMINATION IN THE MILK MARKET 188
A. How Milk Regulations Work 188
B. The Social Cost of Regulation 191
APPENDIX B: THE MOVIE THEATER COST STRUCTURE 193

Chapter 6: Public Goods and Common Resources Toward Understanding the Economics of Property Rights 194
I. AN INTRODUCTION TO PUBLIC GOODS 195
II. INNOVATIONS: CLASSIC PUBLIC GOODS 199
A. The Solution in an Ideal World 200
B. Patent Awards 203
C. How the Patent System Affects Societal Surplus 204 D. The Patent Quandary 208
E. Other Ideas about Patents 212
III. CONTRACTS UNDER DURESS: THE COMMON RESOURCE PROBLEM 214
A. Honor the Contract 216
B. Nullify the Contract and Impose a Reasonable Settlement 217
C. The Optimal Settlement Rule 217
D. The Main Problem: Setting Average Value to Marginal Cost 220
E. Another Way to Think about the Problem 221
IV. THE SOURCE OF RENT EROSION: POORLY DEFINED PROPERTY RIGHTS 222

Chapter 7: Externalities
The Coase Theorem 228
I. WHY EXTERNALITY ISSUES ARE DIFFERENT 228
II. AIRPORT NOISE 230
A. Setting Up an Externality Model 230
B. There Is No Costless Solution to an Externality Problem 233
C. The Socially Optimum Level of Externality 234
III. THE COASE THEOREM 235
A. Airlines Own Noise Rights 235
B. Homeowners Own Noise Rights 236
C. What If Transactions Costs Are Not Zero? 237
D. Corrective Taxes 240
IV. ALLOWING FOR NOISE ABATEMENT 241
A. Stylized Abatement Technology 242
B. A Corrective Tax with Abatement 244
C. Coase with Abatement 245
D. Tradable Noise Permits 245
E. What If Homeowners Can Abate Some Noise? 246

Chapter 8: Pollution in the Workplace: Contract or Externality?
An Introduction to the Rules of Law 247
I. COMPENSATION FOR EXPOSURE TO AIR PARTICULATES 248
A. Setting Up the Air Particulate Problem 249
B. The Demand for Clean Air 249
C. The Supply of Clean Air 250
D. The Socially Optimal Amount of Clean Air 251
II. HOW DO WE OBTAIN THE SOCIALLY EFFICIENT SOLUTION? 251
A. A Contract Solution (Buyer Beware) 251
B. Regulatory Solution 252
C. Strict Liability Standard 253
III. THE COMPENSATION PRINCIPLE AND ECONOMIC DAMAGES 254
A. Torts Are the Flip Side of Contracts 255
B. What If Judgment Amounts Are Not Economic Damages? 258
C. Transactions Costs Again 260
D. Value of Life in a Contract Setting 261
E. Value of Life in a Liability Setting 262
IV. NEGLIGENCE STANDARDS 267
A. An Efficient Negligence Standard 267
B. What If Workers Can Reduce Harm Themselves? 268
C. Contributory Negligence 269
D. Comparative Negligence 269
E. Strict Liability with Contributory Negligence 270
APPENDIX A: THE DECISION TO SMOKE AND RULES OF LAW 272
APPENDIX B: DRIVING AND ACCIDENTS 276
APPENDIX C: ABATEMENT WITH MASKS 280

Chapter 9: Lemons Markets and Adverse Selection
Signals, Bonds, Reputation, and Tie-ins as Solutions 282
I. THE ''LEMONS'' MARKET PROBLEM 284
A. How a ''Lemons'' Market Arises 284
B. A Market for Information 287
II. BONDING A PROMISE OF HIGH QUALITY 288
A. Reputation Value 289
B. Quality Assurance Premium: Where Does Reputation Value Come From? 290
C. Specialized Investments 293
D. Advertising 295
E. Warranties 297
III. PROBLEMS WHEN THE SELLER IS UNINFORMED: ADVERSE SELECTION 299
A. Temporal Adverse Selection 300
B. Cross-section Adverse Selection 302
C. Some Market Solutions 305 D. A ''Tie-in'' Contract 307
E. The Employment Contract as a Tie-in 308
IV. ADVERSE SELECTION IN THE JOB MARKET 313
APPENDIX: AUCTIONS AS APPLICATIONS OF DEMAND THEORY AND BONDING 316

