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Introduction to Business Law
Topic 4: Incentives
TO P I C 4 ; I N C E N T I V E S T H A T TH E L A W I S TR Y I N G T O C R E A TE .
1. EX ANTE VS. EX POST "A bank robbery gone wrong" → the family of the victim sues the bank; and the judge in question has to decide whether to blame the banks or decide that the bank did the right thing and it's not the banks fault.
EX POST: we like to think "after something has occurred", in this case after the person has been killed, we are inclined to think that damages for the grieving family is important. This ain't going to bring back the dead person, but can have their pain smoothen.
EX ANTE: before the fact occurred, it's asking yourself about incentives you are creating while deciding as a court. You are not asking how to remedy the family in question, it's what kind of a signal you are giving to all the banks and to all the robbers. If yes, you are essentially saying to the bank that they should always give the money to the robbers, and you are giving an incentive to the robber, because now he knows that every time he robs they are going to give them the money → you are creating PERVERSE INCENTIVES.
If the judge says that the bank is not guilty, you are saying that they should not give the money, and the robber would get to incentive of not robbing, because they won't get the money, they'll only shoot people.
The judge always has to consider both ex ante and ex post to analyze the incentives that they are going to create.
The same things happens with kidnapping and ransoms → if you pay, you create incentives to make more kidnappings happen. The same thing happens with unemployment help: if the help is to high, people won't be inclined to work anymore.
So, when deciding on a case, we usually have problem with this ex ante/post, not only in court, but also in law-making Parties involved in the dispute: they only care about what happened and hat to do about it that happened and what to do about it. They want to solve their own problem → EX POST Judge should rule also on what SHOULD have done about it. Policy perspective. Looks forward to the future while also solving the case at stake, he want to look into what incentives is he creating but also has to solve the problem in front of him → EX ANTE + EX POST In medicine: when someone in a lab discovers a new medicine, the most useful scenario for society would be that this recipe for the medicine would be shared freely, so people could build on it and make it better, but this doesn't happens, because if you do not get any money for your creation, there aren't any incentives to innovate at all. Trademark protections are there to incentivize you to create more and innovate.
1 Introduction to Business Law Topic 4: Incentives Attorney-client privilege: when you talk to your attorney something, that it's kept between the both of them. There are cases in which the police demanded the attorney notes to be opened so everyone would know the information behind it. Why don't they do that? Then no one would be incentivized to be honest with their lawyer/psychiatrist.
2. THE IDEA OF EFFICIENCY Why the Ex Ante effects are so attractive? Dominant view in Economics and other social sciences states that incentives are good if they are efficient.
In law and in economics, incentives are good if they are efficient. The point oof efficiency if to make legal rules as a device to keep the cost o transactions as down as possible, not only by legal law but also by legal decisions. The most efficient rules that we know are the rules of ownership.
Rules on ownership that provide owners with the incentives to adequately get the most out of their property and take care of it. If you own something, you'll take as much advantage of it as you can.
Rules on contract law that provide parties with the incentives to enter into a voluntary agreement which would enhance their respective welfare and would avoid taking costly alternatives to enforce them (retaliation, personal commitments). When you sign a contract, you sign with the believe that everything said it's going to be respected.
The case of accidents: when an accident happens, you'll try to enact a rule to prevent every single accident to happen again. It's the most efficient way to do this? No. Eliminating risks might be unachievable and extremely expensive. (There are car accidents → let's eliminate cars! not efficient) Economic analysis of law would think into if the sacrifice of an accident is bigger than the things that come from not changing the rule.
Accident Law as an example: - Under the traditional tort law (a branch of law that deals with damages and the relationship from the victim to the causing of the accident (tortfeasor) , accident law, law of damages) accident victims may be awarded compensation from the tortfeasor if three requirements are met: (a) Plaintiff (victim) must show that she suffered harm (b) Plaintiff must show that harm was caused by the defendant (c) Plaintiff must show that the defendant was in breach of a duty, e.g., that he was negligent (not exercising the care that the law demands from you) Negligence: failure to take the necessary precautions according to the circumstances of the accident. The defendant avoids being held liable if she satisfied the applicable standard of care to avoid the harm that she caused Negligence - Dogs/Domestic animals: If you have a dangerous dog, and you don't put a mussel on him, and he bites someone, you were negligent, it's your fault.
Negligence - Wild animals: it happens with you owning one, if the wild animal does something, no matter the level of precautions you take, is your fault.
if the cost of precaution is lower than the cost of accident, you shall take precaution; otherwise, you'll let the accident happen → JUDGE LEARNED HAND RULE → this is n 2 Introduction to Business Law Topic 4: Incentives economic analysis of law, not a legal view nor a social norm. If we thought in term of law or in term of social norms we wouldn't want any accident to happen, but the economic view shows us that we must let some accidents to happen.
