Answers to End-of-Chapter Questions and Problems

The purpose of the end-of-chapter questions and problems varies. Some questions and problems are designed
merely to ensure that students actually read and comprehended the readings. Those questions and problems,
thus, generally are answered in the text itself. Other questions and problems carry implications and interesting
discussion points from the analysis in the text. Those questions and problems generally are not answered in the
text itself, but require additional thought and analysis by the students.
1.

Pareto criteria should apply only in cases of completely voluntary market transactions with no, or
insignificant, external costs. An exchange is Pareto efficient (or Pareto improving) if at least one
person is made better off and no one is made worse off. In order to ensure that no one is left worse off,
the transaction must have the consent of all affected parties.

2.

On the weakest condition of rationality, according to which people act rationally so long as their
preferences, at any point in time, are completely transitive, a person would only be irrational if, at one
time, they preferred A to B, B to C, and C to A. Even if someone buys something they claim to hate,
they may not be acting irrationally; they may, instead, be lying about hating or they may deem their
hatred irrelevant in light of other, entirely rational considerations. For example, a cancer patient may
really hate chemotherapy treatments, but still may agree to undergo such treatments because for
supervening utility-related reasons (e.g., a strong preference to live).

3.

They mean that under conditions of scarcity, trade-offs are always required, so that any choice creates an
opportunity cost. In other words, no choice is free of opportunity cost. If one accepts someone elses
invitation to lunch, she may not have to pay an explicit price for the meal; but she nevertheless pays an
implicit cost in terms of other opportunities that are excluded because of her decision to accept the
invitation. For example, instead of having lunch with her friend, she might have (1) gotten more work
done during the lunch hour; (2) gone for a run during the lunch hour; or (3) eaten lunch with someone
else. Such foregone opportunities may be spun out almost infinitely. However, when economists write
about opportunity cost, they mean the most highly valued foregone alternative decision or opportunity.

4.

This question points up the difference between desire and demand. Desire is unlimited. Everyone has a
desire. But not every desire constitutes a demand in the economic sense of that term. Economic
demand is limited by budget. So, in a sense, a demand is a desire backed up by ability to pay. Or, more
technically, an individual faces a budget constraint, and all demands reflect purchase decisions in light
of that budget constraint. When economists draw demand curves, say for televisions, those curves do not
represent the desire of anyone for a television, unless their desire is supported by willingness and
ability to pay some price. People with zero budgets are not demanders in the economic sense, but they
certainly remain desirers.

5.

The supply curve is determined by the producers marginal costs of production. When some of those
costs are externalized, the producer can supply more of the good or service to the market at every price.
The supply curve shifts down and to the right (as in Figure 1.4). This shift is likely to be allocatively
inefficient because the market equilibrium price (where the S2 curve crosses the D curve) does not
accurately reflect the total social costs of production; rather, it reflects only the fraction of those costs the
producer must actually bear. As a result, the producer will tend to overproduce the good or service, as
compared with a situation where the private costs of production equaled the social costs of production. It
is also important to recognize circumstances of external benefits (as opposed to external costs), where
the supply curve is shifted up and to the leftthe producer under-supplies the marketbecause they
cannot capture all of the benefits of production.

6.

Historically, economists have thought of lighthouses as public goods based on the presumption that
private market actors would not supply them because of jointness of supply and nonexcludability
problems. A private lighthouse supplier would likely be unable to charge all passing ships that used light
from the lighthouse to avoid the rocky shoals for the cost of supplying the light. It would be too
expensive (if it were technically possible at all) for the lighthouse owner to turn off the light when
passing ships refused to pay, and turn it back on again for paying ships. Thus, ships could use the light
whether or not they paid; they would have no incentive to pay. Consequently, lighthouse suppliers could
not recoup their expenses, and would not supply lighthouses in the first place. But lighthouses should be
supplied because they provide an important service, which is to say, they are an economic gooda
public good. As a public good, however, many economists have presumed, they would have to be built
by the government. Ronald Coase challenged this presumption in an article that noted how many
lighthouses have actually been built by private market actors. David Van Zandt wrote a response (cited
in the same footnote) in which he noted that in all known cases of private construction and operation of
lighthouses, the projects were at least partly publicly funded.

7.

There really is no such thing as a pure public good. The nature of the market for every good is
determined, in substantial part, by technological and institutional circumstances. When those
circumstances change, what is a public good today may become a private good tomorrow. So, for
example, the innovation of barbed wire (a technological change) in the middle of the 19th century
greatly reduced the cost of enclosing land, which in turn reduced the costs of privatizing the public
domain of the western United States. See the article by Anderson and Hill cited in the chapter. Today,
clean air is still considered a public good, but it is quite possible that clean air could become sufficiently
scarce to justify the costs of privatization (including the costs of innovating technologies to draw
boundaries in the atmosphere). Alternatively, the supply of clean air might remain constant relative to
demand, but the costs of imposing private property rights on clean air might drop, perhaps because of
technological innovations. What counts, ultimately, as a public good is determined economically by
reference to supply and demand and the costs of privatization, given technological capabilities at a
particular time. It is important to bear in mind, however, that the evolution of property rights is not
unidirectionally towards greater privatization. Property rights sometimes evolve in the opposite
direction, from well-defined private property to more ambiguous correlative rights. For example, water
resources in the United States in the 19th century were subject to more private property rights than they
are today, generally speaking. See, e.g., MORTON HORWITZ, I TRANSFORMATION OF AMERICAN LAW
(1977).
This question is designed to test student comprehension of the readings on efficiency. For an exchange
to be Pareto improving, it must make at least one person better off, while leaving no one worse off.
For a state of affairs to be Pareto optimal, there can be no further exchange which would be Pareto
improving. The conditions for Pareto efficiency include (a) voluntary exchange (by all affected parties),
and (b) actual compensation to ensure that no one ends up worse off. An exchange is Kaldor-Hicks
efficient if it produces net social benefits, so that those who gain from the exchange could, in theory,
fully compensate those who lose, and still wind up with a net gain (Kaldor efficiency). Meanwhile, the
losers could not bribe the winners into foregoing their gains from the exchange, without suffering a
worse loss (Hicks efficiency). The Kaldor-Hicks efficiency criteria do not require actual compensation;
nor do they require strictly voluntary participation in the exchange. The purpose of the Kaldor-Hicks
efficiency criteria, and their primary tool Cost-Benefit Analysis, is to enable society to judge the welfare
implications of non-market transactions, as well as market transactions with externalities, which the
Pareto criterion cannot judge. That is to say, Kaldor-Hicks can judge (albeit only imperfectly) the social

8.

welfare effects of judicial and legislative decisions, as well as market transactions involving significant
externalities, which the more pure, as well as more strict, Pareto efficiency criterion cannot assess.
9.

