UNIVERSITY OF TORONTO Faculty of Arts and Science DECEMBER 2003 EXAMINATIONS. ECO 320 F AN ECONOMIC ANALYSIS OF LAW PROF.

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1 UNIVERSITY OF TORONTO Faculty of Arts and Science DECEMBER 2003 EXAMINATIONS ECO 320 F AN ECONOMIC ANALYSIS OF LAW PROF. Joanne Roberts Suggested Answers Duration - 2 hours Examination Aids: Non-Programmable Calculators The exam will be marked out of 90. The marks for each question are in parentheses. Please be clear and provide intuition for your answers. 1. (10 marks) What are the purposes of contract law? Describe how they can be met. (For full marks, discuss at least four purposes.) A Any 4 of the following: (2 marks for each purpose discussed, + 2 for quality of explanation) (i) To enable people to cooperate by converting games with noncooperative (inefficient) solutions into games with cooperative (efficient) solutions. By making contracts enforceable, parties can make credible promises. (ii) To encourage the efficient disclosure of information within the contractual relationship, by crafting rules of formation and enforcement that guide the parties about which information they have an obligation to divulge and which information they can keep private. (iii) To secure optimal commitment to performing by providing appropriate remedies for breach of contract which induce parties to make efficient performance and breach choices. (iv) To secure optimal reliance by not compensating a victim of breach for overreliance. (v) To minimize transaction costs of negotiating contracts by supplying efficient default terms and regulations. (vi) To foster enduring relationships, which solve the problem of cooperation with less reliance on contracts. 2. (10 marks) It might be more important to estimate the damages accurately under a rule of strict liability than under a negligence standard. Why? A If damages are not estimated accurately under a strict liability rule, (potential) injurers will cause the injurer s precaution to respond in the same direction as the error. Under a negligence rule, the (potential) injurer need

2 only take the level of precaution which will relieve them of liability. If the damages are over-estimated or modestly under-estimated, there will be no incentive to take extra precaution in contrast to under a rule of strict liability. 3. (20 marks) The case of Vincent v. Lake Erie Transportation Co., 109 Minn. 456 N. W. 221 (1910) presented the following facts: The Plaintiff owned a wharf in which ships docked to unload cargo. The defendant owned a ship that docked at the plaintiff s wharf during a storm. During the storm, the defendant s ships was thrown against the plaintiff s wharf, thereby causing damage to the wharf totalling $500. The plaintiff brought an action against defendant to recover for the damage to his wharf. The defendant refused to pay arguing that the damage was an act of god, and that it would have been imprudent and immoral of him to exit the dock and thereby risk grave harm to the crew and to the ship. The court in Vincent decided that (1) the ship owner had the right to stay moored to the wharf even without asking permission from the wharf owner and (2) the ship owner is under an obligation to compensate the wharf owner for the damage to the wharf. a. Is there an economic justification for the two elements of the court s decision? A This is a situtation where transaction costs are high so that it would be hard for the parties to reach an agreement through bargaining prior to the ship docking. In situations where bargaining is not feasible (or is very costly) so that the first-best efficient outcome cannot be reached via a market mechanism, economic analysis suggests that a second-best solution is for the court to take a best guess at the party s valuations and award an appropriate level of damages. The legal rule established in this case would seem to be an example of the use of this second-best solution, since it is probably efficient for the ship-owner to be allowed to dock at the wharf under these circumstances. b. Assume that ship-owners and wharf-owners are typically both present at the time of loading and unloading of cargo. What would have been the outcome if the court had held that the ship had no right to stay moored to the wharf and should have taken its chances at sea? A In this case, it might have been possible for the market mechanism to opperate in which case presumably the ship-owner would have negotiated with the wharf-owner for the right to dock at the wharf in return for a fee. 4. (13 marks) Consider the example of the cattle rancher (R) and the corn farmer (F) discussed in class. If the cattle are allowed to roam free, they will cause $100 damage to F s crops. It would cost R $75 to build a fence to keep the cattle away from his crops. Excluding the cost of a fence and any damages to the farmer s crops, the rancher s business earns him $500 in profits, and the farmer earns $300 in profits. Consider three possible legal rules:

