ECO320 Final Exam UPDATED ACTUAL
Exam Questions and CORRECT Answers
"Central Problem" - CORRECT ANSWER - optimality in the economic analysis of law
- maximize social surplus
Property Rights/Law - CORRECT ANSWER - supplies the legal framework for allocating
resources & distributing wealth
- a bundle of rights describing what people may & may not do with the resources they own: the
extent to which they may -->
possess/use/develop/improve/transform/consume/deplete/destroy/sell/donate/bequeath/transfer/m
ortgage/lease/loan/exclude
- economic theory tries to predict the effects of alternative forms of ownership, especially the
effects on efficiency & distribution
Rule of First Possession / Rule of Capture - CORRECT ANSWER - the first party to use an
unowned resource acquires claim to it
- an example of maintaining low transaction costs by defining property rights clearly & simply
- cost minimizing as it focuses on just a few simple facts
- encourages efficiency by emphasizing the production of wealth over the transfer of wealth
- danger being that the rule may lead to over-investment
Rule of Tied Ownership - CORRECT ANSWER - may occur when the Rule of First
Possession can lead to economic costs
Coase Theorem - CORRECT ANSWER When transaction costs are zero, an efficient
(socially optimal) use of resources results from private bargaining, regardless of the legal
assignment of property rights
Coase Theorem & Damages vs. Injunction - CORRECT ANSWER *Low Transaction Costs -
-> injunction is the more efficient remedy:
,- right to an injunction gives the parties a clearer position from which to bargain, although parties
may eventually agree to a settlement based on compensation
*High Transaction Costs (to prevent bargaining) --> switching from injunction to damages
makes the injurer better off without making the victim worse off
Open Range Rule - Ranchers' Rights - CORRECT ANSWER - the farmer is responsible for
keeping the cattle off his property
- the farmer bears (must pay for) any damages caused by the cattle
- Rancher chooses optimal # of cattle & optimize their own surplus
- Farmer has no legal recourse against damages done by cattle
- Farmer must take precautions to reduce the damage
Closed Range Rule - Farmers' Rights - CORRECT ANSWER - the rancher is responsible for
keeping the cattle on their property
- the farmer bears (must pay for) any damages caused by the battle
- Rancher chooses to optimize total social surplus
- Rancher must reduce damage to Farmer
Fairness vs. Efficiency - CORRECT ANSWER - fairness requires the party who causes harm
to pay for it
- efficiency requires allocating the right to the party who values it most
Suppose that a railroad runs beside a field in which commercial crops are grown. The railroad is
powered by a steam locomotive that spews hot cinders out of its smokestack. From time to time
those cinders land on the crops nearest to the track and burn them to the ground. Assume that
each year, the farmer whose crops are burned loses $5000 in profits, and that the annual cost to
the railroad of installing and maintaining a spark-arrester that would prevent any damage to the
crops is $3000.
,(a) Does it matter to the efficient use of the farmer's land or to the efficient operation of the
railroad whether the law protects the farmer from invasion by sparks or allows the railroad to
emit sparks without liability? Explain.
(b) How high can legal fees be before impact on efficient outcomes are affected? Explain. -
CORRECT ANSWER (a) If there are zero (0) or low transaction costs, the Theorem of Coase
applies
- The railroad will operate the train with a spark arrestor regardless whether the law protects the
farmer from invasion by sparks or allows the railroad to emit sparks without liability. The
efficient outcome is the same under either rule
* However, the choice of rule will affect the distributive outcome
- The strict liability rule protecting the farmer means the farmer saves $5,000 and the railway
will install the spark arrestor for $3,000
- A permissive or no liability rule protecting the railroad means the farmer saves only $2,000 and
the railway will install the spark arrestor for $3,000 paid by the farmer by contract. The farmer is
$3,000 poorer and the railway is $3,000 richer
(b) If legal fees exceed $2,000, the Theorem of Coase does not apply -->
- the railroad will operate the train without a spark arrestor if the law allows the railroad to emit
sparks without liability
- the railroad will operate the train with a spark arrestor if the law protects the farmer from
invasion by sparks.