Allocative efficiency deals with distribution of goods among various demanders, at various prices, given
a certain available supply. Allocative efficiency is maximized when the greatest total consumer
satisfaction is derived from the available supply of resources. All demanders who are willing to pay for a
good or service at the cost of production can obtain the good or service. Productive efficiency concerns
the output of goods and services, given the prices of inputs. Productive efficiency is maximized when
the highest possible number of outputs is produced from a given number of inputs at the lowest possible
cost. In other words, industry outputs are produced at the lowest opportunity cost of inputs. To sum up,
for a market to be allocatively efficient it must supply goods to demanders who value them most highly;
for it to be productively efficient, it must supply those goods at least cost. Both allocative and productive
efficiency are important measures of economic performance. Together they reflect overall economic
efficiency. It should be noted, however, that this is a static condition. Douglass North emphasizes a third
kind of efficiencyadaptive efficiencywhich measures economic performance over time as
technologies change and institutions adapt to changing circumstances.

10.

Yes, it is efficient, if there are no (positive or negative) externalities. On that assumption, all demand is
being satisfied at a price that suppliers are able to meet. Thus, allocative efficiency is maximized.
However, if there are significant externalities, the market equilibrium may be allocatively inefficient
compared to an alternative equilibrium point established by a supply curve that included externalized
costs or benefits. In general terms, markets can fail to maximize allocative efficiency under conditions of
significant externalities.

11.

Assuming no substitute treatments, and assuming that people who need the medication value their lives
highly, they will forego nearly every other opportunity to purchase the life-saving drug. In other words,
the opportunity cost of the life-saving drug is nearly infinite for those who need the drug. No matter how
high a price the producer charges, they will endeavor to pay the price, rather than go without the drug.
Thus, demand for the drug is price-inelastic.

12.

When economists use the phrase market failure, they are referring to a situation in which the market is
failing, for some reason or another, to achieve allocative efficiency. Either: (a) supply doesnt equal
demand, perhaps because there is a monopoly supplier or the market is for a public good; (b) or supply
equals demand only by ignoring (positive or negative) externalities; or (c) transaction costs are so high
as to prevent parties from engaging in mutually beneficial trade.

13.

Given ubiquitous transaction costs, and the high probability of externalities, Coase observed that
markets, firms, and governments all fail to maximize allocative efficiency all of the time. And none
always outperforms the others. So, there is no first-best institutional solution to problems of social cost.
The market may outperform firms or governments in one set of circumstances, but perform less
efficiently in another. The question of institutional choice is, thus, circumstantial and comparative.
Society should choose that structure of institutions that, in the circumstances, is least likely to fail or is
likely to fail least.

14.

The free-rider problem. It is easy to imagine individuals coming up with various excuses for not
contributing their fair share of the financial burden of national defense. And it would be practically
3

impossible to exclude them from the benefits of national defense. Thus, national defense is in the nature
of a public good: it suffers from jointness of supply and nonexcludability.
15.

Because of the Prisoners Dilemma, introduced in the textbox on Game Theory. The police separate the
suspects to prevent communication and tacit cooperation, and the criminal justice system structures the
payoffs to silence and confession so as to induce confessions. Even though both suspects would clearly
be better off if they both remain silent, the payoffs induce each of them to confess.

16.

This is a question that we answer later in the book, in the first part of Chapter 8 on contract formation
and enforcement. Even at this point, however, it should be clear that in a Lender-Debtor game (as
described in the textbox on Game Theory), contract enforcement institutions are crucial. Put yourself in
the position of a lender (Player 1 in a lender-debtor game). In the absence of reliable contract
enforcement institutions and organizations, would you ever hand the money over to a loan applicant (the
would-be debtor)? No way. In the absence of institutions and organizations to reliably enforce contracts,
including loan agreements, credit markets would arise in the first place, and welfare-enhancing gains
from credit transactions would go unexploited. It is worth noting, however, that reliable loan
repayment may not necessitate legal rules and courts. Organized crime, for example, uses various
informal mechanisms to ensure repayment of debts.

17.

They mean that individuals respond to incentives, not quite as Pavlovian dogs (economics is not so
deterministic as that), in rational ways. They seek to avoid costs and obtain benefits (as they subjectively
assess them). Ifinstitutions create positive incentives for someone to do X, they become more likely to
do X. For example, by subsidizing the production of ethanol the tax code creates positive incentives for
Midwestern farmers to plant more corn (rather than other crops). Negative incentives matter just as
much. Even the relatively low risk of an IRS audit, let alone the penalties associated with cheating on
taxes, is enough to prevent most individuals from pushing the envelope too far when they file their
annual income tax returns. More generally throughout the economy, investments in skill and knowledge
will reflect the underlying structure of incentives. As Douglass North has written, [i]f the highest rate of
return in an economy comes from piracy we can expect that the organizations will invest in skills and
knowledge that will make them better pirates. Similarly if there are high returns to productive activities
we will expect organizations to devote resources to investing in skill and knowledge that will increase
productivity. Douglass C. North, Five Propositions about Institutional Change, in EXPLAINING
SOCIAL INSTITUTIONS (J. Knight and I. Sened, eds., 1995).

Ch2
Answers to End-of-Chapter Questions and Problems
1.

