Chapter 4 - Incentives (I. Basic toolkit) (2016)

Apunte Inglés
Universidad Universidad Pompeu Fabra (UPF)
Grado International Business Economics - 1º curso
Asignatura Introduction to business law
Año del apunte 2016
Páginas 9
Fecha de subida 20/04/2016 (Actualizado: 20/04/2016)
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IV. Incentives - Toolkit concepts INDEX 1. Ex- ante vs. Ex-post ....................................................................................................... 2 2. The idea of efficiency .................................................................................................... 3 3. Thinking at the margin .................................................................................................. 4 NEGLIGENCE ................................................................................................................. 4 STRICT LIABILITY ........................................................................................................... 4 4. The single owner........................................................................................................... 6 5. The coase theorem ....................................................................................................... 7 6. The least cost avoider ................................................................................................... 8 UNILATERIAL ACCIDENTS:............................................................................................. 8 BILATERIAL ACCIDENTS:................................................................................................ 8 7. Administrative costs ..................................................................................................... 9 1 avillagrasa IBE, 1st year - 2nd Term 1. Ex- ante vs. Ex-post EXAMPLE 1. There’s a bank robbery and the thief says “I am going to shoot unless you give me 5.000€. Mr. Bank says no, so the thief shoots, and some people gets hurt and some die.
2. If someone is kidnapped, what should we do? We want to pay to have them back because if we were kidnapped we would want someone to pay for us. However, if we always pay, kidnappers would keep kidnapping. However, this is an ex-past argument. Law can’t avoid crimes, only can hire the cost of them to disincentives people from doing them. But we also have to analyze the ex-ante.
DEFINITION Ex ante: looking forward and asking which effects our decision is going to have in the future. It considers the past as sunk cost Ex post: looking back at what has happened to decide what can we do to make it “better” When a judge decides the case, he has to look at the case itself and the future consequences it will have in the future (from an ex ante and ex post view). Parties involved in the dispute only care about ex post (what happened and how to solve it).
The attorney (abogado) can keep secrets from his client. The client should confess to his attorney. (Attorney -client privilege). Lawyers have to keep the conversations with the client s secret (because if not nobody would confess) except if the conversation refers to future crimes. However, if I know that my client is a murder I can still say that he’s not (even if he is).
Also if my client is guilty and I’m not comfortable with it (rap ist, for example) I can reject the case.
2 avillagrasa IBE, 1st year - 2nd Term 2. The idea of efficiency The judicial system should assign resources to be efficient rather than fair. When we talk about ex-ante, we don’t have perfect information, so decisions are going to be inefficient, so we will go for the 2nd best alternative (not efficient).
We should try to reduce waste (if we could eliminate it, then we would be in the perfect, efficient, 1st option). Eliminate waste may be too expensive or simply impossible so we just go for minimize it. We can’t reach Pareto Efficiency (output where, if we move we’re making someone worst off) because we’re going to hurt someone, so we go to Kaldor-Hiks Efficiency, which says that if when you move you make some people better off and some worst off, you can do it as long as you compensate the ones that got damaged from that move. With this perspective, in global, after the people worst off has been compensated, everyone is better off.
How to decide how many motorbike vs. Car accidents are acceptable ? We take into account the probability of accident (was the moto circulating well? Was the car driver drunk?), amount of loss (Did someone die? Was the vehicle damaged?). Eliminate accidents is impossible so the final goal is to minimize them.
This is why we have rules of ownership, because if you would take care of it. If the judicial system gives you total rights of that object that is yours, you will, by your own, make the maximum profit and take care of it, so the state does not have to take care of it. If the object is not yours, there are fewer incentives to take care of it, since we are not able to keep the profits.
We believe that when you are signing a contract is because you are better off. This is why you have to read it and then decide if you’re better off and so accept the contract.
Ex: Imagine you find a bike that in the market is worth 250€, but I found it in the 2nd hand market for 30€ and it seems new. Eventually I discover that is a stolen bike and the owner wants it back. In this case I have to return it (even if I didn’t know that it was stolen) because the price was giving me information.
