E309 Law and Economics
IU Spring 2008 Prof. Alexeev
Midterm examination 2
Part 1. (30 points) Short essays (approximately one blue book page or less per answer). Answer two of the following three questions.
1.1. Friedman argues that the Homestead Act of 1862 might have been “the most expensive mistake the US government has ever made.” (Under the Act, a settler obtained ownership of a plot of land from the federal government by farming it for a number of years and meeting some other requirements.) What is the gist of the above argument (i.e., why the land allocation mechanism under the Act might have been highly wasteful)? What would normally be a better way to privatize federally owned land? Are there counterarguments (i.e., can one defend the economic efficiency of the Homestead Act)?
1.2.Describe briefly a proposal to replace the existing patent system with an auction of the rights for the invention, making sure to explain the government’s role in the auction and why it is a good idea to have the winner of the auction pay the second (or even third or fourth) highest bid, rather than his own. What would be the main advantage of such an auction over the existing patent system?
1.3. What are the main social benefits and costs of copyright protection? What features of copyright law mitigate the social costs of copyright protection? Does it make economic sense to extend copyright retroactively (as was done by the Sonny Bono CopyrightTerm Extension Act of 1998)?
Part 2 (30 points) Short essays. Answer two of the following three questions.
2.1.What are opportunity cost damages? Rank expectation damages, reliance damages, and opportunity cost damages in terms of size and explain your rankings. (That is, indicate which damage payment is generally the greatest and which is the smallest and why.)
2.2.What are the main distinguishing features of contracts made under duress (i.e., how can one distinguish them from acceptable threats in legitimate contract negotiations)? Explain the arguments for and against enforcing such contracts. Which arguments are stronger?
2.3. Generally, the legal systems defers to the parties to a contract and upholds the terms of the contract. There are, however, several types of circumstances when courts regulate contracts (i.e., the terms of the contract are either changed or invalidated by the courts). List at least three examples of such types of circumstances (excluding duress) and explain the economic reasoning for two of them.
Part 3. (40 points) Do the following three problems.
3.1. (20 points) Seller S promises to deliver a custom-made aquarium to buyer B1 for $P to be paid on delivery. The aquarium costs $300 for S to make. After S made the aquarium, B realized that he lost interest in fish and decided not to take delivery. Because B1 breached the contract, S had to sell the aquarium to B2 for $250. Had S not entered into contract with B1, he would not have been making the aquarium and would not incur any costs.
(i)Assuming that P=$500, what are (a) expectation damages; (b) reliance damages and (c) restitution? (Hint: recall the definitions of expectation damages, reliance damages, and restitution.)
Answer: (a) Expectation damages should make S indifferent between B1’s breach and performance. If B1 performs, S gets 500−300=$200. If B1 breaches S loses $50. Therefore, expectation damages should be $200−(−$50)=$250. You get the same answer if you argue that after his costs of $300, S gets $P in case of performance but only $250 in case of breach. Therefore, expectation damages should be P−250=$250. (b) Reliance damages make S just as well of as he would have been without the contract. Therefore, reliance damages are $50. (c) Restitution is $0, because S did not pay B1 anything.
(ii)If the probability of B1’s breach is 0.2, what is the minimum price, $P, that S would accept for the aquarium under (a) expectation damages? (b) restitution?
Answer: Denote damages that B1 pays S by D. Then, S’s expected payoff from the contract is W=0.8*(P−300)+0.2*(250−300+D). If D=P−250, then in order for W≥0, P has to be at least $300. If D=$0, then to make W≥0, P has to be at least $312.5.
3.2. (12 points) Two people, each of whom has wealth of 200 ready to invest, live near a free-access public pasture. Each person can either invest his 200 in a one-year government bond (the price of each bond is 200) that pays interest of 10% per year, or use it to buy a steer that will graze on the pasture. Steers require no effort to tend, and are sold in one year for a price that depends on the amount of weight they gain during the year. Yearly weight gain, however, depends on the number of steers that graze on the pasture. If only one steer grazes on the pasture, it can be sold for 230. If two steers graze there, each can be sold for 222. Nobody else can use the pasture.
(1)What investment would maximize the joint investment of the two people?
Answer: One person invests in the steer and one in the bond, making total wealth one year from now 230+220=450.
(2)How many steers would be purchased if the two people make their investment decisions independently?
Answer: Two, because for each person, the return to buying a steer would be 222>220.
(3) How would private ownership of the pasture maximize social wealth? (Suggest a specific solution that would involve numbers appropriate for this example.)
Answer: A private owner of the pasture would maximize his profit and charge each owner of a steer $10 for the use of the pasture. Then, only one person would use, generating revenue for the pasture owner of $10.
3.3. (8 points) Mike negotiates a contract with a builder for a new house. It costs Mike and the builder $80 to negotiate and write into the contract a rule for sharing potential losses due to a possible earthquake in the area. If the earthquake takes place, Mike and the builder would have to spend a total of $10,000 on litigation to determine the allocation of losses from it. What would be the minimum probability of an earthquake (as perceived by Mike and the builder) to make it rational for the risk-neutral parties to address this contingency in their contract? (Assume that if litigation takes place, it would allocate the losses efficiently.)
Answer: To justify ex ante negotiations, we need 80≤P*10,000, where P is the probability of the earthquake. Therefore, the minimum P=0.008.