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ОглавлениеChapter ONE
Introduction to Microeconomics
The introduction explained that the task of the manager in the legal environment is to identify and qualify risk. This chapter focuses simply on a model for qualifying all kinds of risks. That model is based on economic theory.
Economics is choice in the presence of scarcity. A resource is scarce when there is less of it than can provide for all possible needs. Managers often deal with this problem because scarcity necessarily requires a decision of how to use resources. That decision is complicated because managers have desires to both help themselves and to help others, which would seem to create a paradox as to how scarce resources should be utilized. Adam Smith questioned that paradox by arguing that by following their own self-interests, economic agents frequently serve society as well.
Cooperation
Most managers realize that when they are able to cooperate with peers, subordinates and supervisors, the organization is most productive. This is true for the economy on the whole as well.
Cooperation is greatly responsible for the development of more affordable and desirable products and services; in a society where each individual can rely on others to provide the majority of products and services, one can focus on perfecting their own wares. By doing so, they are able to sell more, as the desirability and affordability of their merchandise is greater than that of competitors’, in the process benefitting both themselves in the form of higher prosperity and society as a whole with cheaper, better, or more abundant goods.
The Production Possibilities Frontier
The manager in the example below has two employees that need direction. Cara is working on one plot of land and Bob is working on another plot of land. The manager can direct Cara and Bob to produce apples, peaches or some combination of these. Cara and Bob have a limited ability to produce because their respective plots of land have limited size.
The manager can use the Production Possibilities Frontier (PPF) to analyze this situation. The PPF is a simple model describing the trade-offs that an entity (a person, a company, a nation) has to make when making production decisions. In its simplest form, the PPF is a two-dimensional figure with two axes each representing a product (like apples and peaches). Increasing the quantity of one resource necessarily limits the ability to produce the other resource (because land is limited). The slope of the production possibility frontier is called the marginal rate of transformation (MRT). In case of a linear PPF, the slope (“m”) is constant. The “rise over run” equation can be used to determine the slope of a linear curve.
Worked Example
Consider a first producer, Cara, whose PPF is defined by Equation 1 and shown in Figure 1 and a second producer, Bob, whose PPF is defined by Equation 2 and shown in Figure 2. Both producers can make apples (A) and peaches (P):
| PPF(Cara):20=2P+A | (Eqn. 1) |
| PPF(Bob):20=P+2A | (Eqn. 2) |
Figure 1 The PPF for Cara.
Figure 2 The PPF for Bob.
What is the slope (or the marginal rate of transformation) of Cara’s PPF?
The equation for slope is:
m=y2−y1x2−x1=(0−10)(20−0)=−1020=−12
This means that for every two additional apples Cara produces, she will produce one fewer peach. Cara can only produce at or below her production possibility frontier. She could not produce ten apples and ten peaches because that point is not on her product possibility frontier. See if you can take this example and use it to answer some questions about Bob.
Case Problems
How many apples can Bob produce?
How many peaches can Bob produce?
For each reduction in peach production, how many extra apples can Bob produce?
What is the slope of Bob’s PPF?
Can Bob produce 10 peaches and 10 apples?
Specialization
The key is specialization. Alice is better at producing apples—for every apple she produces, she only has to give up half a peach—and Bob is better at producing peaches—for every peach he produces, he only has to give up half an apple. If Alice produces only apples and Bob produces only peaches, Alice will have 20 apples, and Bob will have 20 peaches. Exchanging 10 apples to 10 peaches nets each of them 10 apples and 10 peaches—something that was impossible for them on their own.
In some situations, managers have no choice about how to allocate resources. For instance, if Bob were to go on paternity leave, the manager would have to let him go and then return a few weeks later under a statute passed by Congress in the United States. In general, where there is a law that limits (or requires) the use of resources, that statute is part of the regulatory environment of business.
The law provides constraints to economic activities. It defines illegal activities, mandatory activities, and how certain activities are regulated at the state and federal levels. Of equal importance to the law is the confidence that mediation is available; economic partners have less need to trust each other than they would in the absence of mediation.