Cost of the accident = probability of the accident happening*loss of the accident Judge Learned Hand: The owner's duty, as in other similar situations, to provide against resulting injuries is a function of three variables: (1) The probability that she will break away; (2) the gravity of the resulting injury, if she does; (3) the burden of adequate precautions. → this law is a precedent ***IMPORTANT One value of the law – might not be its most important one or its most important goal one or its most important goal – is contributing to find the cheapest way of solving problems and then provide the incentives to individuals to act accordingly.
Measure of waste→ loss of welfare enhancement; (loss of welfare we could have and might not have achieved) → Min waste as an equivalent of maximizing wealth or welfare.
Therefore, if depends on the situation; sometimes the waste is the precaution and sometimes the loss is letting the accident happen.
Minimizing Waste = Maximizing Welfare - Pareto Efficiency: a situation in which you cannot make anyone better without making someone else worse off.
- Kaldor-Hicks Efficiency: talks about the whole situation, how to maximize the wealth in the whole situation, without looking at the individuals, it cares about the whole situation, the total benefits. It's used because the law says that since the pie is bigger, if one of the persons has more than the other, he could help the second person and give him part of his pie. It's the one that's used in economic analysis of law.
3. THINKING AT THE MARGIN The notions which we've been talking about are counterintuitive, they are against what you think is unfair.
Incentives do not work the same for everybody: the Q is not what the average citizen will do but what the marginal citizen will do… So if you put a new law, you cannot make it for incentivizing everybody in the same way. The law asks what those people who are in doubt whether to commit the crime and not doing it will react to the new incentives. You don't try to influence every single person, just those who doubt whether doing it or not.
This doesn’t mean that the rule is bad, because you cannot switch everyone incentives.
- Not all individuals will be influenced in the same way: - Example: raising taxes (you'll only help those unemployed who need three/four months to find a job, etc…), bank’s liability for robbery, death penalty… they are only useful for those "in the margin", those who doubt between doing something or not.
- There are other incentives involved in decision: reputation, wealth, feelings… - Biases and other shortcomings.
EXAMPLES: risky activities; 3 Introduction to Business Law Topic 4: Incentives - Use of knives → a knife is conceived as a weapon; and you cannot carry a knife in an airplane → they aren't forbidden because ALL people are going to go stabbing in planes, BUT some people could do that, and this law is for them.
- Defective products → if we have a defective product (e.g. an electric heater that causes a fire), you can have two people being responsible: the buyer and the seller. The seller is responsible for 2 years (guarantee) for any defect. The sellers isn't responsible forever because the products are being used by the buyers Accident Law: Distinction between Negligence Liability and Strict Liability Negligence liability: the defendant is liable if he failed to meet the required standard of care and harm occurred as a consequence; duty of care (this is the standard put in somebody) is not archived, then the person has to be held liable, responsible (it can be the dog owner, the director of a bank…) Strict liability: the defendant is liable for the harm he caused regardless of the care or precautions he took to prevent the accident. It's less common. The precautions that you took doesn't matter.
Under both strict liability and the negligence rule, injurers are led to take socially optimal l levels of care, but under the negligence rule, they engage in their activity excessively because, unlike under strict liability, they do not pay for the accident losses that they cause Up to a certain point in you executing the negligence liability, you can be found not responsible, while in strict liability, you are always responsible.
Reaching the second best: - The first best solution is efficient at every margin (if you have no cars, there is no possibility of people dying because of cars -The second best it is not, and some margins are efficient enhancers and other not This means that the law is not always perfect.
4 Introduction to Business Law Topic 4: Incentives 4. THE SINGLE OWNER Agent’s decisions are not influenced by their impact on others’ resources (negative externalities) unless agents are made responsible for this waste (internalizing externalities), e.g., paying for the misuse, loss or other waste of someone else's resources.
So, agents in general do not care about the negative externalities that they impose to other unless they are made responsible. Internalizing externalities means usually paying for the damages, or changing something that we made badly, etc… (e.g. volswagen and their cars) Case of railways (book): the fires caused by railroads at the beginning of industrialization in USA → who'll pay for damages for those fires? the person that should pay it's the railroad owners, because they are the ones making money and also creating the externality, and also the incentives that you'd create for making the owners of the rail pay would be perverse incentives.
When acting according to the B<PL, potential tortfeasors are internalizing the expected damage tortfeasors are internalizing the expected damage they may cause to victims.
Problems/challenges of internalization: 1) judges and juries do not have all the information and may not be able to calculate the required level of care and hence determine whether there is an efficient level of precaution 2) some things at stake might not be quantifiable – value of life – so then it will be difficult to determine whether precautions are efficient or not.