Yes, law is necessary for all but the most rudimentary forms of economic exchange. The law establishes
the rules of the game that facilitate exchange by reducing the costs of transacting. For instance, a set
of standardized weights and measures reduces the costs of information for buyers and sellers alike. Such
rules become more important as exchange becomes more impersonal andcomplex. In the absence of
formal legal rules protecting property rights and enforcing contracts, the rate of economic exchange is
likely to decline greatly, leading to reduced social welfare.

2.

He means that law is a fundamental institution that structures economic and social activities. He includes
both formal laws and informal social norms among the rules of the game. North provides the
4

following example of how formal legal rules, informal social norms, and other institutions, such as
economic markets, structure economic activity:
For a single straightforward exchange, I use the transfer of a residential property in the
modern United States. This transfer involves a bundle of rights over a physical asset in
exchange for a sum of money. The rights are both legal rights defining what one can do with
the property and rights over the physical attributes of the property. The sum of money is a
command over resources. Institutions determine how costly it is to make he exchange. The
costs consist of the resources necessary to measure both and enforcing the agreement, and an
uncertainty discount reflecting the degree of imperfection in the measurement and
enforcement of the terms of the exchange.The size of the uncertainty discount will be
influenced by such specific-to-the-contract factors as asymmetric information about the
condition of the house (known to the seller) and the financial condition of the buyer (known
to the buyer), by such communitywide factors as the effectiveness of crime prevention, and
by such nationwide factors as the stability of the price level.
In the sellers utility are the price, terms, and security of the contractual obligation,
that is, the likelihood that the buyer will live up to the contract ex post. The value of the
residence to the buyer is a function not only of price and credit terms but also of the
attributes that are transferred with the sale. Some, such as the legal rights that are transferred
and the dimensions of the property and house, are easily measured, and some, such as the
general features of the property, are readily observed on inspection. But others, such as the
maintenance and upkeep costs and the characteristics of neighbors, may be far more difficult
to ascertain. Equally, the security of property against default, expropriation, uncertain title,
and theft will vary according to the difficulty of ascertaining their likelihood and, therefore,
their importance.
Now in the traditional neoclassical paradigm, with perfect information (i.e., zero
transaction costs), the value of the asset that is transferred assumes not only perfect
information but perfectly secure property rights as well. In that case, because both buyer and
seller have been able to ascertain costlessly the value of all the attributes (both physical and
property rights) and there is no uncertainty or insecurity of property rights, the standard
supply and demand models of housing with zero transaction costs would define the value of
the asset. In fact, because all of the above-mentioned attributes influence the value of the
residence to the buyer and seller, the smaller the discount from the idealized neoclassical
model, the more perfect the market. Institutions in the aggregate define and determine the
size of the discount, and the transaction costs that the buyer and seller incur reflect the
institutional framework.
The transaction costs of the transfer are partly market costssuch as legal fees,
realtor fees, title insurance, and credit rating searchersand partly the costs of time each
party must devote to gathering information, to searching, and so forth. Obtaining
information about crime rates, police protection, and security systems entails search costs to
the buyer. To the degree that the buyers utility function is adversely affected by noisy
neighbors or pets, it will pay to invest in ascertaining neighborhood characteristics and the
norms and conventions that shape neighborhood interactions.
The particular institutions matrix of this housing market consists first of all of a
hierarchy of legal rules derived from provisions of the U.S. constitution and the powers
delegated to the states. State laws defining the conveyance characteristics of real property,
5

zoning laws restricting which rights can be transferred, common and statute law
undergirding, defining, or restricting a host of voluntary organizationsall of these
influence transaction costs. Realtors, title insurance, credit bureaus, and savings and loan
associations that affect the mortgage market all will be influenced. The efficiency of these
organizations is a function of the structure of property rights and enforcement and of the
capital market (including voluntary as well as government guarantees and subsidies and
other instruments that exist in the capital market). Equally important are informal constraints
that broadly supplement and reinforce the formal rules. They range from conventions in
neighborhood conduct to ethical norms defining degrees of honesty in information exchange
between the parties involved.

My description has emphasized institutions that lower transaction costs, but some
such as rules that restrict entry, require useless inspections, raise information costs, or make
property rights less securein fact raise transaction costs. The above-mentioned economic
rules are made in the policy and reflect the bargaining strength of contractors, trade unions,
and others in the political market. Because that market is imperfect, institutions everywhere
are a mixed bag composed of those that lower costs and those that raise them. The U.S.
residential housing market is a relatively efficient market in which on balance the
institutions induce low-cost transacting.
DOUGALSS C. NORTH, INSTITUTIONS, INSTITUTIONAL CHANGE AND ECONOMIC PERFORMANCE 61-63 (1990).
3.

Both are institutions, according to North, which interact to structure the costs of transacting. Depending
on issues of culture, ideology, and the complexity of exchange, social norms be more or less important
than the formal legal rules. In some cases, they may even conflict, as described in the Note on Local
Custom. Some economists have even argued that the modern emphasis on formal law making crowds
out potentially more efficient social norms. It has been argued, for example, that redistributive taxes,
imposed through formal law, crowds out voluntary giving (to some extent). It is often very difficult,
however, to prove or quantify the extent of any such crowding out. In any case, the formal legal rules
and informal social norms both operate, and interact, to structure the organization of production and
exchange.

4.

There are a variety of possible reasons all of which probably have some basis in truth. First, from a
relatively cynical point of view, complicated structures and procedures may obscure the legislative
process, making it relatively difficult for ordinary citizens to follow, or participate in, that process. On
the other hand, but still from a relatively cynical perspective (according to which less legislation is better
than more legislation), the more cumbersome and byzantine the process, the less likely it is that any
particular legislative proposal will be enacted. From a less cynical perspective, the structure of
legislative process may serve to reduce Arrovian cycling problems (as described in Chapter 3), which
ensures the rationality of legislative decisions (or makes less likely legislative irrationality).

5.