Chapter 10: Sorting as a Solution to Asymmetric Information
Coaxing Market Participants to Divulge Valuable Information 321
I. BONDS THAT ALSO PERFORM SORTING: THE BECKER-STIGLER POLICE MODEL 324
A. A Becker-Stigler Pension Bond 324
B. An Indenture Premium 328
C. How Does the Bond Create a Sort? 328
D. An Alternative Bond: An Efficiency Wage 330
E. Putting the Two Bonds Together 332
II. THE SPENCE MODEL OF SORTING 334
A. The Idea in Brief 334
B. Application to Law School 335
C. Pursuing the Model One Step Further 335
III. OTHER SORTING DEVICES IN THE LABOR MARKET 336
A. The Not-so-free Free Sick Leave 336
B. Sorting on the Basis of Discount Rates 338
C. 401(k) Pension Plans: Another Sort on the Basis of Discount Rates 341
D. A Postscript on Becker-Stigler: Role of High Discounters 342
IV. MORE EXAMPLES OF SORTS AND BONDS 344
A. Slotting Allowances 344
B. Preparing for a Job Interview 345

Chapter 11: Moral Hazard and Agency Problems
When Mispricing Affects Behavior 348
I. NOMENCLATURE 349
II. MORAL HAZARD 350
A. A Simple Water Meter Example 351
B. The Moral Hazard of Insurance 351
C. The Proverbial Free Lunch 354
D. Limits on Moral Hazard 356
E. Moral Hazard Is Not Necessarily a ''Showstopper'' 360
III. PRECOMMITMENT AS A SOLUTION TO EX POST MORAL HAZARD: THE CASE OF HEALTH INSURANCE 362
A. The Moral Hazard Problem 362
B. Consumer Surplus 364
C. Contracting for Efficient Care 366
D. What Happens If the ERISA Preemption Is Eliminated 367
IV. AGENCY COST: A CLOSE COUSIN TO MORAL HAZARD 369
A. What Are Agency Costs? 369
B. Examples of Agency Costs 369
V. AGENCY COSTS AND RENT EROSION: THE CASE OF TORT LAWYERS 375
A. The Reimbursement System 375
B. The Principal-Agent Problem 375
C. Implications of Rent Erosion 377

Chapter 12: Game Theory and Related Issues
Strategic Thinking When Players Are Few and Information Is Poor 380
I. THE DATING GAME: BASIC CONCEPTS IN GAME THEORY 381
A. How the Game Works 381
B. Outcomes with Different Payoffs 385
C. Where Is Coase? The Role of the Cooperative Solution 389
II. BEYOND THE DATING GAME: OTHER PRACTICAL APPLICATIONS 389
A. Games in the Hiring Process 390
B. Irrational Behavior: What If Signals Are Crossed? 393
C. Dick Gets Mugged in the Park 395
III. INSTITUTIONS AND COOPERATIVE OUTCOMES 397
A. The Prisoner’s Dilemma Reconsidered 397
B. Solving the Common Resource Problem: Holdups in the Building Trades 398
C. Solving the Public Goods Collection Problem: Protection for the Neighborhood 400
V. HOW LEGAL STANDARDS CHANGE THE PAYOFFS 401
A. Drivers and Cyclists 401
B. A Noise Problem 403 V. APPLICATIONS TO QUASI-MONOPOLY MARKETS: SOME SIMPLE GAME THEORY MODELS 407
A. The Cournot Model 408
B. Sequential Decision: Stackelberg 411
C. A Tit-for-tat Strategy 413
B. Index 417

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