5. THE COASE THEOREM Externalities (negative spillovers) Cost imposed by an activity that is not accrued by the person or firm who engages in the activity → How can we internalize externalities? Solutions: 1. Taxation; Pigouvian taxes (e.g. tax for polluting; the EU sells the right to pollute to companies; why? stopping all types of pollution is impossible, is not efficient; so we want to archive the least as possible for some level of production still to exist; also the taxes of new/old cars: the old cars pay more because they pollute more.
They are equal to the negative cost of the externality. This imposition is aimed to reduce the level of the harmful activity, the most expensive something is, the less people tat are going to be. e.g. cigarettes getting more and more expensive with time, as said by the EU: externality → you use the health services paid by everyone.
The market output in terms of externalities isn't efficient, so the taxation tries to put the equilibrium towards something that's more socially efficient) 2. Regulation (in terms of not just taxation, but saying, for instance, where a factory can be placed (not near ocean/rivers, that they must recycle, that they cannot throw waste to the ocean, etc.); regulating is not costless; enhancing and monitoring costs are extremely expensive, and it also you are not helping firms to invest and be better while producing less negative externality, it just pushed firms outside form the market.
3. Property Rights (Coase Theorem) → The important thing is for the law to assign the rights to whoever would pay the most for them if bargaining were costless.
5 Introduction to Business Law Topic 4: Incentives Coase theorem: the theory says that the private market will solve externality problems on its own, always arriving at the efficient outcome, but only if those arrangements can be made and negotiated costless (in terms of time, money, etc.). So, while the initial distribution on legal rights will determine allocation of gains and losses among the parties, it will not affect action taken → this means that the property right do not influence how the issue is going to be faced by bargaining, so, property rights say who's the owner, but there are externalities, and the parties are going to agree on their own who is going to pay for what externality. This theorem established a need of well -defined, divisible, defendable property rights Well defined: which is the object of the property property right and in which manner can owners exercise this right? Divisible: are the rights separable and can be traded? Defendable: are the rights enforceable? Are rights recognized by custom, society, government or court? EXAMPLE: CATER/CROPS Sometimes cattle leave it's place and they will cause problem with other farmer's crops, and then the owner of the cows and the farmer will arrive to a decision that will make them both better off. We don't care about who owns the cows, because they both have interest on being better: getting better crops and the cows being happier → it doesn’t matter who own how much of the pie, it just matters that the pie is bigger than before Also, he suggested that an efficient outcome would still result if the rancher were to be given the rights to allow the cattle to stay in the farmer's property. → Farmer wil be willing to pay to the rancher for him to build a wall and avoid this problem in the future.
6. THE LEAST COST AVOIDER Another solution: where there's an externality, just send a bill to whom could have had avoided the problem more cheaply (so, the one who could have avoided the accident with less cost, is the one responsible) → You're forcing the least cost avoider to compare the cost of paying the bills with the cost of taking more precautions. (if I have a wild animal, I know it's dangerous, but if a kid just goes by and get's attacked, it's not his fault, how could we know that?) → Strict liability: the defendant is in the best position to reduce the risk of injures (btw you can be found not responsible in strict liability, is just way more difficult) → Victim's own role in the accident → contributory negligence, they are both guilty somehow; joint care: is the cheapest for both parties involved had taken some precaution We see someone drowning → legal duty to save him? *Yes → incentive? -From me: not going to the beach (the guy could also sue you if you accidentally harming him -From the guy: no precautions *No → incentive? -Me: there's no harm from me, no one forces you, you'll probably do it (he cannot sue you) 6 Introduction to Business Law Topic 4: Incentives -Guy: precautions are taken So, the guy is the least cost avoider EXCEPTION OF THE RULE→ specific relationships: - sea captain and sailor → the cap must save the sailor; it's his duty, he has the training - innkeeper and guest → innkeeper is responsible - railroad conductor and passenger → they must help always (conductor) In terms of contracts: there's a strict liability for performance → you have an absolute obligation to perform the contract you signed no matter what, UNLESS it becomes hard or impossible to perform without anybody's fault. Here, the least cost avoider applies.
E.G.: US contracting of a company to ship wheat to Iran, Suez Canal closed, and hten the coast of the trip increased drastically.
- The parties didn't say nothing in the contract - Should the contract be broken or enforced (forcing the company to do business without additional payment) → They used the least cost avoider → they said that the company could've bought a insurance against the canal closing; the buyer does one transaction, so they don't really get a lot from it, on the other hand, the shipping company has to do this lots of times and they get lots of problems, so if they are the ones that are going to be held responsible.
E.G. 2: *Old painting stolen and resold many times for full value; the original owner discovers the painting in the house of the most recent buyer. Thinking of terms of least cost avoider, the original owner cannot do anything to prevent the painting from being stolen (he can do I more difficult, but he cannot make I impossible), on the other hand, the buyer could've informed himself before buying, so the first owner would be the one who had the right of the painting → ** if you pay the real price, you can assume that the painting is real, but if the painting had been bought for less than it's real value the buyer already know that something is wrong, so it's his fault * An impostor passing as an art dealer, he persuades an owner of a painting to let him borrow it, and then he runs off and sells it form someone else → the painting is acquired from fraud, the impostor had the legal right to examine the painting; here the owner (first) is the least cost avoider, because he should've investigated it better, while the new buyer could've not bought it.