Isolated Decision Making
The general decision model in economics is called cost-benefit analysis. At its simplest, it works by comparing the benefit and cost of every action and by taking the action where net benefit (profit) is at its greatest or by taking all of the actions where this gap is positive. The first approach is used where only one action can be taken. The second approach is applicable when the manager can take multiple actions. The manager can compare the cost and benefit of each repair and choose the one with the largest net profit between cost and benefits.
Costs
In economics, the cost of something is considered in view of the next best option and is called opportunity cost. As opposed to accountants or finance professionals, economists consider every outcome or loss a cost incurs due to choosing an action.
Both the costs and the benefits need to be evaluated to determine their magnitude. While monetary costs and monetary benefits come with a built-in measurement system, other kinds of costs and benefits have to be measured individually. In economics, the subjective value of a given good or service is the reservation price.1
A sunk cost is contrasted with an opportunity cost. A sunk cost is a resource that has either been allocated or lost regardless of a decision. In choosing one option, more than one thing might be forfeited. For instance, if three decisions are ranked first, second, and third, only one can be chosen. The opportunity cost of choosing first is losing second. Third would not have been chosen regardless of choosing first or second and is therefore the sunk cost. Forgoing other opportunities can only compare with the “second best” option as an opportunity cost, since all other options must be given up for the second best possibility anyway.
Benefits
Similar to costs, benefits are also viewed rather broadly in economics. Aside from the monetary benefits, every other conceivable benefit like happiness, friendship, health, or the potentially positive feeling of learning something new must be considered. Holistically, this is utility.2
Utility can quantify the inherent non-linearity of the perceived value gained from increasing the amount of any given good a consumer consumes. The first unit of consumption creates a large utility improvement. The additional utility of a second unit of consumption is less. This tendency of lowering additional gain from increased consumption is called diminishing marginal utility.3
It is important to note that nearly all goods, including money itself, have diminishing marginal utility. In case of production (as it is generally assumed to be done by some kind of corporate entity), there is more attention paid to monetary gains than to utility.
Marginalism
Whether money or utility is used, marginalism attempts to explain the change in value of products by reference to their secondary unit. In marketing, firms use the marginal approach to determine sensitivity of quantity sold with respect to price. The technique can be used in many fields and includes the following steps. First, make a small change. Then, observe the result. If the change improves total profit, make a similar change in the same direction. If the change reduces total profit, make a change in the opposite direction. This process repeats until total profit (or total utility) is maximized.
Marginal cost is the change in total cost when the manager above changes the production amount and similarly, marginal benefit is the change in total benefit when the manager changes the amount produced. In case of consumption marginal cost and benefit are the result in the change in the total cost and benefit due to a change in the consumption of the individual. The technique works similarly in a corporate setting, replacing marginal utility with marginal profit, when the question is optimal output amount.
This kind of marginal analysis works best when there is a single point where total profit is maximized. However, there can be several points where there is a local maximum which is different than the global maximum. Consider the chart shown in Figure 3 below:
Figure 3 Minima and Maxima.
Using a marginal analysis, the manager may believe that the local maximum is the global maximum if the changes made are sufficiently small. However, a larger sample of wider points might reveal that a much larger quantity creates a global maximum.
Incentives
In economics, the acts of establishing rewards or punishments for certain behaviors is called incentivizing and disincentivizing, and the reward itself is called an incentive; the punishment, a disincentive. Students who learn useful skills incentivize a firm to hire them—while the firm, that establishes the practice of hiring trained professionals, incentivizes students as they consider their directions of study. The remainder of this book focuses on how firms can create incentives to get people to purchase services (Chapter 4), goods (Chapter 5), pay bills (Chapter 6), work toward the employer’s best interests (Chapter 7), and form new firms (Chapter 8).
Introduction to Markets
In the market model, costs, benefits, and subjective valuation all play a part. In economics, a market is a place where buyers and sellers of a product meet. This might be a physical location, an on-line location, or just an abstract concept.
The market model is centered around the concepts of supply and demand. Supply describes the behavior of the sellers, demand the behavior of buyers. Both of these terms are defined for individuals as well as for entire markets. Individual demand describes a single buyer, while market demand is the aggregate of all buyers of the particular good or service.