3 avillagrasa IBE, 1st year - 2nd Term 3. Thinking at the margin It means to, rather than thinking on average people we should focus on the people who are in the margin. This is the extremes. So we have to look for a rule to be applied for this people at the margin. However, we also have to think that some people would do substitutions, which can be even worst (ex: ban cigarettes and people start drinking more).
Also, when an accident occurs, depending on the following factors it will be solves in a way or another.
Cost of precaution 500 1200 1000 Probability of the accident 0,5 0,5 0,5 Loss caused by the accident 2000 2000 2000 Expected loss of the accident 1000 1000 1000 Will we require precaution to be adopted? Yes No Indifferent NEGLIGENCE It would be very expensive to make an investment in precaution (victims bear everything). We should require in investment as long as the cost is less than the expected loss caused by the accident. This means that, if we expect a loss of 1000€, we won’t spend 2000€ in precaution.
When we talk about accidents, we are applied negligence. There’s negligence if the loss caused by the accident is lower than the cost of precaution. If the person causing the accident paid more than 1000€, he won’t be found negligent (not liable), so the victim can’t ask for a compensation. If he didn’t he will have to compensate the victim.
To apply negligence rule we have to quantify and get information of the cost an accident would have.
STRICT LIABILITY This is another system where the one causing harm will always pay. Therefore, the victim is better off here. It works like insurance, so there can be some problems of Moral Hazard. If we - potential victims - know that we will be compensated, we may not care much about security, we may increase the risk of accident.
It is cheaper but creates incentive problems. This is commonly used for activities that people do but we don’t like, so we increase the cost of doing them and so less people will do it.
This is applied with pets too, we consider a Labrador a “good” dog, so if they bit someone, they are applied negligence rule (1 bite is okay but 2 are not). However, a pit-bull (considered dangerous) is applied strict liability, because we are assuming it to be dangerous.
4 avillagrasa IBE, 1st year - 2nd Term To decide which decision to take we have to look at the margin. Generally we internalize all the losses, even if they are not efficient. We proceed to make a marginal analysis. Even if we are negligent, we are using the margin: the investment in proportion is a function such that the higher the precaution, the lower the risk. We stop when the expected loss is equal to the marginal cost of putting more precaution.
The problem is that everything is risky, so it’s very difficult. We have to look at the risk, and accept a minimum risk (which will be applied negligence rule).
Under both, strict liability and negligence rule, injurers are led to take socially optimal levels of care, but under the negligence rule, they engage in their activity excessively because, unlike under strict liability, they don’t pay for the accident losses that they cause.
Incentives don’t work the same for everybody (this is why we “look at the margin”): - Not all individuals would be influenced the same way (ex: raising taxes, bank’s liability for robbery, death penalty…) There are other incentives involved in the decision (reputation, wealth, feelings…) Biases and other shortcomings The first best is the efficient for all margins, but is not achievable; therefore, we have to take the 2 nd best, which is only good for some margins.
5 avillagrasa IBE, 1st year - 2nd Term 4. The single owner Liabilities are acting as an externality (negative), so we have to internalize the cost in the agent’s utility function. There are 3 mechanisms to do it: a. Impose a tax (tax=cost of the externality), b. The Coase’s theorem c. Regulation (permits).
So, at the end, if you can pay for the accident you’re causing, you can do it (unfair but efficient in some way).
If we think as the single owner, we will be internalizing. This means that we will do an activity as long as we keep making benefits with it. For example, if I have a golf camp and some of the balls go to my neighbor window, if I don’t have to pay anything, I’m not going to put any fence. However, if I have to pay for each broken window I will consider a higher fence to avoid the problem or paying every time a window breaks (if cost of the fence is higher than the cost of the window).
PROBLEMS The internalization is good and it is useful for negligence cases. However, some costs can’t be quantified (how much is worth a life?) and in some cases is difficult to know how much protection put the injurer.
