Identification problems
1. What is the definition of an identification problem (in the context we have discussed in EC337)?
2. Two general empirical patterns are that (1) premiums for medical malpractice insurance are historically high and rising; and (2) health care costs represent an historically large and growing fraction of GDP. In arguing for tort reform, many people attribute pattern (2) to pattern (1).
State the potential problem with this argument.
Torts
"Direct" Hand Rule
1. As a potential "injurer", you are trying to calculate the level of precaution that you should take in order to maximize your expected utility. Assume that the amount of precaution that you can take is a continuous variable (e.g. the number of miles-per-hour by which you choose to slow down your vehicle while driving in a school zone), and that the probability of an accident is determined by the level of precaution that you take, following the function p(x). Assume further that the only cost of taking precaution that you face is an opportunity cost w per unit of precaution (i.e. if you choose to set your level of precaution to 9, then your total cost of taking precaution equals 9w).
a. Assume that your utility is linear in consumption, given by the function U(c) = c, and that your budget constraint is c=M - wx - d, where d=D>0 if you have an accident and d=0 otherwise, and M is your income in dollars. Write down an equation defining your utility-maximizing level of precaution.
b. Let x* denote your answer from Part (a). Despite having taken precaution level x*, you have an accident. The judge in your trial studied the teachings of the famous Judge Learned Hand, and so will apply the Hand Rule to decide your fate. If you are found negligent, you will be fined heavily at some amount F>D, and otherwise just charged court and legal fees totaling D dollars. What will be the outcome of your case, and why?
Moral hazard
2. As a potential victim, you are trying to calculate the level of precaution that you should take in order to maximize your expected utility. This time the amount of precaution that you can take is a discrete (0 or 1) variable (e.g. you either wear your glasses when you drive, or you don't). The cost of taking precaution is again given by w. In addition, you either have good luck (G) or bad luck (B), each with probability 0.5. Thus, there are four possible states of the world determined by the level of precaution you choose and the luck that you have.
The payment that you are required to make to your insurance company in each state of the world is given by the following table:
where DH>DL>0 are the overall costs of the accident and s is the share of those costs that your insurance company requires you to pay (i.e. the fraction of co-insurance).
a. Assume that your utility function is linear (i.e. U(c)=c) and that you simply consume your income net of any insurance payments that you have to make and your cost of taking precaution, if any (i.e. your budget constraint is c=M-L where M is your income and L is the sum of insurance payments, given in the table above, and cost of precaution if applicable). Write down an equation/inequality for s, defined as the minimum level of co-insurance necessary to make it utility-maximizing for you to take precaution (Hint: s is a function of w).
b. What does this model say about the efficient level of s for people with different values of w? What problems, if any, does this suggest that insurance companies may have in writing efficient insurance policies?
c. Calculate s for M=50, DL=50, DH=50, and w=5.
d. Now assume that your utility function is quadratic, given by the function U(c)=100c - c2.
If your insurance policy specifies that s=0.18, will you take precaution? (Assume the same values for the other variables as in Part (d) above).
e. What can you say about the welfare costs of asymmetric information under the two different utility functions considered above?
Criminal Law
Economic basis of criminal law
1. Provide an economic justification for why some "victimless" crimes are, nevertheless, crimes.
Optimal punishment
2. Assume that 95 percent of all robberies are committed by one of the victim's neighbors. Provide economic justifications both for and against a policy of burning down all houses in the victim's neighborhood (except for the victim's house) as a method of punishing robbers.
Death penalty
3. Give an example of an additional procedural safeguard that applies to death penalty cases. Provide an economic justification for such safeguards.
4. True or false (and explain): In the case of McKleskey v Kemp (481 U.S. 279), the majority opinion written by the United States Supreme Court took the view that The Baldus Study provided no statistical evidence that sentencing correlates with race.
Judicial discretion
5. Give an economic justification for judicial discretion. Provide at least two examples.
Law and the Legal Process/Civil Procedure
1. "The United States should shift to the British rule for payment of legal fees because it would help deter the filing of frivolous cases." Justify or criticize using the model developed in class.
2. Mary is considering filing a lawsuit. Her lawyer gives her an (unbiased) assessment of her chances of winning if she files the suit in court. The probability that she will win is 0.10. Should Congress pass laws to discourage potential plaintiffs like Mary from filing their lawsuits?