Individual Demand
Individual demand shows how much of a given product a buyer is willing and able to purchase, which is dependent on the price of the product at the time of consideration. Higher prices make the consumer both (1) able to buy less of the product and (2) have to give up more consumption of other products for each unit of the given good consumed (the opportunity cost increases).4 This tendency of consumers to buy more of cheaper things is called the law of demand.5
Similarly, individual supply shows how much of a product a seller is willing and able to sell of a given product. The tendency for suppliers to increase the availability of their product is called law of supply.6
Case Problems
Alice’s individual demand for hamburgers is shown below.
How many hamburgers will Alice buy if the price is $7?
There is a sale and the price of hamburgers goes down to $5. How many will Alice buy now?
Bob sells hamburgers as shown in the figure below:
Figure 4 Alice’s individual weekly supply of hamburgers.
Figure 5 Bob’s individual weekly supply of hamburgers.
How many hamburgers will Bob make if the price is $4 each?
There is a hamburger boom, and the price goes up to $5 each. How many hamburgers will Bob make now?
Market Demand, Supply, and Equilibrium
When analyzing markets, the individual supplies and individual demands are aggregated. For each price, market demand shows the total amount that can be sold of a product, and market supply shows the total amount of the available product.7 Since market demand and supply are aggregates of individual demand and supply, the laws of demand and supply remain in effect. Because of the way the addition works, the price axis will not change either for demand or supply. The quantity axis, however, will expand dramatically.
Once individual demands and supplies are transformed to market demand and supply, their functions are comparable. Before the aggregation, it makes no sense to try to offset individual supplies or demands. The quantities depicted in Figure 4 and Figure 5 differ greatly, which happens in the common market scenario when the number of buyers greatly exceeds the number of producers. Once they are aggregated, however, they are directly comparable, by focusing only on the combined amounts rather than the quantity of entities involved.
The very core of the workings of the market model is that market demand and market supply meet each other at the marketplace. All the entities who want to buy a product meet all the entities who want to sell it. As a result, the market demand and the market supply can be graphically depicted with the same set of coordinates, and their interaction can be observed, as in Figure 6.
Figure 6 The market supply and demand of hamburgers during an average week in Marketville.
Demand is the quantity that buyers want and are able to buy at each price point, while supply is the quantity the sellers want and are able to sell for each price. The price value ($5) of the intersection in Figure 5 is called the equilibrium price. When the price on the market equals the equilibrium price, it means that buyers want to buy exactly the same number of goods that the sellers are willing to sell. This amount is known as the equilibrium quantity. When the price is the equilibrium price, all the products brought to the market by the producers will be bought by the buyers, and all the buyers who want to buy products at that price will be able to do so. The market effectively “clears” itself of goods, and all the demand is satiated, thus equilibrium price is also called market-clearing price.8
Markets tend to move toward equilibrium under certain circumstances. Those circumstances include: 1) The entities are rational. That is, they realize their own self-interests and always follow them, 2) the markets are competitive, meaning that the buyers and sellers are relatively numerous and similar in size, so no single one of them can exert undue influence on what is happening on the market, and 3) perfect information ensures that all buyers and sellers are familiar with all of the relevant information regarding the product. When a market exhibits these traits, it is a perfectly competitive market or perfect competition.
In a perfect competition, the behavior of individual buyers and suppliers ensures that the market converges towards equilibrium. Consider the situation depicted in Figure 7. The equilibrium price is still 5, but for some reason, the current price on the market is only $4. At that price, the suppliers are only willing to provide 1,000 hamburgers, but the buyers want to purchase 2,000 leading to a hamburger shortage. Out of the 2,000 units in demand, buyers are only able to purchase half that amount.
Figure 7 Disequilibrium in Marketville.
In the short run, non-market rationing solutions spring up nearly immediately. People will queue up for hamburgers, and those who arrive early will be able to buy the product, while latecomers will not. Eventually, sellers will realize that they are able to charge more. They will raise the price to $5, hire more employees to expand their production, and maybe even open new restaurants, increasing the total supply of hamburgers to 1,500. Seeing the price increase, consumers could decide to eat something else—or still purchase hamburgers, but eat less of them.9 This reduction of the quantity demanded to 1,500 hamburgers means that all consumers will get to have a hamburger, which might eliminate the lengthy queuing for it.