6 avillagrasa IBE, 1st year - 2nd Term 5. The Coase’s theorem When we have externalities (something I do but harms others) we can: a. Tax b. Regulate c. Give permits (Coase solution) He proposes to give permits which will only allow some people to produce (for example restriction in CO2 emissions or smoking laws). He proposes “allow people to negotiate and we will obtain the same efficient point”. His point is that, regardless of who has the rights, they are going to achieve an efficient outcome1.
For this to work we need well defined, divisible defendable property rights, able to be enforced and there shouldn’t be transaction costs (negotiation cost=0).
EXAMPLE When we have externalities we can either give permits, put taxes or negotiate (with the one who has the right of clean air, for example): - - 1 Smokers have the rights: If I want somebody to stop doing something I have to give them what they’ll get from the unit we want them to cut off. In the table, we will be willing to accept anything positive to produce the 5 th unit, and I will be willing to pay up to 5 for you to stop producing it. For the 4 th unit I will be willing to pay 5, while the producer wants to get more than 1. For the 3 rd unit I have to pay between 4 and 5, and for the 2nd unit the minimum the producer will be willing to accept is 6, while I’m willing to pay 5, therefore, there can’t be agreement. This is why the optimal is in the 2nd unit.
Non-smokers have the rights: before negotiation, I will want you to produce 0 units. For the 1st unit, smokers are willing to pay 8 and non-smokers want at least 5. For the 2nd one, smokers are willing to pay 6, and we will accept more than 5.
However, for the 3rd unit there isn’t any agreement: we want 5 while smokers are only willing to pay up to 5.
Like in Intro. Micro when sudying externalities 7 avillagrasa IBE, 1st year - 2nd Term 6. The least cost avoider Many of the accidents we get involved in, are also conditioned by external factors, such as weather or other people. This makes us made a distinction between bilateral and unilateral accidents. The least cost avoider is the party who had the lower cost to stop the accident from happening.
UNILATERIAL ACCIDENTS: The party that can cause the accident is the one who controls the risk.
BILATERIAL ACCIDENTS: Accidents that have a probability of happen that depends on the behavior of both the victim and the other.
POSSIBLE RULES  Strict liability: the injurer always pays (moral hazard)  No liability: anybody pays for damages.
 Negligence liability: if the cost of taking precautions was lower than the expected cost of the accident.
 Contributory negligence: If the victim has acted opportunistically (contributory negligence), he doesn’t have any right to request a compensation.
 Comparative negligence liability: If both victim and injurer have been negligent (the victim acts opportunistically because they know that the injurer has been negligent and so they are likely to be compensated).
8 avillagrasa IBE, 1st year - 2nd Term 7. Administrative costs The objective of the judicial system is to minimize costs as much as possible.
Administrative costs are the cost of managing accidents: - Creating and enforcing regulations - Courts (settlements out-of-court)  Insurance - Lawyers Enforcement is very important because if I know that I’m never going to be caught, the law is useless. The higher the probability of being caught, the more people is going to complain with the law. This means that citizens have internalized the cost (so enforcing is cheaper) and are following the law.
When we talk about costs and minimizing waste, we have to look at it broadly (some people doesn’t like radars, but they are a good system because they are cheap as an enforcement mechanism, and people doesn’t go to court for it. So, we like it or not, it is useful).
There’s uncertainty when we go to court because we can win or lose (prevail or not prevail). So, if there’s a high probability of prevailing it is attracting to go to court (settlement 2is not attractive because I can get a better compensation if I go to court), while if it is the other way around, going court is more expensive than the settlement, which becomes attractive.
With strict liability, drafting the law is cheaper. Also the victim is going to go to the court because he will be compensated.
With negligence rules, the costs of drafting the law are higher. In these cases the likelihood of going to the court is lower because it might be difficult to prove he negligence of the other (the probability of prevailing is lower, demonstrate the burden of proof).
2 Settelment: Fer transaccions 9 avillagrasa IBE, 1st year - 2nd Term ...