7. ADMINISTRATIVE COSTS Another kind of waste → cost on managing accidents: Enforcing rules costs; the courts, the settlements, the lawyers, etc…. The cost of managing the incidents/accidents that happen are also to be taken into account 7 Introduction to Business Law Topic 4: Incentives So, we have to think about how expensive the rule will be when courts, and the parties to lawsuits, try to apply it E.G. BUFFALO HUNT; someone shots a buffalo, it hits him but it runs away and someone else kills him.
Ex ante view: buffalo goes to the one that shots first; the incentive for this is going to hunt, and shooting, etc.
Administrative cost view: buffalo goes to the one that captures it; incentive → just sit around and wait for a wounded buffalo an kill it. This is based on philosophical notions of ownership.
Why? Is not easy to prove which would killed him, and the resources that are spend in finding it could be used to keep hunting. If you have the body, then you can keep it, you can "prove" that you've the body. As us all, the effects are at the margin HOW EXPENSIVE THE RULE WILL BE WHEN ENFORCED A major purpose of law is to maximize the total wealth of everyone by reducing waste of whatever resources they have. This is done by reducing the total of all sorts of costs (costs of accidents but also costs of taking precautions against them and costs of arguing about those things afterwards: i.e., administrative cost ) Statutes of limitation as example: statute of limitation are the time period in which you can demand your right, you don't have unlimited amount of time. when crime are really old, there are lots of things that are forgetter, the evidence gets old, etc…. They are also used because the defendant should be able to "repose" after x years of not having been find guilty.
Rules vs. Standards: Council Directive of 25 July 1985, on the approximation of the laws regulations and administrative provisions of the laws, regulations and administrative provisions of the Member States concerning liability for defective products: The reasonable use depends on the product, is a standard that has to be accomplished but isn't exact. This standards are harder to enact than rules.
8 Introduction to Business Law Topic 4: Incentives EG: CHOCOLATE giant Mars has ordered a massive CHOCOLATE giant Mars has ordered a massive international recall of Mars and Snickers bars made at its Dutch factory after a piece of red plastic was found in one RULES VS STANDARDS: Application of the law to the facts of the case and determine whether a standard as satisfied determine whether a standard was satisfied. Rule: its consequences are triggered once facts are settled. So, standards are more expensive than rules, because they are more general.
Decision between the two: (they are both useful) 1. rules are precise, and standards are vague, if you don't have standards, you leave out lots of cases 2. personalized vs horizontal application of the rule 3. enforcement → easier with rules 4. when rules are really accurate, the administrative costs are lower DEFAULT RULES VS MANDATORY RULES: default rules: whatever is not agreed between me and you can find it in law (e.g. contract rule → we are allowed to agree anything, but if we forget something, we can open the contract rule and we'll find the solution) mandatory rules: you cannot do it differently, you are obliged on doing it in this one particular way when you feel that more problems and more courts are going to be generated, you put it in a rule and as a default rule, so if they don't agree between themselves, the rule will tell them what to do.
Property rules → who's the owner of something; they are not unlimited, they are limited by someone's else property rights Liability rules → who is responsible of the damages that come form that thing Interest of property owners may conflict → a cement factory and neighbors (cement wants to produce, neighbors want the right to leave peacefully); Who has the right? How should this right be protected? Property rule, entitlement rule and inalienability rule.
What's the most efficient way? Property rule where the costs of allocating rights by market transactions is low → yours is the factory, you pay Liability rule where allocating rights by litigation is low → e.g. accidents; litigation will decide who's responsible for what 9 Introduction to Business Law Topic 4: Incentives II. TRUST, COOPERATION, AND OTHER PROBLEMS F OR MULTIPLE PLAYERS AGENCY Agent-Principal relationship; who is the owner, and who is taking the decisions → giving away the control of the general policy of the company; separation between owing and controlling an asset → AGENCY COSTS; Let's imagine that you work for a company in exchange of a salary. What are the issues relevant to your decisions on how to work? In terms of agency, the issues relevant are: the paycheck, the quality of life (separation between working time and free time); the substance of the work (if what you do fits you well, if you like it, etc…); challenging (not always the same); etc.
the company wants to have as much information as possible about you, to know how to incentivize you and make you work well; as an owner, you don't only want to make the asset have the same value, but enhance its value. If you own something, you treat it better than if you are lending it from someone else.
The problem is that conflicts of interest arise between agent and principal.