Like the market, the law is an entitlement allocation mechanism. As stated at the very beginning of the
chapter, the lawlike economic theoryis concerned, first and foremost, with scarcity. The institution
of rules allocating property rights determines who does and who does not get access to, and control over,
scarce resources. The law can also serve to reduce scarcityto increase supply relative to demandby
creating incentives that lead market actors to increase the supply of goods. For example, intellectual
property rights create incentives for technological innovations that can reduce production costs, allowing
producers to supply more of a good to the market at the same, or lower, prices. Arguably, to the extent
legal rules regulating air pollution have reduced ambient concentration levels, they have increased the
supply of clean air, relative to demand. Of course, this reduced scarcity of clean air has not come
without cost to polluters and society as a whole. Whether the benefits have been worth the costs is a
question explored in Chapter 15.

6.

The common law is judge-made law that evolves over time, by accretion, as courts rule in individual
cases. It is evolutionary. Legislation is law made by political bodies, often evolutionary but sometimes
discontinuous and abrupt, which is based on information provided not by individual litigants but through
public and special-interest input. Both are considered legitimate sources of law.
7

7.

The rule of law, as a concept, is susceptible of numerous meanings and implications. On the simplest
definition, it means nothing more than that the law rules equally over all similarly-situated persons in
society, including those who make the law. More elaborate definitions of the rule of law include
requirements of judicial independence, democracy, conceptions of social justice, and so on. On any
definition, however, it is clear that the rule of law is more of an aspiration than a reality in any society.
No state ever perfectly achieves the rule of law; but the rule of law helps us to distinguish between states
that aspire to achieve it (rule of law states) and states that reject the rule of law in favor of the sheer
political or personal authority.

8.

When lawyers talk about the legal system, they typically mean legislatures, administrative agencies,
and the courts. Those legal organizations design, implement, and enforce the institutions of formal
legal rules, which include not only legislation and common law rules, but private contracts, which also
structure private legal relations. In addition, there are informal social norms, such as community mores,
that also structure social and economic interactions. For example, there is no law requiring anyone to
give up a seat on the bus for an older person. But there are, in many places, social norms, enforced by
social opprobrium, which create incentives for bus riders to do this. Are such social norms part of the
overall legal system? In most circumstances, they are not. Social norms generally are considered
ancillary or supplementary to, or even competitive with, the rules of the legal system. On the other
hand, community or industry customs may be, or become, part of the legal system, especially when
expressly recognized in judicial decisions.

Ch3
Answers to End-of-Chapter Questions and Problems
1.

In the two articles cited in footnote 50 on page 85, Warren Samuels and James Buchanan offer
fundamentally different perspectives on the Miller v. Schoene case. Buchanan, writing from a public
choice perspective, argues that the State was responding to pressure from the apple industry when it
passed the law authorizing the destruction of infected cedar trees. In his view, this law altered the
existing allocation of property rightstaking property from cedar tree growers and giving it to apple
orchard growers. If the state had merely done nothing, it is likely that the apple orchard growers would
have paid landowners to remove infected or potentially infected cedar trees so as to protect the apple
orchards, assuming that the value of their apple trees really did exceed the value of the ornamental cedar
trees. The outcome would have been efficient under the Pareto criterion, assuming no significant
externalities beyond the contracting apple orchard growers and ornamental cedar tree growers. Warren
Samuels, writing from an old institutionalist perspective, treats the State as a neutral arbiter to resolve
what is, in essence, a zero-sum game. In his view, this was not a case involving settled, pre-existing
property rights, but a case requiring an initial allocation of property: either cedar tree growers would be
entitled to harm apple orchard growers, or vice versa. Non-action by the State would have been
tantamount to an action in favor of the cedar tree growers. In the circumstances, the State of Virginia
rationally preferred the socially more highly valued commodity, the apple orchards, over the ornamental
cedar trees. One could also view this case from neoclassical, new institutional, and other perspectives
and, perhaps, come to a different conclusion.

2.

This question relates to the introductory readings on credit rate ceilings on pages 54-56. The analysis
there suggests that, in a situation with normally competitive markets, lenders should be able to charge
whatever interest rate they wish. There are three related reasons for this conclusion: (1) as a matter of
economic theory, if the rate of interest were too high, we would expect to see lenders earning super8

normal profits, but that would just inspire other lenders to enter the market, which would drive down
interest rates and profits; (2) there is virtually no empirical evidence that lenders earn higher than normal
profits in high-risk markets, which suggests that the interest rates they charge are related to risk levels;
and (3) the evidence suggests that credit rate ceilings actually harm the very borrowers they are designed
to protect. After credit rate ceilings are imposed, borrowers who previously could get loans at a high
interest rate, tend to have trouble getting loans at all. Legitimate lenders will choose either to not make
risky loans or leave the market entirely, to be replaced by black-market lenders, who will ignore credit
rate ceilings and charge even higher interest rates than those that preceded the imposition of credit rate
ceilings. Only where the market is, for some reason, non-competitive, would the market price of loans
be too high. In that case, price controls might be called for, but an even better solution would be to
replace the monopoly market with market competition.
3.

As Karl Llewellyn points out (in the excerpt on pages 63-5), there are at least five reasons why
economists should pay close attention to law: (1) legal institutions guarantee economic order by
protecting property rights and the freedom of contract; (2) the law distinguishes fair from unfair
economic competition (such as fraud); (3) legal rules delimit competition in the market by granting
productive monopolies, such as patents, while outlawing unproductive monopolies and other forms of
price discrimination; (4) the legal system, through taxation and other mechanisms, creates incentives for
or against certain kinds of economic behavior; and (5) the law helps overcome information constraints
and asymmetries by requiring, for example, warranties, labels on foods, and so on.

4.

This question takes us back to the excerpt from Judge Posner (on pages 62-3). He points out that, as a
matter of fact, not everything that is efficient is legal. Prostitution and the illicit drug trade (discussed in
Chapter 13) are not necessarily inefficient economic activities, but they remain illegal (in the United
States). Should they be legalized? How about currently illegal activities such as torture or assassination?
It is certainly possible to imagine an efficient assassination, for example in the case of Adolph Hitler.
What about killing a single innocent personfor example, someone who through no fault of his own
carries a highly contagious disease that does not kill him but could kill many otherswhen doing so
would save the lives of a hundred others?

5.

It creates incentives for individuals to supply more ducks to the market by making certain kinds of
interference with duck production more costly. By establishing a rule distinguishing between fair
competition and unfair competition in duck production, the court in Keeble facilitates higher levels of
production. Its legal rule greases the wheels of duck commerce.

