Prof. Dr. Friedrich Schneider
Institut für Volkswirtschaftslehre
http://www.econ.jku.at/schneider
Recht und Ökonomie (Law and Economics)
LVA-Nr.: 239.203
SS 2011
(3) The Coase Theorem and Behavioral Economics
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
1. Assumptions and premises (1)
 “People respond to incentives.”
 Law is a method of ordering society to
further social goals.
 Law creates incentives for people to
behave in certain ways.
 Law can help people by facilitating their
achievement of their legitimate goals.
 Economics provides both theoretical
and empirical techniques for examining
law’s likely and actual effects in the
world.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
1. Assumptions and premises (2)
 So, to discourage a particular activity, law
should increase the “price” for engaging
in that activity.
 E.g., by increasing the sanction for
engaging in undesirable behavior.
 Or by increasing monitoring and
enforcement of the undesirable activity.
 If legal sanctions increase or become
more likely, people will “consume” less
of the sanction-triggering activity.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
2. Coase Theorem
 Ronald A. Coase, “The Problem of Social
Cost,” 3 J.L. & Econ. 1 (1960).
 If transaction costs are zero, bargaining
will lead to an efficient allocation of
resources, regardless of the law.
 Law is only necessary to induce efficient
behavior when transaction costs are
positive.
 An implication: assign legal entitlements
to the party who would have ended up
with the entitlement (that is, to the
person who values it the most).
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
3. The Economics of Contract Law
 Law should seek to reduce the costs
of
concluding
and
enforcing
consensual agreements.
 Law does so by providing a set of
default and mandatory rules that
contracting parties can use as a
template
for
concluding
an
agreement.
 Default rules.
 Mandatory rules.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
3. The Economics of Contract Law
 Why do private parties need help
in forming, relying upon, and
completing
consensual
agreements?
 Time-intensive
transactions—i.e.,
those that take time to complete.
 Coordination,
commitment,
and
cooperation.
 Risk allocation.
 Information exchange.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
4. The Economics of Tort Law
 Minimize the social costs of
accidents.
 Precaution costs.
 Accident losses.
 Administrative costs.
 Continue
to
assume
that
potential victims and injurers
are rational decisionmakers.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
4. The Economics of Tort Law
 Tort law holds out the prospect of
liability for accident losses so as to
 create incentives for parties to
choose levels of precaution and
activities in which to participate
in order to minimize their
liability,
 And thereby to minimize the
social costs of accidents.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
5. Precaution costs
 How does a rational potential injurer decide
how much precaution to purchase?
 Assume provisionally that the injurer will
be liable for the victim’s losses if there is
an accident.
 But recognize that most parties are
acting “behind a veil of ignorance”—they
do not know if they will be a victim or an
injurer.
 A rational potential injurer takes all costjustified precaution—i.e., precaution for
which the cost of the last unit of precaution
taken is just equal to the benefit provided
by that precaution.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
5. Precaution costs
 The expected benefit of a unit of precaution
equals the probability of an accident’s
occurring times the anticipated accident
losses.
 Suppose that one more unit of care will
reduce the probability of an accident’s
occurring by 0.005 and that if an accident
occurs, given that amount of precaution, the
losses are likely to be $100,000.
 The expected benefit of that unit of precaution
is (0.005) x $100,000 = $500.
 So, if that unit of precaution costs less than
$500, society would like a potential injurer to
purchase the precaution because the cost is
less than the expected benefit.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
6. Additional topics in the
economics of tort liability
 Different tort liability standards.
 The
relationship
between
administrative
agency safety regulation and tort liability.
 Should regulatory compliance be a defense
in a private tort action?
 “Who are these rational people you’re talking
about?”
 If injurers and victims are not fully
rational, then a situation that might seem
to be one of bilateral precaution may be,
instead, one of unilateral precaution.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
7. Crime and Punishment
 Becker’s rational-choice theory of the
decision to commit a crime:
 Criminal compares the expected costs
and expected benefits of a crime.
 Expected
costs
(EC)
include
the
probability of detection, arrest, and
conviction times the value of the sanction
imposed.
 Expected benefits (EB) include the
monetary value of the crime plus any
non-monetary satisfaction the criminal
receives.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
7. Crime and Punishment
 A rational potential criminal commits
the crime if EB > EC and refrains if EB
< EC.
 Society can reduce crime by raising
the expected costs of crime.
 Raise the probability of detection,
arrest, and conviction or,
 Increase the criminal sanction or,
 Do both.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
8. Recent U.S. Statistics on Crime
 Since the mid- and late 1980s a decline in
non-violent crime. There is now less auto
theft in the U.S. than in much of Western
Europe.
 Property crimes down 30 percent in the
1990s.
 Since 1991 a precipitous decline in violent
crime, with homicide at the lowest level
since the 1930s.
 Homicide rates down 40 percent in the
1990s.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
9. Why the Decline in Crime?
 “Deterrence works.”
 Increasing incarceration rates.
 More police and improved policing
strategies.
 Decline in crack cocaine.
 A robust economy.
 Increased victim precaution.
 Alarms and security procedures.
 Faster and more effective trauma
treatment.
 The legalization of abortion?
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”