When the price is higher than the equilibrium price, similar mechanisms can be seen. In that case, the quantity supplied exceeds quantity demanded, leading to surplus production (or as economists euphemistically call it, unintended inventory investment). In practice, this means that sellers can’t get rid of their stock (or in case of the hamburger example, only a few consumers come in to eat them). Seeing the products pile up (or the dearth of consumers), producers will organize a “sale”—which is literally a reduction of price, potentially moving the market towards equilibrium.
Market Efficiency and Failures
A perfectly competitive market achieves two kinds of efficiencies: distributive efficiency and allocative efficiency. Distributive efficiency is an effect of goods and services being received by those with the greatest need, if need is defined as willingness to pay the most for a product.10 The market mechanism ensures that everyone whose reservation price is greater or equal than the market price will be able to buy the product, while those whose reservation price is below the market price will not be able to do so. This also ensures that all the sellers combined can extract the highest total amount of payments from the buyers.
Allocative efficiency exists when the goods and services produced in the economy match consumer preferences. This occurs when the unit produced provides a marginal benefit to consumers equal to the marginal cost of production. Companies that use fewer resources (thus using the resources more efficiently) will be able to offer their products (and turn a profit) at lower prices.11 The market mechanism ensures that every single firm that is profitable at a price below market price will produce goods, while those firms that require higher prices in order to be profitable will instead produce something else.
Market Failures
A market failure occurs when the allocation of goods and services is not efficient in the manner described above. There are two kinds of market failure in law: 1) those which the courts regulate and 2) those which the courts leave to market participants to resolve.
A competitive market requires many buyers who purchase relatively small quantities compared to the quantity demanded. There are many sellers who all produce relatively small amounts of the good compared to the quantity demanded. There is no way to distinguish between goods of the sellers. Courts generally do not regulate markets to add buyers or sellers or to standardize goods.12
A market failure can occur when participants are either unaware of their self-interest or act contrary to it. Again, courts are hesitant to question to the motives of market participants.13 Market efficiency assumes that market participants have perfect information in that all material information about their products is known. Courts are willing to step in on this point in both contracts for services and contracts for the sale of goods as noted in Chapters 4 and 5.
Transaction Costs
Transaction costs are all the costs associated with the purchase that have to do with making sure the purchase actually happens. Legal fees associated with lawsuits are the transaction cost most commonly discussed in this volume. Searching costs involved in finding the right employee are explored in Chapter 7.
An additional cost is information gathering. In the age of the Internet, an overabundance of information makes it hard to determine what is reliable, creating additional transaction costs for information validation efforts.
Bargaining is a transaction cost in the process of coming up with the actual details of a given transaction. Bargaining involves the process of finding terms (usually those other than price and quantity) that are necessary in order to close the deal. Some terms worth bargaining for are described in more detail in Chapters 4–6.
Enforcement costs include all the costs related to making sure that the other party upholds the terms of the deal struck. These costs can vary greatly depending on the governing legal system in the country. Companies in common law nations tend to employ a larger number of lawyers than companies in civil law countries, as the built-in structure of the legal system allows more room for interpretation, thus making more work for the legal professionals. This means that the common law systems inherently tend to incur higher transaction costs than civil law systems.
Externalities
An externality is a cost that is put on a third party to a transaction that is neither the buyer nor the seller. Positive externalities cause a benefit to a third party, while negative externalities cause a cost to a third party. Consumer externalities occur as a result of a consuming behavior, while producer externality is a result of production.
The economic problem with externalities is that the additional costs and benefits occur to third parties, so on their own, decision makers frequently ignore them. This means that in case of a negative externality, the private cost of production or consumption is lower than the social cost. Negative externalities lead to overproduction or overconsumption, as part of the cost is borne by others.