1. The agent probably doesn’t make the biggest effort he could make 2. Excessive perks of consumption: negative externality (? 3. Entrenchment: means to be stuck in a position; the principal want to punish the agent when it fails, so the agent is "entrenched" in a position of not taking risk in fear that the principal is going to punish him 4. Risk avoidance: if the agent takes the risk and fails, the consequences could be being fired. In his fear of being fired, he starts avoiding any type of risk, which means that the company in question cannot grow Shrinking by the agent → not working enough; the law started by saying that shrinking wouldn't be a problem if the compensation is high enough. Moral hazard → taking too much risk from the side of agent, why does this happen? because he doesn't bare any type of consequences. The law is trying to create the most incentives to moral hazard be harmless and shrieking not happening.
The expense that the principal has to bare of watching the principal al the time and the expense that the agent of trying to reassure the principal that he's making a good job is a agency cost. The losses that occur when this efforts fail are also consider agency cost.
HOW DO YOU SOLVE THIS CONFLICTS? 1. Monitoring (basic monitoring, it's costly, takes time) Stockholders → they elect the board of directors Bondholders Board of directors → they monitor manager and its decisions, to make sure that everything is going ok. they fire managers Government regulators 10 Introduction to Business Law Topic 4: Incentives Outside auditors → someone from outside the firm that looks if you didn't cheat of make a fraud with internal accounting; 2. Contracts The principal wants to ensure himself that the agent is going to do a good work, so he does a contract tying the contract pay to the result he produces. The agent, however, would rather to be paid regardless of result. Nowadays, most companies offer a fixed part and a variable part.
Incentives: principals and shareholders try to give compensation packages to managers for the to act in shareholders' interest. This means that the short term value is getting more and more important, because you make the managers only look to the benefits that they can get, making decisions that may hurt the company later. You cannot determine this directly.
The basic problem is, how do you get unbiased information? If you ask the employees, they will always tell you that they are working perfectly, and if you look at the data, there might be external things that influence the data.
INCENTIVE ISSUES: - Monitoring - Secret random monitoring → no one knows which people are going to be monitored, you just know that there is going to be a percentage monitored → everyone has incentive to work - Random public monitoring → you know who is going to be monitored (they also know) → not everyone will work, they are going to shirk if they aren't monitored - Management compensation You want to compensate the manager according to the price of the share. You give perverse incentive to only focus in inflating the share price, without caring how the company is actually doing. So, what could we tie the compensation to? Share price is not ok, because they don't tell you actually how well the company is doing. You could tie it with Return of Assets; but this has he problem that there are things that you cannot control. If the manager is in charge of employees ,you could tie them to the sales of employees. another option is tie it to Profit and CSR (corporate social responsibility) (how much did you make and "how" did you make it) - Free rider problem EXAMPLE: REAL ESTATE AGENTS In Barcelona, real estate agents don't need a license, the company needs it, but not those working in it. When you put your house for sale, you want to sell it at a good price as good as possible, and maybe, you want to know that the house is going to be taken care off. The real estate agent usually has his pay related to the sale of the house → the more expensive they sell it, the better their income - CEO vs Shareholders Possible contracts between them: flat salaries, bonuses, stocks, stock options (you have the right under this contract to buy from this company a stock and you decide how are you 11 Introduction to Business Law Topic 4: Incentives going to work to make this worth more)…. Another incentive (esp. in USA) → corporate takeovers; the possibility of corporate takeovers (someone buying your company) can be an incentive, because if someone takes over your company, your CEO is out, and also the top manager; manager know that, they have to avoid being taking over, and one way to avoid his is making you shares really high, so it will be costly to buy) The CEO (chief executive officer) is not in the board of directors; he is the connection between managers and the board of directors; he is part of the management MATH EXAMPLE; Suppose that there is no team production and that workers can be costless monitored • Workers utility function U = (I - e2) • Worker requires a minimum $1,000 just to show up for work • You must compensate me if you want me to exert more effort • Ex: If e =10, then I =$1,100 Ex: If e = 100 then I = $11 000 Ex: If e = 100, then I = $11,000 Suppose the firm benefits by $100 for each extra unit of effort made b the employee of effort made by the employee • B = 100e • Which is the level of effort that will maximize the firm‘s profit? • Which is the salary y necessary to induce the efficient level of effort? • Let the worker buy the right to all of their output • Worker pays the firm 1,500 for the right to all of the gross benefits • Will the worker behave efficiently? the worker pays the firm for the right to the gross benefit, so he losses -1500; but now for an effort of 1 he will get the same benefits that the firm would be getting for 1 (100): e=1 → u_w: -1501; B=100 e=10 → u_w: -1600; B=1000 → it's a better for him PROBLEM WITH OWNERSHIP: -Wealth constraint: you cannot just pay off your position, because you are constrint with what you actually have; you usually look for a job because you don't have money, so you cannot but the right to the gross benefit - Risk aversion: when you have the same amount in the game, and different probabilities, you'll always go for the one with the bigger probability, but only if it's the same amount of money in the game. If one is better than the other, you don't know how people is going to react.