Donohue and Levitt attribute half of the
decline in crime since 1991 to the
legalization of abortion in 1973.
 Roe v. Wade led to a significant increase
in the number of abortions. (1.6 million
per year by 1980; 1 abortion per 2 live
births.) Therefore, relatively fewer 18
year-olds in the population beginning in
1991.
 All the other factors together account for
the other half of the decline.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”
 What’s
the
evidence
for
abortion’s effect on crime?
legalized
 (1) Broad consistency with the prevailing
pattern—namely, most crime is committed
by 18-24 year-old males; because of
legalized abortion, there are fewer 18
year-olds exactly 18 years after Roe, and
that’s when the downturn in crime began.
 (2) Five states legalized abortion in 1970
(before
Roe
v.
Wade),
and
they
experienced a decline in crime before the
rest of the country did.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”
 (3) “Higher rates of abortion in a state in
the late 1970s and early 1980s are
strongly linked to lower crime [in that
state] for the period from 1985 to 1997.”
 (4) “There is no relationship between
abortion rates in the mid-1970s and crime
changes between 1972 and 1985.”
 (5) Almost all of the decline in crime in the
1990s can be “attributed to reduction in
crime among the cohorts born after
abortion legislation; there is little change
in crime among older cohorts [over the last
30 years].”
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”

The other hypotheses are unlikely to explain the
drop in crime in the 1990s.

(6) The greater use of imprisonment, more police,
and changes in police strategies have been going on
for a long time. It’s unlikely that they could cause a
sudden and sharp drop in crime just in the 1990s.
And the drop occurred in places, such as Los Angeles,
where there was no particular improvement in the
police force.

(7) Similarly for the decline in the crack cocaine
trade.
That was largely a phenomenon of major
urban areas. But the crime drop occurred not just in
major urban areas but everywhere.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”

(8) The robust economy has been with us since
the early 1980s, not just in the 1990s. And,
moreover, there is a relatively weak correlation
between macroeconomic activity and crime
levels.
Indeed, there is some evidence that
much crime is anti-cyclical, increasing when the
economy is doing well and declining when it is
doing poorly.
 (9)
Donohue
and
Levitt
identify
two
components that make up the total effect that
legalized abortion had on crime:
► The “cohort size” effect
When the cohort reaches the late teens—the
prime years for committing crimes, there are
fewer of them and, therefore, less crime.
20 of 39
Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”
► The “cohort quality” effect
“Children born after abortion legalization may
on average have lower subsequent rates of
criminality.”
 “Women who have abortions are those most
at risk to give birth to children who would
engage in criminal activity.”
Teenagers,
unmarried women, and the economically
disadvantaged.
 “Women may use abortion to optimize the
timing of childbearing.” Through abortion
women may delay childbearing till later if
their current conditions are suboptimal.
Children tend to be born into better
environments.
21 of 39
Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
10. Donohue & Levitt, “The Impact
of Legalized Abortion on Crime”
(10) Of the half of the drop in crime in
the 1990s that Donohue & Levitt
attribute to the legalization of abortion,