6.

Theres not much they can do. They can subsidize housing out of public funds (provided through
taxation) or they can attempt to reduce the regulatory burden (i.e., costs) on those who would construct
more low- and moderate-income housing. This is not necessarily to endorse either of those alternative
measures, neither of which would be cost-free.

7.

The rules of the road affect economic activity; generally they increase it. The first known legal rule of
the road in the United Kingdom was enacted in the first half of the 18th century. It required horses to
move along the left side of London Bridge, in order to prevent traffic jams on the bridge. Eventually it
became the legal rule that on all roads in the UK, vehicles are restricted to driving on the left side of the
road. While such rules of the road limit each individuals liberty to drive as quickly as they want on
either side of the road, the rules unquestionably facilitate the smooth flow of traffic to the benefit of
9

society as a whole. One can quibble about the optimally efficient speed limit or other specific rules, but
generally the formal rules of the road, supplemented by certain social norms of safe driving, facilitate
cooperation and allow people more easily and safely to get where they want to go.
8.

He would have paid more attention to land market theory, according to which the present economic
value of a piece of land includes future values discounted to present-day prices. Based on this theory, the
judge would at least have greeted with greater skepticism the remaindermens assertions of the expected
future value of the land after highway construction since that future value should have been revealed in
present market prices. The judge, therefore, would have questioned whether the price the remaindermen
were seeking was higher than any rational potential buyer was willing to pay. An economically
sophisticated judge would have discounted the future expected value of the land to present day dollars,
which certainly would have benefited Anna Weedon. The outcome of the case would likely have been
more efficient, as well as just.

9.

In tribal societies, social norms impose codes of conduct that provide for reliable exchange relations.
Monitoring and enforcement costs are generally low because everyone knows each other and they exist
in repeat-play relationships. In modern, more complex economic societies, by contrast, the prevalence of
impersonal, one-time-only exchange, and the lack of ties that bind people increase the costs of
monitoring and enforcing contracts. The possibility for opportunism would increase in the absence of
formal contracts and third-party enforcement. That is to say, social norms that are efficient for
organizing social relations in small, homogeneous societies are likely to be less efficient than formal
legal rules at facilitating exchange in more complex, heterogeneous societies. This is not to say,
however, that social norms have no role to play in modern, complex economic systems. See the
discussion of social norms among New Yorks diamond merchants in Chapter 8.

10.

As noted in the text, the main features of new institutional economics, which distinguish it from old
institutionalism, are (a) an acceptance of neoclassical assumptions as a starting point (but not an end
point) for analysis, and (b) transaction costs as a measuring tool for comparative institutional analysis.
Old institutionalists and new institutionalists believe in the fundamental importance of institutions,
including law, and the importance of comparative institutional analysis. But old institutionalism had no
metric for actually comparing institutions and outcomes. The new institutionalists, following Coase, use
the metric of transaction costs for that purpose. Without the measure of transaction costs, how could old
institutionalists possibly choose between various institutional solutions to any perceived problem of
social cost (other than sheer political power)? For more detailed discussions of the differences and
similarities of old and new institutionalism, see MACOLM RUTHERFORD, INSTITUTIONAL ECONOMICS
(1996), and NICHOLAS MERCURO AND STEVEN G. MEDEMA, ECONOMICS AND THE LAW (1997).

11.

Neoclassical economists presume that individuals are all rational maximizers of their self interests. They
are, in effect, cost and benefit calculators. The behavioralists point out that people arent really like that.
They may, rationally, try to do the best they can for themselves, but their rationality is bounded by
cognitive processing constraints, which means they often must rely on heuristic and other noncalculative devices for making decisions. Moreover, behavioralists observe that individuals dont always
try to maximize outcomes; they sometimes engage in satsificing behavior or cost-minimizing
behavior. However, as Coase points out, it would be a mistake to disregard neoclassical theory and its
rationality postulate, which continues to demonstrate great predictive power. That is to say, even if
individuals dont always behave as neoclassical theory would predict, there are many, many
10

circumstances in which they do. Under what circumstances would you predict that someone, if given the
choice between receiving a $10 bill and a $1 bill, will choose the $1 bill?
Ch4
Answers to End of Chapter Questions and Problems
1.

Both parties did. In the absence of the activity of the confectioner (Bridgeman), there would have been
no conflict with Dr. Sturgess practice. And vice versa. It was the conflict between the two parties
activities that created the harm.

2.

Pigou presumes that the externality always results from the act of one party, who consequently should
always bear that cost. Coase, by contrast, observes that externalities arise from the conflicting activities
of two or more parties. Therefore, the proper allocation of the costs is uncertain. The polluter should not
automatically bear pollution costs that could be more cheaply borne by the victim. It is important to
note that Coase is not trying to tear down Pigovian welfare economics but to amend it in light of Pigous
analytical error in presuming that externalities must always be internalized to maximize efficiency.
Coase would agree with Pigou that polluters should bear the costs of pollution, but only so long as they
are the least cost avoiders/abaters of the harm.

3.

Coase presumably would say that laws prohibiting murders do harm would-be murderers, although he
most certainly would add that this is probably an efficient allocation of entitlements. The social costs of
allowing murders would generally exceed the private benefits to the murderers. The social costs of
prohibiting murders are likely to be lower than the social costs of allowing murders. However, there may
arise specific cases where murder could be efficient. For example, consider the murder of a Hitler. Such
a murder might be wrong under certain moral strictures, but could well be socially efficient.

4.

Coase seems to believe that judges are actually pretty good economists; they tend to allocate
entitlements as economic theory would suggest: to minimize social costs so as to maximize the social
product. Although he presents some cases where judges seemed to recognize the social-cost problem
(more astutely than welfare economists have tended to do), he presents no real evidence that courts
generally allocate entitlements efficiently across the run of cases. In fact, there is reason to believe that
courts are not institutionally well-suited to make those judgments. For one thing, all of the economic
evidence courts consider is based on testimony by parties who have incentives to present biased cost and
benefit estimates. In addition, there is little evidence that courts regularly engage in deliberate
comparative cost-benefit analyses before allocating entitlements. In the case of Lord Judge Thesinger, as
the text notes, he and his fellow judges did seek to influence economic outcomes. However, there was
no explicit analysis of transaction costs or the overall efficiency of alternative allocations of
entitlements.