- Team production: there are synergies that happen when we work with someone else.
Team production usually produces better results.
PRISONERS' DILEMMA Law decides in term on incentives and in term of what game theory says what laws to put to incentivize the right behavior.
Prisoner's dilemma → you get caught, they interrogate you and your partner separately.
You both make deal before to not confess, but once alone, do you trust him? Characteristics: 12 Introduction to Business Law Topic 4: Incentives –The rules of the game (the thing we just said) –A player's strategy → do you confess or do you keep quiet? –A player's payoff → what's the benefits of confessing or not doing it? -A players has a dominant strategy → he will always do a specific strategy no matter what the other one is doing So: Both Keep Quiet: (1, 1) both one year of jail Both Talk: (5, 5) both 5 years of jail Person A talks, person B keeps quiet→ payoff (0, 10) (A has 0 years, B goes away 10 years) Person B talks, person A keeps quiet→ payoff (10, 0) (B has 0 years, A goes away 10 years) The better outcome would be both keeping quiet, but since both of us have really good incentives to talk, because none of us wants to go to jail at all, we will both confess, leading to an inefficient outcome, that's both going to jail for 5 years.
This prisoners dilemma occurs because it happens one time that we get caught, and one time that we get interrogated, we don't know how the other is going to react, so we don't trust him. If this happened in a repeated scenario, this wouldn't happen → In repeated scenarios, prisoner's dilemma doesn't happen.
If those guys could talk between them during the interrogation, the efficient outcome would be the outcome. → Law of contract serves as this communication channel to make us trust each other.
The third problem is that there's no punishment for deflecting, the other guy cannot do anything to you if you talk and he doesn't. How do we solve that in law? Law of torts, for damages., you have the right in law to punish someone if they do not what's written in the contract.
With utility, never forget: the more the better, and order matters. So, we have to change the table, ordering the outcomes (4, best outcone; 1 → worst outcome) 4 → 0 years 3 → 1 year 2 → 5 years 1 → 10 years Both Keep Quiet: (3,3) both one year of jail Both Talk: (2,2) both 5 years of jail Person A talks, person B keeps quiet→ payoff (4,1) (A has 0 years, B goes away 10 years) Person B talks, person A keeps quiet→ payoff (1,4) (B has 0 years, A goes away 10 years) 13 Introduction to Business Law Topic 4: Incentives Nash equilibrium is simply a position in which both of the players have no incentives to change its position, since whoever changes will do immediately worse by making the move PRACTICAL EXAMPLES OF PRISONERS' DILEMMA: 1. Lawyer abuses (discovery: a procedure in USA that obliges you to give all the information that you have to the opposing parties. so, if you ask for discovery and ask for thousands of documents, that's lawyer abuse, because you make the opposite council to spend all of his time in searching for those documents → this wouldn't happen if the lawyers trusted each other) → in small villages this is less common, because there's a big chance of getting to work again with this particular lawyer (repetition) 2. Labor union: associations of workers that protect your rights. "if I don't pay the fee of being part of the union, the union is going to fight for my rights no matter what. " how is this solved in law? By making it obligatory.
3. Bankruptcy rules→ let's say you are a creditor of a company, so the company has to pay you back. if this company announces bankruptcy, your initial reaction is go and try to be paid as much as you can in that instant. All of us think like that (prisoners dilemma).
But the company doesn't have the money to pay us all. Law knows that, so the bankruptcy rule says who needs to be paid first (first pay workers, than pay the rest of the creditors).
If a company misbehaves and breaks that rule, there's a rule that says that creditors must payback (any payment made 90 days before the bankruptcy) and then pay employees with this money.
4. Unwanted cooperation → we have cases in which we don't want cooperation to happen, in which law wants the prisoners' dilemma to persist. plea bargaining: the district attorney and the one that commit a crime make a deal. keeping the prisoners dilemma gives us access the prove that otherwise we wouldn't be able to access. antitrust law: keep the competition alive for the benefit of the market.
5. The Tragedy of the Commons: by us doing the thing that is best for us in that situation, we are in the long run harming everybody else, and even us. It works for every common and finite resource; e.g. cutting trees, fishing → when we go fishing we have the incentive to fish as much as we can, but if we all do that, in the long run we will get to a point where there are not going to be any fish left. Corporate Social Responsibility says "give back to the community"; it's for factors that pollute/generate negative externalities → it's a soft law; it's voluntary → this is a problem, because it' not sustainable to maintain the level of production.
THE GAME OF CHICKEN: To cars that are one in front of the other, racing in contrary directions in a one-way road.
You have two strategies, you can go straight and be hit with another car or move and be called a chicken. If both go straight, you crash. If one changes, this one is the chicken and the other is the boss. If both move, they are both chickens. The best solution would be to do exactly the opposite of the other player.