In case of a positive externality, the private benefit of the production or consumption is lower than the social benefit. For example, when one decides to vaccinate their child, they consider the fact that their child has a lowered risk of infection—and ignore the positive externality of increased protection that vaccination conveys to other children. Positive externalities lead to underproduction or underconsumption, as part of the benefit is realized by others.
Externalities distort the market mechanism, eliminating the surety that markets guarantee efficient production and consumption. Because externalities lead to overconsumption, underconsumption, overproduction, or underproduction, it is beneficial from the standpoint of a society to try to mitigate or eliminate the effects of externalities. This is called internalizing the externalities.
From about 1930 to the end of World War II, courts aggressively put the costs of externalities onto the party receiving the benefit. A cost-benefit analysis became popular after that which asked whether society was better off with the third party bearing the externality. Chapter 3 explains this in detail.
Public Goods
A public good is one where use by one person cannot be excluded by another person and where there is no rivalry between users. Excludability focuses on whether it is feasible to block certain people from using the resource or not. Rivalry focuses on whether there is competition among consumers for the given good. Material in the public domain is free for anyone to use as one wishes. Since the public good is free, there is no market mechanism that can control its use.
As the table below shows, this defines four distinct kinds of goods. The most common are the private goods, and most products fall into this category. Goods where there is no rivalry, yet consumers are still excludable, are called club goods. The name signifies that (ideally) the members of a club are in no rivalry with each other (if the club is sufficiently well-endowed), but they have the chance of limiting access to others. Living at a country club is an example of this behavior. A more common example is the use of a given software. Buying Microsoft Office, does not reduce the number of available Microsoft Office packages for another, yet others can be excluded from the consumption of the product through the mandatory on-line registration process. Club goods have artificial scarcity. The lack of rivalry means they are available in great abundance but are kept scarce to keep their price up and/or to retain exclusivity.
| Rivalry | No rivalry | |
| Excludable | Private goods most normal products like clothes, beverages, etc. | Club goods golf courses, parks, software artificial scarcity |
| Non-excludable free-rider problem | Common-pool resources fish in a fishery, grass in a pasture negative externality | Public goods (air, defense) |
Common-pool resources have the opposite limitation. They represent some scarce resource, but it is problematic to exclude people from their consumption. Because of this, an overuse of the resource materializes (as everyone considers it a “free” resource), and the overuse can lead to depletion altogether.
The free-rider problem is shared among common-pool resources and public goods. Since consumers cannot be excluded, it is very hard to incentivize them to pay anything for the good or service.
Market Structures
Perfect competition assumes that there are many small sellers in the marketplace. There are three market structures that disrupt that assumption: monopoly, oligopoly, and monopolistic competition.
A monopoly is a market structure where a single entity controls the supply. A monopsony is a market structure where a single entity controls the demand. In either case, the market participant is never in competition with anyone else, and its only concern is the demand curve (in case of monopolies) or the supply curve (in case of monopsonies). Based on its own costs, it can pick a production level or a consumption level and set a price on the demand curve or supply curve that will maximize its own profit, without having to fear competitive pressures. This generally leads to both higher prices and lower quantities produced, compared to the theoretical ideal of the perfect competition.
Monopolies form for a variety of reasons. Mainly, it can be difficult, excessively costly, risky, or impossible for new firms to enter the market. For instance, there can be limited access to physical resources or lack of an economy of scale.
In situations like this, the consumer might face either monopoly-like conditions (apparently discreet firms, who coordinate their pricing strategies), or actual monopolies, such as when firms in a given industry agree to not compete with each other within the same geographical area. Cases like this are called local monopolies. Notable examples in the United States are local telephone and Internet companies. Looking at the US market as a whole, it seems oligopolistic but in reality, carriers engage in “parallel conduct” by operating next to one another while not actually competing directly.14
Finally, since being a monopoly can result in extra profit, firms aim to become one whenever possible. When a firm seeks to a benefit from the government by its lobbying efforts instead of providing land, labor, capital or innovation, that is known as rent seeking behavior. In an economic sense, these resources are wasted, as they are not spent to increase the output of society. Instead, they are used to increase the gain of one company at the expense of other companies and consumers. This frequently reduces total output.
