Harm relief:

A factory produces smoke that causes damage of $1000 to a neighboring resident. The smoke damage can be eliminated in one of two ways: The factory can install a chimney at a cost of $2500, or the resident can screen their porch for $500. Consider the following two legal rules: • The factory has an unlimited right to pollute. • If the factory pollutes, it must pay the residents damages. (a) Suppose first that it is prohibitively expensive for the factory owner and the resident to negotiate. What will the outcomes be under the two legal rules? Is either more efficient than the other? (b) Suppose instead that the factory owner and resident can bargain costlessly. What will the outcomes be under the two legal rules? Is either more efficient than the other? 2. Why is moral hazard a problem in the context of insurance? Give an example. 3. Suppose Peter promises to deliver a machine to Egon. The machine allows Egon to produce a profit of $2.5 million over its life cycle, but only if he also invests $1 million in other upgrades to his operation. They agree on a sale price of $1 million. (a) Suppose Egon will install upgrades after delivery. Is delivering on this promise efficient if: i. the machine costs ends up costing $1.2 million to build? ii. the machine costs ends up costing $2 million to build? (b) Suppose Egon has already installed upgrades. Is delivering on this promise efficient if: i. the machine costs ends up costing $1.2 million to build? ii. the machine costs ends up costing $2 million to build? (c) In this latter case, under expectation damages, how much would Peter have to pay if he does not deliver on the contract? (d) Given that the upgrades have been installed, how much would the “single owner” be willing to pay to build the machine? 4. Describe a situation where tort liability may be ineffective for addressing an externality. 5. Suppose a manufacturer and customer can each take precaution to eliminate the risk posed by a product. (a) When is it efficient for the manufacturer to take all of the precaution? (b) What liability rule will ensure that this occurs? (c) When is it efficient for the consumer to take all of the precaution? (d) What liability rule will ensure that this occurs? (e) When is it efficient for both parties to take precaution? (f) What liability rule can achieve this? 6. Consider the following situation: A landlord could invest in yearly maintenance of an apartment complex which would reduce the likelihood of a fire from 2% to 1% at an aggregate cost of $5,000 to residents; the fire, if it occurred, would result in $1,000,000 worth of damage to the residents. (a) Is this an efficient investment? (b) If there were no transaction costs, would residents have an incentive to negotiate for this with the landlord? 7. Notification falls into a class of punishments known as shaming punishments. Here are some real examples of shaming punishments: Shoplifters have been required to stand outside stores wearing signs announcing their crimes; a purse snatcher was ordered to wear noisy tap shoes in public; drivers convicted of DUI have been ordered to use special license plates announcing their crimes; and, a slum landlord was ordered to live in one of his rat-infested properties. How could shaming punishments improve economic efficiency relative to more conventional punishments, such as fines and prison? 8. When sexual offenders are released from prison, they are still subject to restrictions imposed upon them by the criminal justice system. These restrictions vary by state, but they generally take two forms: registration and notification. A released sexual offender is required to register with the local authorities. Furthermore, the local authorities may notify local residents that a released sexual offender will be living in their neighborhood. What do you think are some costs and benefits associated with these laws?        

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