Agenda for 16th Class

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Agenda for 16th Class

  • Admin
    • Slide Handout
  • Cleaner Skies
  • Prisoner’s Dilemma and Collection Action Problems
  • Information
  • Assignment for Next Class
    • King v Burwell (Obama Care case), #129 (pp. 616-29)
  • Questions to think about / Writing Assignment for Group 1
    • Questions 1-11 on pp. 628-29

Structure of Class

  • Interpretation
    • Statutory Interpretation. Chapter 1 (## 3-12)
    • Common Law Interpretation. ## 127, #37
  • Normative Reasoning
    • Economic Analysis. Chapter 4
    • Rights. Chapter 5A,C-E
  • Legal Theory
    • Dworkin/Scalia. Chapter 6 (already covered)
    • Positivism & Realism. Chapter 2 ##20-23
    • Rules & Standards. #126,128

Exam Info

  • Probably
    • In class
      • ~12 multiple choice questions
      • Could finish in 40 minutes, but will have 1-2 hours
    • Take home
      • 1 essay
      • Could finish in 2 hours, but will have several more hours
  • Open book -- Can use any materials, including dictionary and calculator
  • Multiple choice and Essay will test your ability to apply methods of interpretation and normative reasoning to new factual/legal situations
    • Will not test details of cases or other materials have read
    • Will be like exercises we have done for class
      • Warden Grim, Flower, Union Pacific, Cleaner Skies
      • Cleaner Skies is best indication integrates interpretive and normative materials
        • Will give 2-3 more examples of old exams which integrate normative and interpretive parts of class
        • Model answer for Cleaner Skies is exam memo and 3 model answers
  • Will post other old exams & answers later

How to Study

  • Prepare carefully for each class
    • Do as many writing assignments as you can
      • Especially assignments which are old exams
  • Review after each class
    • Make sure you understand all the concepts
    • Review model answers posted to Portal
      • Especially model answers to old exams
  • Outlining
  • In late November / early December
    • Do additional old exams that I will post
      • Write out full answer individually
      • Discuss and compare answers in group
      • Discuss and compare to model answers in group
  • Review class in early December

Cleaner Skies

Prisoners’ Dilemma

  • Suspect 2
  • Confess
  • Keep quiet
  • Suspect 1
  • Confess
  • -5, -5
  • -1, -7
  • Keep Quiet
  • -7, -1
  • -2. -2
  • Dominant Strategy. Nash Equilibrium
  • Each suspect imposes negative externalities on the other
  • Parties cannot communicate, so transactions costs high, so parties do not reach efficient result

Pollution Externalities Game

  • Firm 2
  • Pollute
  • Install
  • Firm 1
  • Pollute
  • -4000, -4000
  • -2000, -5000
  • Install
  • -5000, -2000
  • -3000. -3000
  • Almost identical to Prisoners’ dilemma
  • If numbers small, might expect agreement to install pollution control
  • When numbers large, negotiation very difficult
    • Collective action problem
      • Everyone better off if everyone installs pollution control equipment
      • But each person better off if free rides
        • Better to not install pollution control equipment, if everyone else does

Collective Action Problems

  • Collective Action Problems are ubiquitous
    • Becoming informed voter, voting
    • Funding public goods, e.g. fire departments, bridges, national defense
    • Global warming
    • Fishing
  • Every collective action problem is also an externalities problem
    • Sometimes groups can resolve
      • Political lobbying by interest groups
      • Democracy
      • Voluntary organizations
      • Clubs
    • Often government is only or best solution
    • When numbers are large, transactions costs are high, so legal rules matters


  • Efficiency of competition assumes perfect information
  • Imperfect information is a transactions cost
    • Efficient allocation of resources may be impaired by imperfect information
  • Imperfect information (like externalities) is ubiquitous
    • When law school and student choose each other
      • Law school doesn’t know how smart or hardworking students are
      • Students don’t know how good school is
      • Law school tries to gather info – admissions process
      • Students try to gather info – US News, campus visits, blogs
      • But information gathering is expensive and imperfect
    • When promisor breaches
      • May not know how much harm will cause promisee
      • May not know whether judge will find breach or not
      • Judge or jury may not know whether breach intentional or accidental
      • Judge or jury may not know whether promisee could have mitigated damages
      • Discovery and trial try to get answers to these questions, but expensive and not completely accurate

The Market & Information

  • Market corrects or mitigates some informational problems
    • Product markets
      • Consumer Reports, Angie’s List, Amazon consumer reviews, EBay ratings, etc.
    • Insurance
    • Loan markets
      • Credit ratings, loan applications
    • Schools (see previous slide)