- Both the efficient and distributive outcomes vary in this case
Transaction Costs - CORRECT ANSWER - encompasses all of the impediments to
bargaining
- the costs of bargaining
(1) Search Costs
(2) Document Costs
(3) Enforcement Costs
, For which liability standard would you expect the litigation costs to be greater—negligence or
strict liability? Why? Is that an additional efficiency argument for preferring one standard to the
other? - CORRECT ANSWER * On a case-by-case basis, litigation costs are likely to be
higher for negligence for the Claimant *
- Unlike strict liability, negligence requires the claimant establishing that a duty of care existed
between the injurer and the claimant, and that the injurer failed to meet the requisite standard of
care
- However, the effect on overall efficiency is less clear. Higher costs may dissuade potential
claimants, leading to under-compensation
- For potential defendants it is optimal to adopt the optimal standard of care leading to higher
precautionary spending, even though they legally need not do so
Property Rights & Coase Theorem - CORRECT ANSWER - if transaction costs are zero,
private bargaining will achieve efficiency, regardless of the legal assignment of property rights
- if transaction costs are relatively high enough to prevent private bargaining, the efficient use of
resources will depend on how property rights are assigned
Net Value of Bargaining - CORRECT ANSWER = cooperative surplus - transaction costs
Invariance Version of Coase - CORRECT ANSWER - the use of resources is invariant to the
assignment of property rights
- the initial assignment of property rights will only have an impact on the distribution of
payments between the parties, but not the economic outcome of the parties' activities
Endowment Effect - CORRECT ANSWER - the divergence between buying & selling price
- the tendency of people to be unwilling to sell a good they already own even if they are offered a
price that is greater than the price they would be willing to pay to buy the good if they didn't
already own it
- endowment: an initial assignment of ownership rights
Exam Questions and CORRECT Answers
"Central Problem" - CORRECT ANSWER - optimality in the economic analysis of law
- maximize social surplus
Property Rights/Law - CORRECT ANSWER - supplies the legal framework for allocating
resources & distributing wealth
- a bundle of rights describing what people may & may not do with the resources they own: the
extent to which they may -->
possess/use/develop/improve/transform/consume/deplete/destroy/sell/donate/bequeath/transfer/m
ortgage/lease/loan/exclude
- economic theory tries to predict the effects of alternative forms of ownership, especially the
effects on efficiency & distribution
Rule of First Possession / Rule of Capture - CORRECT ANSWER - the first party to use an
unowned resource acquires claim to it
- an example of maintaining low transaction costs by defining property rights clearly & simply
- cost minimizing as it focuses on just a few simple facts
- encourages efficiency by emphasizing the production of wealth over the transfer of wealth
- danger being that the rule may lead to over-investment
Rule of Tied Ownership - CORRECT ANSWER - may occur when the Rule of First
Possession can lead to economic costs
Coase Theorem - CORRECT ANSWER When transaction costs are zero, an efficient
(socially optimal) use of resources results from private bargaining, regardless of the legal
assignment of property rights
Coase Theorem & Damages vs. Injunction - CORRECT ANSWER *Low Transaction Costs -
-> injunction is the more efficient remedy:
,- right to an injunction gives the parties a clearer position from which to bargain, although parties
may eventually agree to a settlement based on compensation
*High Transaction Costs (to prevent bargaining) --> switching from injunction to damages
makes the injurer better off without making the victim worse off
Open Range Rule - Ranchers' Rights - CORRECT ANSWER - the farmer is responsible for
keeping the cattle off his property
- the farmer bears (must pay for) any damages caused by the cattle
- Rancher chooses optimal # of cattle & optimize their own surplus
- Farmer has no legal recourse against damages done by cattle
- Farmer must take precautions to reduce the damage
Closed Range Rule - Farmers' Rights - CORRECT ANSWER - the rancher is responsible for
keeping the cattle on their property
- the farmer bears (must pay for) any damages caused by the battle
- Rancher chooses to optimize total social surplus
- Rancher must reduce damage to Farmer
Fairness vs. Efficiency - CORRECT ANSWER - fairness requires the party who causes harm
to pay for it
- efficiency requires allocating the right to the party who values it most
Suppose that a railroad runs beside a field in which commercial crops are grown. The railroad is
powered by a steam locomotive that spews hot cinders out of its smokestack. From time to time
those cinders land on the crops nearest to the track and burn them to the ground. Assume that
each year, the farmer whose crops are burned loses $5000 in profits, and that the annual cost to
the railroad of installing and maintaining a spark-arrester that would prevent any damage to the
crops is $3000.