3 1) R has the right to operate his business (i.e. F bears all costs of fencing or crop damage) 2) F is entitled to compensatory damages from R if no fence is built. 3) F is entitled to an injunction against R (i.e. R must prevent the cattle from destroying F s crops.) a) First assume that transaction costs are high enough to preclude bargaining. Discuss whether efficiency will be achieved under each of these three alternative rules. In so doing, identify the payoffs to each player, and the joint payoffs earned by the players under each rule. A Clearly the efficient thing here is for R to build the fence since 75<100. [note that there was some confusion during the exam about this question in respect of whether the farmer was able to build a fence. So long as students make clear their assumption, and are consistent in their analysis they should not lose marks for making that assumption. This answer proceeds on the assumption that only the Rancher can build the fence.] Under rule 1, no fence will be built and R will earn 500, F will bear the full cost of the crop damage and have a net payoff of 200. Total payoff is therefore 700. Under rules 2 and 3, R will choose to build the fence. Under rule 3 he is obligated to build the fence and under rule 2 he will find it cheaper to build the fence than to pay the 100 in damages to the farmer. In both cases, therefore, R s net payoff will be 425 and F s payoff will be 300 for a total first-best social payoff of 725. b) Now assume that transaction costs are not high enough to preclude bargaining. Given this new assumption, discuss whether efficiency will be achieved under each of the three alternative rules. In this case, specify the threat values for each player, the surplus that can be gained through bargaining, what the bargain will be, and the payoffs gained by each player after the bargain. A In this case, under rule 1, the parties will bargain and the farmer will be able to pay the rancher somewhere between 75 and 100 for the rancher to build the fence (Nash bargaining solution will be 87.5), and the result will be efficient in this case as well as under rules 2 and 3 (same net social payoff of 725). Threat values are the payoffs without cooperation: under rule 1, R s threat value is 500 and F s is (25 marks) a. a. Suppose there are 100 potential criminals, each of whom can commit at most a single act of vandalism. Some potential vandals derive great pleasure from vandalism, while others derive only moderate pleasure. Suppose there is one potential criminal who gets $1 of pleasure from vandalism, one who gets $2 of pleasure from vandalism, and so on, with the last getting $100 of pleasure from

4 vandalism. Each instance of vandalism, however, causes $100 property damage. Potential criminals are mostly kids with very limited assets. Each has $100 in wealth. Society has decided to punish vandals with fines. Proceeds from fines are used to reduce taxes. It costs $15,000*p to catch and convict p percent of criminals. That is, it would cost $15,000 to catch all criminals, $7,500 to catch 50%, and $150 to catch one percent. Criminals are caught only after they have committed an act of vandalism. Assume that it costs nothing to collect fines, once the criminal has been convicted. Potential criminals are risk neutral and amoral. That is, they decide whether to commit vandalism based solely on a calculation of the pleasure of committing vandalism and the expected value of punishment. The government can set the fine anywhere between zero and $100 and can set the probability of conviction anywhere between zero and 100%. What combination of fine and conviction probability would a wealth-maximizing government choose? Assume that the wealth-maximizing government considers equally the welfare of all citizens, including victims of vandalism, criminals, and taxpayers. A Let b be the cut-off benefit level. Let f be the fine. Let prob be the probability of being caught. Since it is costless to impose a higher fine and since it costs money to increase prob, a wealth maximizing government will want to set f to the maximum possible value in this case f=100. Criminal i will commit a crime iff b i prob*f = prob*100 = p, where p = 100*prob. Therefore, all criminals will benefit greater than p will commit a crime, and everyone else will not. Therefore, there will be 100-p crimes committed. The various costs and benefits are the following: Fines collected (reducing tax revenue) = prob*(100-p)*100 = p*(100-p). Benefit to criminals = sum of b i from i=p to 100. Cost of catching people = 15000*prob = 150*p. Harm to victims of crime = 100*(100-p). To find the optimal p (and hence prob), set MB equal to MC of increasing p by 1. The marginal benefit is the additional harm saved by preventing one more crime and the increase in expected fines collected by increasing the probability of catching criminals. The marginal change in fines