Information & the Law

  • Much of law is concerned with information
    • Litigation is principally about production of information
    • Much consumer regulation is forced disclosure of information
      • Nutritional labeling
      • Securities Law
        • Prospectus before initial offering
        • Quarterly reporting of profits
      • MPG for cars
      • APR for loans and savings instruments
    • Contract law
      • Limitation of damages to those which are “forseeable” forces promisee with high damages to disclose (Hadley v Baxendale)
    • Product liability law makes price of product reflect producer’s estimate of expected liability
      • Expected liability likely (otherwise) unknown to consumer
    • Title recordation in Property law

Moral Hazard

  • Insurance context
    • Insured has suboptimal incentive to take precautions
      • If insured against fire, may not install sprinklers or be as careful with fireplace
      • If have health insurance, may not be as careful to eat right or exercise
      • If have health insurance, may request treatments that unlikely to be effective
    • Tort law is form of insurance
      • Product liability may make consumers less careful
      • Duty to rescue may make parents (and others) less careful
    • Government programs are a form of insurance
  • Contracts generally
    • After contract entered into, party may have incentive to act in way that is detrimental to other party
      • Employee may not work hard
      • Lawyer paid by hour may spend too much time on project
      • Renter may not take good care of apartment

Responses to Moral Hazard

  • Gather information
    • Moral hazard is result of fact that insurer does not know how insured is behaving
      • If insurer knew, then could condition insurance on insured behaving properly
    • Insurer’s “monitor” insured
      • Fire insurer may inspect home for smoke detectors, brush clearance, roof materials, etc
      • Government monitors welfare recipients, requires job search, etc.
  • Deny insurance if precautions not taken
    • Comparative/contributory negligence in tort
    • Insurance exclusion for arson
    • Fire employees if shirk
  • Build incentive into contract
    • Insurance seldom covers full cost of hazard
      • So insured has some incentive to take precaution
    • Employer can make pay proportional to output
  • Government regulation seldom helpful
    • Government doesn’t usually have superior information
    • But sometimes can help
      • By using information gathering of criminal law
      • By threatening larger penalties (e.g. imprisonment)
      • E.g. imprisonment for securities fraud

Moral Hazard, Coase Theorem, & Externalities

  • Cost of obtaining relevant information is transactions cost
    • If info could be obtained costlessly, moral hazard wouldn’t exist
    • Since info is expensive, inefficiency may result
  • Moral Hazard is kind of externality
    • Insured imposes costs on insurer
    • Employee imposes costs (or less benefit) on employer
    • Sometimes not considered an externality, because
      • Insured and insurer are in contractual relationship
      • Employer and employee in contractual relationship

Principal-Agent Problem

  • Many situations where one person (agent) works for another (principal)
    • Lawyer works for client
    • Employee works for employer
    • Promisor works for promisee
  • Problem
    • How get agent to act in interest of principal
    • Problem is often moral hazard
      • Agent can take actions which adversely affect prinicipal (not work sufficiently hard (shirking), damage equipment, etc.)

Responses to Principal-Agent Problem

  • Monitoring
    • Terminate contract if agent shirks
  • Performance-based contract
    • Pay agent in accordance with some measure of performance
      • Contingent fee for lawyer
        • Plaintiff’s lawyer gets 1/3rd of damages, if prevails
      • Piece work
      • Pay CEO in stock or option
      • Bonuses for good performance evaluations
  • Input-based contacts
    • Hourly fee or wage
    • Cost-plus construction contracts
  • Fixed fee contracts
    • Salary
  • Best contract depends on circumstances
    • Incentive contract -- if performance easy to measure
    • Fixed fee – if repeated interactions or agent is very concerned about reputation
    • Input based – if cost unpredictable, agent is risk averse, and efficiency can be monitored

Adverse Selection I

  • Markets may fail where one side lacks information and thus sets prices based on average
    • Thus inducing those who are above average to leave the market (b/c price not attractive to them)
  • Classic example: Insurance
    • If insurer has imperfect information
      • Insurance priced at average risk
      • But person who knows low risk may then decide not to insurer
      • But that raises average risk of those still buying insurance
      • Thus raising prices
      • Causing more people to drop out of insurance market
    • Examples
      • Health insurance
      • Product liability/warranty, if voluntary
        • Those who are careful may opt not to purchase warranty
        • Thus raising average risk and cost…

Adverse Selection Example I

  • Suppose 2 people want life insurance
    • A is smoker, 10% probability that will die next year
      • $10,000 expected cost to insurer for $100,000 policy
      • A is willing to pay $11,000 for insurance
    • B is non-smoking marathon-runner
      • 1% probability that will die next year
      • $1,000 expected cost to insurer for $100,000 policy
      • B is willing to pay $2000 for insurance
  • If insurer can’t get credible information on smoking and exercise habits
    • Price for insurance, if both A and B are both buying insurance must be at least, $5500 (average of $10,000 and $1,000)
    • But then insurance is not worthwhile to B