,(a) Does it matter to the efficient use of the farmer's land or to the efficient operation of the
railroad whether the law protects the farmer from invasion by sparks or allows the railroad to
emit sparks without liability? Explain.
(b) How high can legal fees be before impact on efficient outcomes are affected? Explain. -
CORRECT ANSWER (a) If there are zero (0) or low transaction costs, the Theorem of Coase
applies
- The railroad will operate the train with a spark arrestor regardless whether the law protects the
farmer from invasion by sparks or allows the railroad to emit sparks without liability. The
efficient outcome is the same under either rule
* However, the choice of rule will affect the distributive outcome
- The strict liability rule protecting the farmer means the farmer saves $5,000 and the railway
will install the spark arrestor for $3,000
- A permissive or no liability rule protecting the railroad means the farmer saves only $2,000 and
the railway will install the spark arrestor for $3,000 paid by the farmer by contract. The farmer is
$3,000 poorer and the railway is $3,000 richer
(b) If legal fees exceed $2,000, the Theorem of Coase does not apply -->
- the railroad will operate the train without a spark arrestor if the law allows the railroad to emit
sparks without liability
- the railroad will operate the train with a spark arrestor if the law protects the farmer from
invasion by sparks.
- Both the efficient and distributive outcomes vary in this case
Transaction Costs - CORRECT ANSWER - encompasses all of the impediments to
bargaining
- the costs of bargaining
(1) Search Costs
(2) Document Costs
(3) Enforcement Costs
, For which liability standard would you expect the litigation costs to be greater—negligence or
strict liability? Why? Is that an additional efficiency argument for preferring one standard to the
other? - CORRECT ANSWER * On a case-by-case basis, litigation costs are likely to be
higher for negligence for the Claimant *
- Unlike strict liability, negligence requires the claimant establishing that a duty of care existed
between the injurer and the claimant, and that the injurer failed to meet the requisite standard of
care
- However, the effect on overall efficiency is less clear. Higher costs may dissuade potential
claimants, leading to under-compensation
- For potential defendants it is optimal to adopt the optimal standard of care leading to higher
precautionary spending, even though they legally need not do so
Property Rights & Coase Theorem - CORRECT ANSWER - if transaction costs are zero,
private bargaining will achieve efficiency, regardless of the legal assignment of property rights
- if transaction costs are relatively high enough to prevent private bargaining, the efficient use of
resources will depend on how property rights are assigned
Net Value of Bargaining - CORRECT ANSWER = cooperative surplus - transaction costs
Invariance Version of Coase - CORRECT ANSWER - the use of resources is invariant to the
assignment of property rights
- the initial assignment of property rights will only have an impact on the distribution of
payments between the parties, but not the economic outcome of the parties' activities
Endowment Effect - CORRECT ANSWER - the divergence between buying & selling price
- the tendency of people to be unwilling to sell a good they already own even if they are offered a
price that is greater than the price they would be willing to pay to buy the good if they didn't
already own it
- endowment: an initial assignment of ownership rights