14 Introduction to Business Law Topic 4: Incentives STAG HUNT: Two players go on stag hunt, and they have two different options. What they are going to eat, depends on what they do. You can take the tools for hunt a rabbit, or the ones to hunt a stag. If you take the rabbit tools, you hunt for yourself. If you take the tools for the stag, you cannot o it on your own, you have to do it together. If you take the stag tools and the other one the rabbit tools, you go home hungry and the other one gets a rabbit. The optimal solution is getting the same tools as your partner.
With the stag hunt, full cooperation is needed for success. Another solution that could work is fully deflecting (chicken).
In the prisoners dilemma, the best thing is to deflect no matter what the other one is doing. In the hunting stag game, he best thing is cooperate no matter what. So, once you get the assurance that he is going to do what he says, you do the same. That's how you play with the incentives in law.
EXAMPLES: Lehman Brothers (investment bank) → once the news spread that they were going down, all the investors tried to sell, everything at once. In that same second, everything went even worse, it fell even drastically every single second. This is an example of stag hunt. You have to scenarios: keep you money in, giving them the option of trying to do better, or on the other hand, get your money out. It all depends on what the rest of people is doing. If everyone stays cal, the best thing is to leave everything in, because probably is going to be ok. On the other hand, if everyone gets it out, you don't want to be the fool that lost all o his money, so you sell too.
UTILITY: You have the chance to decide of going to a trip, to a party or to the gym.
Best option: Trip → 3 utility points (or 444, 9806 → the number doesn't matter) 2nd best option: Party → 2 utility points (or 300, 1000) 3rd best option/worse option: Gym → 1 utility point (or 200, 999) You chose what gives you more utility. Utility says what's better, but not how much, the size doesn't matter.
PUBLIC GOODS: We have seen that the role of government in promoting efficiency is to intervene in the pricing mechanism of goods that create externalities. Now we will investigate a class of goods where it is usually more efficient for the government to supply instead of the private sector.
Public goods are supplied because it's better for them to be publicly given, because in the market you'll get to inefficient situations.
A Public Good has 2 properties: 15 Introduction to Business Law Topic 4: Incentives (1) If it has been provided to one consumer it is difficult/impossible to stop another from enjoying it too. → Public goods are Non-Excludable (public parks; listening to a song out loud) (2) The amount of the good I enjoy has no affect on the amount you enjoy the amount you enjoy. →“Non-rival” Free rider problem: The fundamental problem of all public goods is I’d rather someone else paid for the public goods I cons med someone else paid for the public goods I consumed.
1, 1 -1, 3 3, -1 0,0 3$ → clean street -4$ → 1 pays -2$ → we both pay With this problem, what happens? The problem of public goods the preferred outcome is always having something but not paying for them. Here, the government starts choosing for you.
Public bads: environmental pollution: we al share it, we all live with it, and it's awful for everybody Solving public goods problem: i. Taxes: In EU, this is how the problem is solved: we forced you to pay taxes, so me as the government can provide things that you as an individual cannot.
ii. Libertarians: In US they do provide some public goods, but not in the same quantities.
The logic is "let the market have the liberty to provide it", so, to incentivize people to do this services, you need to making in excludable, making people pay from its use, so this way, people are going to be incentivized to do them (for example, paying for highways) iii. Public Subsidy: public subsidy is a special form of solving the public goods problem., For example, charities: people volunteer to help other people for free. Because of the fact that charities are so important, the government puts laws (esp. for damages) to help the charity to keep working, making them not liable. Another example is courts and judges.
Society as a whole benefits from the decisions taken in the court, so you as an individual don't pay for the court nor the judge to make their job.
16 Introduction to Business Law Topic 4: Incentives III. PROBLEMS OF PROOF Burdens in law: • Burden of production: means that you have the obligation of showing the prove and the case, what you are trying to claim. For suing another person, you have the burden of producing the evidence to make a case.
• Presumptions: something that you don't know for sure. Really important in contracts, whatever you don't put on you contract, law applies, and in law there are many presumptions that many times don't work in your benefit.
• Burden of Persuasion: is simply the burden that the person who needs to prove the statement carries. They carry the responsibility to persuade the judge that their arguments are correct.
Burden: cost, something that you have to bare, a nuisance. SO, in law, it means that different people are responsible of doing something.
Presumption Example: A son who wants to collect his father’s estate has a burden of persuasion to prove that his father is dead. There is no evidence of death but the father has been absent for seven evidence of death, but the father has been absent for seven years.
However, this fact is not proof of death. In this case, the son can argue that he should collect the estate, on the grounds of a legal rule that raises a presumption.
There are many situations in law that demands us to make a presumption. A problem arises because there is some particular proposition that needs to be accepted at least tentatively (in theory) before the argumentation can move ahead, but at that point in the dialog, this proposition cannot be proved because the evidence that is available so far is insufficient. so far is insufficient.