about half of that total effect is
attributable to the “cohort size”
effect and

about half to the “cohort quality”
effect.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
11. New developments in law and
economics
(1) Empirical research.
(2) Behavioral law and economics.
(3) The impact of law and economics on
the legal academy.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
12. Law and empirical economics
 Natural experiment: damage done to
property by unsupervised cattle in
Shasta County, California.
 In part of the county the owners of cattle
were responsible for damage done by their
unsupervised cattle.
 In the other half of the county, owners
were not responsible.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
12. Ellickson and Social Norms
 Should there be a difference between the
two halves of the county in terms of the
number of cattle and other indicators of
efficiency?
 Not necessarily, if the Coase Theorem is
true.
 There was no difference in behavior
between the two halves, even though the
liability rules were different. Why?
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
12. Ellickson and Social Norms
 Not because neighbors were bargaining to
the most efficient result, regardless of the
law.
 Rather, because neighbors
paying attention to the law.
were
not
 They sought to conform their behavior to
the prevailing social norms, not to the
law.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13. Behavioral law and economics
 Recall the close connection between
rational choice theory and traditional law
and economics.
 Social and cognitive psychologists have
found some systematic deviations from
the predictions of RCT.
 Taking these deviations into account in
analyzing law leads to changes in the
economic analysis of that flowed from
RCT.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13. Behavioral law and economics
 Consider four examples:
 Endowment effect / status quo bias.
 The ultimatum bargaining game
experiments.
 Loss aversion.
 Difficulties with probabilistic reasoning.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.1. Endowment effect / status quo bias
 People seem to place a very high value on
the things they have and the way things
are.
 Systematic
difference
between
the
willingness-to-pay (WTP) price to acquire
something one doesn’t have and the
willingness-to-accept (WTA) price to give
up that same thing if one already
possesses it.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.1. Status quo bias
 WTA ≈ 2 WTP.
 Not experience-related.
 Applies to pens, coffee mugs,
other trivially valuable items.
and
 Implication:
 Far more difficult to change the way
things are than one might anticipate.
 Change may not just be a matter of
transaction costs.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.1. Status quo bias
WTA
WTP
Person A
$8
$6
Person B
$10
$4
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.2. The ultimatum bargaining
game
 Two parties are to split $20.
 This is a pure cooperative surplus.
 The players are not allowed to talk or meet.
 Player 1 makes an offer for division of
the $20.
 Player 2 can accept the offer, in which
case they each get the proposed
division, or reject the offer, in which
case neither player receives anything.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.2. Results of the game
 The game has been played in over 100
countries with thousands of players of all
ages and socio-economic circumstances.
 The modal result is a 50-50 split.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.2. Results of the game
 An unexpected finding (although not necessarily
inconsistent with rational choice theory) is that
if Player 1 proposes a split that give him or her
more than 70 percent of the surplus, Player 2
almost always rejects the offer.
 People have a strong sense of what is fair.
 Interestingly, if Player 1 is selected on some
seemingly meritorious criterion, Player 2 will
tolerate Player 1’s receiving more of the
surplus than if Player 1 is selected randomly.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.2. Implications
 Perhaps we need not worry overly about
how
parties
divide
up
cooperative
surpluses. They seem to do it equitably.
 But we need, perhaps, to pay attention to
the fact that overreaching can cause
otherwise mutually beneficial transactions
to fail.
 The Normative Hobbes Theorem.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.3. Loss aversion
 The standard social science theory of
decisionmaking under uncertainty is
that of subjective expected utility
(SEU).
 Individuals are thought to maximize
expected utility rather than expected
value.
 The difference arises from attitudes
toward
risk:
risk-neutrality,
riskpreferring, and risk-aversion.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.3. Loss aversion
 Kahneman and Tversky found that
most people are risk-averse with
respect to gains but risk-seeking with
respect to losses.
 Option A: $50 with certainty
 Option B: $100 with probability 0.5 or
$0 with probability 0.5
 Same expected value.
 Most people prefer Option A.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.3. Loss aversion
 Option C:
-$50 with certainty
 Option D:
-$100 with probability 0.5 or
$0 with probability 0.5
 Same expected value.
 Most people prefer Option D.
 Implication: In civil actions, defendants
may be less likely to settle than plaintiffs.
 The standard law-and-economics theory of
litigation versus settlement is that trial
almost always results from mistaken and
inconsistent estimates of the likelihood of
prevailing at trial.
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Recht und Ökonomie SS 2011
The Coase Theorem and Behavioral Economics
Prof. Dr. Friedrich Schneider
13.4. Difficulties with probabilistic
reasoning
 Many legal situations
decision-makers make
calculations.
imply that
probabilistic
 Rational criminals are thought to compare
expected costs and expected benefits of
crime.
 Tortfeasors and victims are imagined to
compare precaution costs with expected
liability.
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The Law and Economics of Tort and Criminal Law