5.

We have no good answer to this question. We posit it merely to emphasize the fact that Coase continues
to be misunderstood, sometimes it seems intentionally so. Because Coase uses a neoclassical framework
with which economists are familiar and comfortable, it is natural that they might find compelling the
conclusions that stem from that framework, which are embodied in the so-called Coase theorem. Still,
it is difficult to fathom how anyone paying any kind of attention to the real world in which problems of
social cost actually arise could possibly believe in the assumptions that comprise the Coase theorem.

11

6.

It is only unfair if you presume that being first in time and having initial liberty to make bricks
conferred on Mr. Hadachek an unconditional legal right to continue making bricks. According to the
Court, however, he held no such entitlement. Consequently, the fact that Court allocated rights in a way
that was detrimental to Mr. Hadachek was not necessarily unfair. From Coases perspective, there is no
necessary reason why being first in time to use a resource should be the basis for an entitlement to
continue using it. One can be first in time but still be the least cost avoider of social costs, as the
Court, by implication, ruled in the Hadachek case.

7.

Such a judge would have analyzed the costs and benefits (including incentive effects) of alternative
outcomesallocating the entitlement to Sturges v. allocating the entitlement to Bridgemanand
selected the alternative legal rule that provided the greatest net social benefit or the least net social cost.
There is precious little evidence, however, that judges typically do this, or could do this if they were so
inclined. Arguably, judges would require a great more information than they are privy to under the rules
of evidence, if they were to engage in serious comparative institutional analysis to maximize social
welfare.

8.

This is a hypothetical question. The courts decision does not specify which party was the least cost
avoider. But lets assume it was Lefevre. In that case, from Coases perspective, it would have been most
efficient for the court to allocate the entitlement to Bryant, the higher cost avoider. That allocation would
have minimized the joint costs, resulting in the highest possible net social benefit.

9.

Transaction costs are always positive to begin with. Litigation often engenders animosity between
parties, which raises the costs of transacting still higher. Those transaction costs could well impede an
efficiency-enhancing reallocation of the entitlement between the parties.

Ch5
Answers to End-of-Chapter Questions and Problems
1.

Most law and economics scholars refer to property rights in terms of several distinct entitlements over
things, including the right to exclude, the right to possess, the right to use, and so on. An owner of
property is the person or persons who hold the lions share of rights or entitlements to some thing. They
may not, however, be the only person with rights in that thing; one can be an owner without holding
every single right with respect to some item of property.

2.

The economic history of the world suggests that real economic growth is not the rule but the exception.
Economic growth requires certain institutional structures, including efficient property rights, that often
are lacking. One reason such property rights structures are not established, or only inefficient property
rights are established, is that certain elite groups in society benefit from their complete or partial
absence. For instance, kings used to grant monopolies to favorite supporters. Such monopolies were
highly valuable both for those who gave them and for those who received them, even if they were
inefficient for society as a whole.

The most important presumption in game theory is that players will act strategically, selecting a
dominant strategy whenever possible. A dominant strategy is that which, is that which is the best
response regardless of the strategy chosen by the other player(s). In a Prisoners Dilemma game, the
12

dominant strategy is defection because it is a best response given the strategy set of the other player. If
a player chooses to cooperate, and the other player defects, the cost to the cooperating player is very
high. If however, that player defects, the cost is lower even if the other player defects too. You can
demonstrate this in your class by designing a simple Prisoners Dilemma game for your students to play.
4.

To increase conservation of scarce resources by reducing externalities and transaction costs. According
to Demsetz, privatization reduces externalities by imposing more (if not all) of the costs and benefits of
the decision to exploit or conserve a resource on the owner of that resource. At the same time,
privatization reduces the costs of transacting by reducing the number of parties with authority to
participate in a decision to exploit or conserve a particular resource. If the owner decides to conserve
the resource, no one else can come along and exploit it, which they might do in a situation of openaccess or communal ownership. Economic theory would in general lead to the conclusion that an owner
will utilize resources to maximize benefits over time. This usually means there is a payoff to
conservation.

13

5.

There are circumstances in which individual private property owners can benefit from scale economies
by combining their interests into common (club) pools. For example, irrigation systems are rarely (if
ever) subject to individual private ownership. They tend to be commonly or publicly owned to spread
both the costs and benefits among all users of the irrigation water. Importantly, in order for such a
system to operate, the users must be able to exclude non-contributors; otherwise, the common property
system devolves into open access, which is unsustainable. Another common example of a club good is
a country club, which is not the private property of any single member but the collective property of all
the members. The members pool their resources to create facilities, exclusive to the members, such as
golf courses, which none of them alone could afford to provide, but which are desirable as alternatives
to, say, public golf courses.

6.

First possessors are generally (but not always) preferred at law. As illustrated in Paschal v. Hamilton,
subsequent possessors are sometimes preferred to first possessors in order to facilitate commerce. Coase
would say that first possession is not always a sound basis for allocating property rights because there is
no necessary reason why a first possessor should always be the higher cost avoider of social costs.
However, in many cases first possessors are likely to be higher cost avoiders. Across the run of cases, a
default rule favoring first possessors may economize on transaction costs, and therefore be an efficient
rule.

7.

Social norms may be more efficient than formal legal rules when the society to which they apply is
relatively small and homogeneous, and where monitoring and enforcement of formal legal rules would
be more costly. Not all social norms are efficient, however. For example, social norms of segregation in
the southern United States were demonstrably inefficient; they substantially reduced the social product.
Racial discrimination generally raises labor costs (in the absence of outright slavery), and therefore
raises product costs. And yet, as a social norm, it proved quite resistant to change either by free market
actors or formal legal rules.

8.