Adverse Selection II

  • Lemons problem
    • Used car purchaser has imperfect information
    • Willing to pay price that reflects average used car quality
    • But person who has above average quality used car doesn’t want to sell at average price, so doesn’t sell
    • But that lowers average quality and thus price, leading more used car owners not to sell
    • Other examples
      • Loans for new businesses

Responses to Adverse Selection

  • Ex ante information gathering
    • So can price product in accordance with individual characteristics, rather than market average
    • Life insurance – blood pressure and cholestoral screenings, different rates for smokers, etc.
    • Health insurance – exclusion of preexisting conditions
    • Inspection and certification of used cars
  • Warranties
  • Reputation
  • Mandatory insurance
    • So no one can drop out of market
    • Health insurance “mandates” / universal coverage

Questions on pp. 254ff

  • 4. Consider an employment decision. A law firm is considering whether to offer an associate position to a 2L, and the 2L is deciding whether to accept the offer.
  • a) What are the information asymmetries in this potential transaction? What relevant information does the 2L know which the firm does not? What relevant information does the firm know which the 2L does not?
  • b) What can the firm do to (partially) overcome the information asymmetry?
  • c) What can the 2L do to (partially) overcome the information asymmetry?
  • d) Note that many law firms and lawyers have no written contracts. In such cases, the law provides default rules. One of those default rules is “employment at will,” which means that the employee can quit at any time, and the employer can fire the employee at any time. How does employment at will help overcome informational asymmetries or at least reduce their adverse affects?
  • e) Are there any legal rules which help overcome the informational symmetries?

Questions on pp. 254ff

  • 5. Consider the way home mortgages are often sold. A bank contracts with a mortgage broker. A mortgage broker is an independent businessperson, not an employee of the bank. The mortgage broker solicits customers and, when a customer wants a loan, helps the customer fill out the relevant paperwork and sends the paperwork to the bank for approval of the loan.
  • a) The contract with the mortgage broker might specify that the mortgage broker gets a fixed salary – perhaps $3000 per month. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
  • b) The contract with the mortgage broker might specify that the mortgage broker gets a percentage of the value of all loans approved. For example, the mortgage broker might get 0.5% of the value of each loan, which would be $2500 on a $500,000 loan. What problems might occur under such a contract? Would the bank be wise to offer such a contract?
  • c) What macro-economic problems might occur if most loans were negotiated through contacts such as those described in (b)?
  • d) Can you think of a better contract between the bank and the mortgage broker?
  • e) The relationship between a bank and a mortgage broker presents all three types of asymmetric information problems discussed in readings ##50-51, supra – adverse selection, moral hazard, and principal-agent. Identify which aspects of the relationship present which kinds of problems.

Gilson, Role of Lawyers

  • Functions of Lawyer
    • Litigate
    • Advise
    • Draft & negotiate contracts (transactional lawyer)
  • Role of Transactional Lawyer
    • Transaction Cost Engineer
      • Reduce transactions costs for benefit of both parties
      • Solve informational problems
      • Lawyers often cynically viewed just transactions costs
        • But Gilson suggests that function of (good) lawyer is to reduce transactions costs
    • Value Creation
      • Function of (good) lawyer is to “create value”
        • i.e. increase the pie
        • Not just bargaining to get greater share of surplus for client
    • Other roles
      • Regulatory compliance
      • Getting most for client

Gilson, Corporate Acquisition Agreement

  • Lawyer as transactions cost engineer
  • Representations and Warranties
    • Detailed statements of facts concerning the relevant business
      • Including accuracy of financial statements, absence of particular liabilities, ownership and condition of key assets, pending litigation.
    • Seller liable if turn out to be false
    • Purpose. Provide credible information that is key to transaction and its pricing
  • Earn out provisions
    • Part of price depends on performance of business
      • Part of payment delayed and contingent on how well business does
    • Helps parties to agree on deal, even if disagree on profitability of business
    • Also gives former owners an incentive to help

Gilson, Corporate Acquisition Agreement II

  • Covenants and Conditions
    • Covenants. Agreement on how owner will conduct business in period between signing of contract and transfer of ownership
    • Conditions, if not satisfied, relieve buyer of obligation to purchase

Question on pp. 273ff

  • 1. Would you characterize the informational problem in a typical corporate acquisition agreement as primarily an adverse selection, moral hazard, or principal-agent problem?
  • 2. Gilson mentions “Convenants and Conditions” as one of the four main components of an acquisition agreement (see p. 258), but he doesn’t say much about them. What kind of informational problem do you think they address? Adverse selection? Moral hazard? Principal-agent?
  • 3. Gilson focuses on private, contractual solutions to the informational problems posed by corporate acquisitions. Is there a role for courts, legal rules, and/or legislation?

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