Standards: • More likely than not – preponderance of evidence → something more likely happened than not (51% yes, 49% no) • Clear and convincing evidence → is something that the judge can base his decision on. "I thing that party A should pay damages to Party B because clear and convincing evidence they broke their contract" (70% yes, 30% no) • Beyond reasonable doubt → there is no reason to doubt that the person did it (95% yes, 5% no). BUT, there is no certainty, it's a high standard. f the jury doesn't' reach to the point of beyond reasonable doubt that the person did something, they have to say that the person isn't guilty, no matter that they are convinced by clear and convincing evidence.
17 Introduction to Business Law Topic 4: Incentives IV. BEHAVIORAL ECONOMICS AND ITS IMPACT ON THE LAW Here, what we are doing is applying psychology to the economic analysis of law.
Experiments in Behavioral Economics have shown that individuals assign different values to goods depending on whether they have to pay for getting them or they have to be paid for giving them away. We value them different whether if we have them or we don't have them.
• Willingness to pay (WTP): for how much would you buy it • Willingness to accept (WTA): what you would accept if you were to sell it Usually, the higher one is Willingness to Accept; because you cherish more what you already have that what you would buy because you like your stuff and you get attached to them.
MUG EXAMPLE Some students were given university mugs, and then they reported how much they would be willing to sell the mug for. Other students who did not get a mug reported the price they would be willing to pay to get one. The student that had mugs actually put higher prices; two times higher exactly. Why is this important when deciding a policy? Because if something happens to you property, the fact that you own it is going to make you demand more money that what it actually was worth. → ENDOWMENT EFFECT (sometimes also referred as Statu Quo Bias); simply meaning that goods that are included in the individual’s endowment will be more highly valued than those not held in the endowment, the ones that are not his yet.
Some explanations: - Wealth effects: "the more I have the better I feel" - Sentimental Value Theory: you get attached to your stuff, since we are babies. We like our stuff because it has been during a period of time with us, regardless of their economic value.
- Loss aversion (Prospect Theory): We don't want to loss, if we are going to stop having something, you really want to keep it, so you make the other pay more to have it than what is worth Some legal implications: -Takings -Accident Losses: if something happens to your property, you'll value the damage made bigger than the actual worth of the damage, because since the damage was made to your thing, you'll over-value it.
-Contract negotiations: when you are renting out a flat, you'd like to rent it for a higher value because you don't want someone to changed, and you want also to be sure that there are going to pay. Another example, if you are doing a insurance contract, you are having a harming endowment effect, because the insurance is paid on the value of what something is worth, so if you say that something is worth 50 when it's worth 5, you are paying more for something that actually doesn't worth as much; this is suppressed by law, because law 18 Introduction to Business Law Topic 4: Incentives says that insurance company is the one that says the value, and not you, so you are protected from you own negative consequence of the endowment effect.
HINDSIGHT BIAS .
Hindsight Bias is the “I-knew-it-all-along” phenomenon. All the bankers after the crisis happened said "I knew it all along". So, Hindsight bias is when you say that after something happens. So, something can be done perfectly correctly, and nothing should happen, but then happens and you say "oh, I knew it".
This can be a problem in law because when the judge has to decide he is dealing with his own hindsight bias, so he cannot be aware of that and decide with a predisposition of his head. If you are aware that is a common thing to see it happens, you demand prove, and not say "oh, it was easy to see what problem they were going to have before doing it".
FRAMING EFFECTS It says that our decisions are affected by the way that they are framed.
E.G: you go shopping during sales, and before that, you might be broke and have thousands of pants, but while shopping you see a jeans that are 90% off. If your head, they aren't 40$ jeans, they are jeans that are 90% off. Therefore, you want them and you buy them. This can be manipulative, like in sales a shop can say that they have sales, and then just hide the old price with a sticker that says sale, but with the old price, and this is framing effect. They make you believe that you want them because you think that they are cheaper.
E.G. 2: Imagine that the US is preparing for the outbreak of an unusual outbreak of an unusual disease, which is expected to kill 600 people. Choose a program to address the problem: A: 200 people will be saved B: 1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved They are actually both the same, but people are more willing to chose the first one, because we are attracted by positive things. The same outcome, two different framings, and everyone chooses the first.
The way you post the statement decides which decisions people is going to take.
Imagine that the US is preparing for the outbreak of an unusual disease which is expected to kill 600 people. Choose a program to address the problem: A: 400 people will die B: 1/3 chance that nobody will die. 2/3 chance that 600 people will die People will chose the second option, because of the framing.
We will take great risks to avoid a loss. Reframing the same option as a loss changes the choices. In the moment we say loss, everyone wants to avoid it, but when we say gain (survival) everyone chooses the "full" numbers.