This question returns to the tension in intellectual property law between creating incentives to innovate
through granting monopoly property rights and the general desire to preserve market competition for the
good of consumers (as discussed on pages 124-27). Usually the law reserves intellectual property rights
for those goods that have (1) high capital costs of development and (2) great social value. It is doubtful
that dress designs meet either of these conditions. On the other hand, one might wonder whether popular
songs have higher capital costs of development or greater social value than dress designs; yet popular
songs have long been protected by intellectual property rights. Perhaps the real reason why dress designs
lack similar protection is the failure of dress designers to muster sufficient political influence to attain
intellectual property rights for their products. This observation comes, of course, from a public choice
perspective.

9.

It would be inevitable only if there were no sufficient institutional and/or technological means of
averting the tragedy of the commons. But there is no reason to believe that this is the case. In fact, many
open access tragedies have been averted by the imposition of common, private, or public property rights.
This is not to say that resource use conflicts can or will always be averted; there may well even be wars
fought over natural resources. But there is no reason for Hardins extreme pessimism about the
inevitability of the tragedy of the commons.

10.

Almost no one thinks so. A few free market environmentalists would argue that Yellowstone would be
better managed both environmentally and economically under private ownership. See Terry L. Anderson
and Donald R. Leal, Free Market Environmentalism (Palgrave Macmillan 2001). But there are reasons
to be skeptical of this claim. It is certainly true that open access is unsustainable, and that public and
common ownership is preferable in terms of preserving economic values. Moreover, many
14

environmental goods have been privately owned in the past, without undue degradation or
overexploitation. At the same time, other environmental goods have, however, been damaged in private
use. The important point, however, is that a private owner would be expected to maximize private
benefits, which may lead to neglect of the public-good aspects of the resource (a la Figure 1-4 in
Chapter 1). Even if Yellowstone might be more efficiently managed under private ownership,
privatization would have little political support, and not just because of public choice considerations.
Americans seem to value Yellowstone as a public place, regardless of any potential efficiency
advantages of private ownership. This takes us back to Justice Posners observation (discussed in
Chapter 3) that not everything that is economically efficient is, or necessarily should be, policy. Anyway,
virtually no one believes that Yellowstone National Park will be privatized within the lifetime of anyone
now living.
11.

The payoffs in the Prisoners Dilemma game are deliberately structured by the criminal justice system to
prevent the players from cooperating (e.g., by keeping them separated and incommunicado). With the
Herder Problem, by contrast, there is no third party manipulating the game; the herders are allowed to
communicate with each other, which at least creates some positive probability that a sufficient level of
trust will develop to permit cooperation in managing the commons. It is, after all, the level of trust that
determines the likelihood (that is, the probability) of cooperation; and it is that probability, times the
payoff, that determines whether the players will cooperate or defect (as in the payoff matrix on page
120).

Ch6
Answers to End-of-Chapter Questions and Problems
1.

No. There is no reason to believe that changing the rule governing liability for nuisance affects the total
costs of land-use conflicts at all; it merely redistributes those costs between the parties. In shifting from
strict liability to reasonableness, the courts merely shifted some nuisance costs previously borne by
nuisance defendants to nuisance plaintiffs. No one can really say whether the total social costs of private
land-use conflicts were higher or lower after this change; and the change itself almost certainly would
have no bearing on that. What really was efficiency-enhancing was the shift in remedies from automatic
injunctions to a presumption in favor of money damages. An automatic injunction is inefficient
whenever the nuisance-causing activity itself is efficient, i.e., it produces net social benefits. To enjoin
such an efficient activity must be inefficient. This problem was avoided by changing the remedy for
nuisances from automatic injunction to a presumption in favor of money damages, with injunctive relief
limited to extraordinary circumstances in which money damages are deemed insufficient.

2.

This is, of course, a matter of opinion. To the extent the court in Spur was wrong to hold the feedlot
liable at all, we could claim that the coming to the nuisance doctrine would be an efficient rule in that
case. However, it is possible to conceive of cases, not too different from Spur, where applying the
coming to the nuisance doctrine would arguably be inefficient. The Hadachek case, discussed on pages
81-82 of Chapter 4, is one possible example.

3.

The right to vote is not often thought of as a property right, but it is a right protected by an inalienability
rule. If it were not, there is no question that markets for voting rights would arise (in fact, black markets
in voting rights seem to exist already). But voting rights are not alienable for non-economic reasons
relating to conceptions of democracy.

4.

The court was trying to minimize the costs to the defendant (and the public) of avoiding the harm. In
addition, the court was wary of imposing a certain remedy on the defendant given the economic and
technical complexities of air pollution control. See the other excerpt from Boomer in Chapter 15.
15

5.

Injunctions are efficient whenever the nuisance-causing activity itself is inefficient, i.e., produces net
social costs. In that case, it shouldnt matter whether the court enjoins the activity or merely requires full
compensation; if the activity is inefficient, it will stop. Moreover, injunctions may be as or more efficient
than actual damages remedies in cases where it is very difficult for the courts to measure damages
accurately. After all, an inaccurate damages remedy can be every bit as or more inefficient than an
inefficient injunction. Finally, when injunctions are imposed, and turn out to be inefficient, the parties
may well be able to bargain around the injunction to some more efficient outcome.

6.

In the absence of well-defined and enforced property rights, no buyer of goods can be sure of acquiring
good title to the things she buys. This creates a disincentive for exchange, which in turn reduces the
overall level of economic activity and economic growth.

7.

In the first place, in the world of the Coase theorem, there would be no property rules (injunctions) or
liability rules (damage awards) because there would be no courts to decide disputes that would always
be costlessly resolved by contracting parties. However, if courts did for some reason costlessly exist,
their remedies, either compensatory or equitable, would be unfailingly efficient because they would be
based on complete and accurate information.

8.

States have enacted right to farm laws, largely in response to decisions like Spur, in order to protect
agricultural activities against nuisance suits. In effect, they re-establish the coming to the nuisance
doctrine as a decision rule in cases where (1) the farm was there first; and (2) the farm is not
substantially increasing in size or changing its activities substantially.

Ch7
Answers to End-of-Chapter Questions and Problems
1.

