DUE DATE: Thursday, November 10, 2011 Total Possible Points: 100 Please Explain All Answers!

Economics 28600 Autumn 2011 University of Chicago

Homework 3 1. The potential injurer chooses units of precaution x; each unit of x costs the injurer $1. The potential victim also takes units of precaution y, though each unit of y costs $4. It is physically impossible for either party to supply less than one unit of precaution: i.e., x1 and y1. The probability of an accident is given by p(x,y) = 1/(xy). The damage (in dollars) associated with an accident is given by A(x,y)=10,000/(xy). Be sure to show your calculations. (5 pts) a. Write down the problem facing a social planner who is interested in efficiency, that is, in maximizing the size of the social pie. Solve the planners problem to find the socially optimal levels of precaution x* and y*. What are the total costs (prevention plus expected damages) associated with accidents when precautions x and y are at their socially efficient levels? (5 pts) b. Under a liability rule of strict liability (for the injurer) how much precaution will the potential injurer engage in, and how much precaution will the potential victim choose? What are the total costs (prevention plus expected damages) associated with accidents under strict liability? (5 pts) c. Assume that the liability rule is negligence, and that the injurers legal standard of care is given by x* in part (a), the socially efficient level. Under this liability rule, how much precaution will the potential injurer engage in, and how much precaution will the potential victim choose? What are the total costs (prevention plus expected damages) associated with accidents under this negligence rule? (5 pts) d. Assume that the liability rule is negligence, and that the injurers legal standard of care is now given by 2x*. Under this liability rule, how much precaution will the potential injurer engage in, and how much precaution will the potential victim choose? What are the total costs (prevention plus expected damages) associated with accidents under this negligence rule?

2. A surgeon performs an operation on a patient. The doctor can undertake three levels of care: low, medium, and high. No matter what amount of care the surgeon undertakes, there is a possibility that she will injure the patient. The damage from injury is fixed at $50,000. The patients behavior does not affect the probability of the injury. The other relevant data are given in the table below. Level of care by surgeon Low Moderate High Surgeons cost of precaution 20,000 30,000 40,000 Probability of injury to patient 0.5 0.2 0.1

(3 pts) (a) What is the socially efficient level of care by the surgeon? (3 pts) (b) What level of care would a rational surgeon undertake if she is strictly liable? (3 pts) (c) What level of care would the surgeon undertake under a negligence rule if the standard of care is set at Moderate? (5 pts) (d) Suppose the surgeon is uncertain about the standard of care that the court would use if the injury occurs. She thinks that any of the three levels of care are equally likely to be used (i.e., the probability of each standard is 1/3). What are the surgeons payoffs from undertaking each of the levels of care? What level of care will she choose? 3. (14 pts) Compare a liability rule (in bilateral precaution situations) of negligence with a defense of contributory negligence, with a liability rule of negligence combined with comparative negligence. Is either rule more efficient than the other? Are administrative costs likely to be the same under both rules? Be sure to spell out precisely what the two liability rules consist of.

4. (14 points) There are a continuum of drivers with their marginal costs of care (w) distributed (in an unknown fashion) between 1 and 2,500 dollars (per unit of care x). The probability of an accident is p(x) = 1/x, and the damage in the event of an accident is $100. Drivers operate under a negligence regime, and courts establish that the legal standard of care, for all drivers, is x = 6. It is physically impossible for the injurer to supply less than one unit of precaution: i.e., x1. Illustrate socially efficient choices of care on a graph, with w measured along the horizontal axis and x on the vertical axis. Calculate precisely which drivers will choose to meet the legal standard of care, and indicate each drivers choice of care on the graph, too. 5. (14 points) Most of our discussion of liability rules has ignored litigation costs. Assume, now, that in the event of a suit for damages, both the plaintiff and the defendant will have litigation costs, say, of $1000 each. Look at both strict liability and negligence in a unilateral care setting: how does the introduction of these litigation costs alter the analysis? (You can assume for the sake of this question that the court will not take litigation costs into account when rendering any decision about guilt or damages.) 6. (12 points) Oxana smoked from 2007 to 2010, and now she is suing the Merchant-of-Death Tobacco Company for the extra medical expenses that she incurred during those years: expenses that she attributes to smoking Mo-D cigarettes. These expenses were, in 2007, $100; in 2008, $250; in 2009, $350, and in 2010, $500. Her lawyer argues that should Oxana win the case, M-o-D Tobacco should pay Oxana the present value (in year 2011 dollars) of her excess medical expenses. Assume that the interest rate has been 10 per cent per year for the past decade, and also assume that there was no inflation over that time period. How much money is her lawyer asking that Oxana be paid, should she win? Do you think that as a general proposition in damage awards, past damages should be compensated according to the present value? Explain.

7. (12 points) There is some probability that your answers to this homework will go missing, will somehow not be handed in or found or graded or recorded. Please use the Law and Economics approach to discuss how to allocate the risk that this happens. What should be the missing homework policy? Does it matter if the class has five students as opposed to 50 students?