5 collected is 100-2p (this requires calculus and you were not required to figure this out). Thus, MB = p. The marginal cost is the increase in enforcement costs from increasing p by 1 (150) and the marginal decrease in total benefit received by the (potential) criminal population (since the p th criminal is no deterred from committing a crime, the reduction in benefit is just p ) Therefore, the condition for the optimal p is given by: p = p. Solving for p, gives p=16.7 (or prob = 0.167), which implies that the optimal level of enforcement is to catch 16.7% of all criminals. b. Now assume that potential criminals have only $50 in wealth each (instead of $100 as in part a.) Also, in addition to imposing a fine, assume the government has decided to revoke a convicted criminal's driver's license. Each potential criminal values her license at $50. While there are some third-party benefits from criminals having drivers' licenses (they can drive their siblings to school, etc.), there are also some third-party costs from criminals having drivers' licenses (accidents, easier access to property to vandalize). Assume that the third-party benefits and costs exactly cancel each other out. Revoking a license costs the government $0, although of course, as in (a), the government must still spend money to catch and convict criminals. The government can set the fine anywhere between zero and $50 and can set the probability of conviction anywhere between zero and 100%. What combination of fine and conviction probability would a wealth-maximizing government choose? A This doesn t change the number of criminals who will decide to commit a crime since it is optimal to set f=50 and that combined with losing one s license amounts to the same disutility of being caught as above. So the same number of criminals as above will commit a crime given some level of p. However, the one difference is that the tax revenue is reduced since the fines are smaller. The total fines collected are now prob*(100-p)*50 = ½*p*(100-p). This implies that the marginal increase in fines from increasing p by one is 50 p. Thus, the MB of increasing p becomes p. Thus, the condition for the optimal p is: 150-p= 150+p - which gives a corner solution the optimal p is p = 0. The key here is simply that the MB is reduced and the MC is not changed, so the optimal level of enforcement will be lower.

6 c. If the probability chosen in (a) and (b) is the same, explain why. If the probability is different, explain why. 6. (12 marks) Describe three activities that could be deemed to be abuses of dominance. Describe what affects they could have on consumers and competitors. A S.78 of the Competition Act provides a non-exhaustive list of acts that might constitute abuse of dominance, including: (any 3 of these should be significant for full marks 4 marks for each including some for brief explanation). These all require that a firm already have some level of dominance or market power, which it then leverages through one of these methods. i. Vertical margin squeezing: dominant firm operating on two levels of the distribution system acts to either raise the price (price squeeze) or limit the supply (supply squeeze) of an input to a competitor operating only at the downstream level. ii. Vertical integration can sometimes be anti-competitive where for example a downstream firm purchases an upstream firm which has the effect of reducing competition in the upstream market and therefore raising the price of inputs to the firm s downstream rivals. (this is rarely anti-competitive) iii. Freight Equalization: firm quotes similar prices to customers located at varying distances even where transportation costs are significant. This can be selective price cutting where goods are sold to customers who are close to a competitors location for a lower price (perhaps at a loss). Also, this can be a way to facilitate collusion by making pricing more transparent. iv. Fighting Brands: new brands introduced in order to inflict harm on a rival which may limit or eliminate a rival s competitive significance. (this can often be pro-competitive however). v. Preemption of Scarce Facilities: a dominant firm in order to ensure monopoly profits in the downstream market would be able to outbid rivals for the upstream scarce resources and then limit rivals access to the resources. vi. Preventing Price Erosion: a dominant firm may prevent price erosion by buying up products which can in some circumstances be anti-competitive). vii. Anti-competitive product standards: a dominant firm may commit an anti-competitive act if it manipulates product standards (to have standards set very close to their own products, but different than others) in order to harm competitors and competition. viii. Boycotts: dominant firm induces or requires a supplier to sell only to certain customers or not to sell to other customers at all. This may include some exclusive supply contracts.

7 ix. Predatory pricing in the resale of articles: dominant firm selling articles at a price lower than acquisition cost for the purpose of eliminating or disciplining a competitor. x. Others that are not enumerated in s.78 include trade mark display allowance, cooperative marketing allowances, meet-orrelease clauses and most-favored nations clauses. Page 1 of 3 Total Marks = 90