Assuming plaintiffs would prefer to stop the nuisance than receive compensation for harm, they would
rather sue in public nuisance than private nuisance because injunctive relief is a more likely remedy for
public nuisances. Generally speaking, courts today are reluctant to award private nuisance plaintiffs
anything more than money damages.

2.

This question is designed to test the students comprehension of Coases approach to nuisance disputes
as joint cost, or social cost, problems. Portland Meadows is a perfect illustration of Coases approach.
Its quite clear that neither partys use of its land, alone, constituted the nuisance; rather, the nuisance
occurred because of the combination of the light-dependent race track and the light-sensitive outdoor
movie theater. To resolve such a joint-cost problem, Coase would impose the costs of the harm on the
least cost avoider. Did the court do that in this case? At least, the court seemed sensitive to (a) the efforts
the race track had made to avoid the harm, and (b) the lack of similar efforts made by theater. On the
other hand, theres no indication that the court actually quantified the costs to either party of avoiding or
abating the nuisance. It merely decided that the theater did not warrant compensation because its use of
its own land was abnormally light sensitive. In other words, according to the court, there would have
been no nuisance at all, if the theater had been normally light sensitive or light insensitive.

3.

This problem is designed to illustrate the conundrum facing courts, which must decide whether some
legislation affecting property rights constitutes (a) an eminent domain taking requiring, which would
require compensation or (b) a police-power regulation, which (in most circumstances) would not.
According to traditional jurisprudence, legislatures invoke the police power (no compensation) to
prevent public harm; and they use the eminent domain power (withcompensation) to confer public
16

benefits. The problem, as this problem illustrates, is that almost any state action that confers public
benefits can be said to prevent public harm, and vice versa. By preventing development of the pristine
valley, the government is conferring on the public the benefits resulting from prevention of
development. At the same time, by preventing development, the government is avoiding harm to the
public that development would entail. Because this, and most other, government actions restricting
development can be described either as harm avoiding or benefit conferring, there is no objective and
unambiguous means of clearly distinguishing compensable eminent domain takings from
noncompensable police-power regulations. Prior to 1922, however, the courts generally deferred to
legislature to choose between its eminent domain and police powers. With the emergence of the
welfare/regulatory state, however, judicial distrust of legislative motives increased. Judges realized that
legislatures might try to avoid paying compensation by couching eminent domain takings in policepower language. To reduce this risk, the courts took it upon themselves to decide what state actions
constituted legitimate police-power regulations, as opposed to eminent domain takings. Whether this
was a sound decision depends upon ones perspective with respect to (a) the general trustworthiness of
legislatures, and (b) the comparative institutional capacity and trustworthiness of courts to determine
when a regulation constitutes a taking. There is no objectively correct answer to the question of who
should decide. As the next question suggests, public choice theorists might argue that government landuse regulations have little to do with either conferring public benefits or preventing public harms.
4.

Public choice explains government regulation according to (a) theories of collective action, (b)
legislators self-interest, and (c) rent-seeking (as described in the perspectives section of Chapter 3).
Some public choice scholars maintain that government regulations cannot be explained by reference to
some broader public interest; rather, they represent the preferences of powerful interest groups, which
succeed in promoting their own agendas. In other words, public choice scholars tend to view regulatory
legislation as representing a minoritarian bias in the political process. But, of course, property owners
are also an important interest group, which occasionally at least can impose its political will, as in
several recent state laws that make it easier for injured property owners to receive compensation for
regulatory takings.

5.

On Michelmans theory (from the excerpt on pages 191-3), failure to award compensation to Mr. Lucas
might have demoralized similarly-situated property owners, reducing at least marginally their
incentives to invest in property development. This would, of course, have affected the social product.
There would also be distributional consequences. The price of already developed land would rise, but
the value of non-developed land would fall. And housing would be in marginally shorter supply.
Existing residents would benefit, while developers and would-be residents would suffer harm.

6.

Factories prefer to locate close to transportation nodes. They might also cluster because that might make
it cheaper and easier for them to acquire production inputs. In general terms, there are agglomerative
economies of scale. Another reason for industrial clustering is legal: by voluntarily segregating
themselves away from residential development, industries reduce the risk of nuisance and other common
law suits.

7.

The police power is an inherent power of government to regulate behavior to protect the health and
safety of the public. It includes, for example, the right to police criminal behavior, as well as the right to
regulate non-criminal, but potentially harmful (to the public) behavior.

8.

The majority and dissent both expressly answer this question, but their answers are diametrically
opposed. Both cannot be correct. In our view, the majority are right that the Courts ruling in Kelo does
not authorize governments to take property from one private individual and give it to another based
solely on best guesses about enhancing property values or social welfare. The takings in Kelo were
17

9.

based on state findings that the City of New London was a distressed municipality and no specific
future owner had been designated for Mrs. Kelos home. In this respect, Kelo was hardly different from
Berman v. Parker, which the dissent tries, but fails in our view, adequately to distinguish.
Professor Epstein, in his article cited in the question, believes that courts should not involve themselves
with private land use arrangements, so long as those arrangements are freely entered into with due notice
of all restrictions. The original parties can provide for changed conditions if they so desire at the time
when servitudes are created. And when disputes arise there is no apparent reason to consider judicial
coercion superior to consensual renegotiation (p. 1366). Professor Sterk, in his article cited in the
question, disagrees with Professor Epstein: o leave landowners unrestricted in their right to impose by
contract obligations that run to successors-in-interest of land would be to ignore, or to subordinate as
unworthy of decisive consideration, at least two problems. First, a number of servitudes create
externalities. They affect not only the owners of burdened and benefited land, but third parties whose
interests are not represented in the negotiation process. Second, servitudes binding or benefiting multiple
parties are difficult to remove because of high transaction costs. Even when parties to the original
agreement consider the costs of removing the restrictions and take steps to reduce those costs, their
actions do not eliminate the need for subsequent consideration. Current landowners have limited
foresight; permitting their restrictions to govern land use for long periods or periods of unlimited
duration might frustrate even their own preferences for the future. More important, even if current
landowners possessed perfect foresight, to permit their preferences to govern for long periods or forever
would be to resolve against future generations difficult questions of intergenerational fairness (p. 617).

18