Monopolistic competition works like a perfectly competitive industry, but it lacks the homogeneous products requirement. These are far more common than perfectly competitive industries, as consumers cherish variety and are thus willing to pay higher prices for goods if they have a selection. Differentiation is the process where firms choose to ensure that their product is distinct (or perceived to be distinct by the consumers) from those of their competitors.
In a monopolistically competitive market, there is no single big market with many small producers and consumers. Instead, there are many miniscule markets with tiny pseudo-monopolies as suppliers and a big shared batch of consumers, who consider all of the little sub-markets as perfect substitutes. Slight price and perceived-quality changes can drastically alter the demand among such suppliers.
Oligopoly is a very common market structure, where a small number of large firms dominate the market. This is the general outcome of capitalism’s drive for increasing concentration in pursuit of economies of scale—industries that cannot crystallize into a monopoly remain governed by a few powerful entities.
The economic analysis of oligopolies is significantly more complicated than that of other market structures. While companies in monopoly and perfect competition can ignore other entities, in the case of an oligopoly, the decision of other dominant firms will have extreme consequences. Because of this, isolated decision making techniques are generally inadequate for oligopolies. This is where game theory serves as an excellent tool of inquiry.
Many oligopolies tend to cooperate with each other, forming tacit collusions or outright cartels. In this case an oligopoly operates very similarly to a monopoly, producing less and charging more than a perfectly competitive firm. Strategies for collusion and maintaining cooperation can be analyzed using game theory.
Case Problems
The Eastern Railroad Presidents Conference, a group of rail companies, lobbied the Pennsylvania State Legislature for an advertising campaign that disparaged Noerr Motor Freight, Inc. and the rest of the trucking industry in the state. The statute was vetoed, but the trucking companies claim to have suffered some losses from the debate surrounding the law and sued under the Clayton Antitrust Act (1914). Does the U.S. Const. Amend. I protect the Eastern Railroad Presidents Conference’s defamatory efforts?15
Berkey Photo, Inc. competes with Eastman Kodak Company in photofinishing services—the conversion of exposed film into finished prints, slides, or movies. Kodak made a 110 photofinishing system and a Pocket Instamatic camera which sold nearly three million units in 1972. Berkey tried to enter the market the following year with its own camera for the 110 photofinishing system but barely sold 42,000 of its own units that suffered from latent defects. Berkey complains that Kodak illegally monopolized the camera market. Does the creation and use of superior technology constitute an illegal monopoly?16
Behavioral Economics
Another assumption of perfect competition is that decision makers are rational. Rationality requires that the decision makers have a perfect understanding of their own goals and every time they make a decision, they will choose the option that brings them closer to attaining their goals.
In reality, very few humans ever work this way, and even fewer work like this all of the time. Behavioral economics is a collection of economics research that attempts to tackle this problem.
Herbert A. Simon introduced the concept of bounded rationality. It recognizes that decision makers’ information is incomplete. They might not fully understand all aspects of the decision itself. They might have limited time in which to make a choice, and not everyone’s mind works in the same way. Simon postulated that most decision makers use heuristic approaches; simple “mental shortcuts” instead of optimization.
Bounded rationality in general assumes that decision makers use techniques that lead to “good enough” results and stop optimizing further. This inherently takes into consideration the time factor of decision making.
These and other findings suggest that behavior is vastly more complex and harder to model than one expects, and that it depends on one’s current state of mind, psychological condition, and also one’s reference culture and other factors. One such aspect of human behavior is loss aversion—how individuals try to avoid losses more than obtain gains. This can be exploited to create compliance with contracts as explained in Chapter 6.
Handling Uncertainty
There is a large number of situations where the seller or the buyer has an incentive to hide certain information from the other, causing asymmetric information. In contracts for the sale of goods, there are some statutory provisions to prevent this from happening as discussed in Chapter 5. However, many situations are left unregulated for the parties to resolve. In this setting, some statistical analysis can be useful.
Expected Value
The first tool to resolve an asymmetric information problem is expected value. This simply involves summing the products of payouts with their expected likelihoods.
The general formula is the following: If the V event can take the values v1 … vN with the respective probabilities of p1 … pN, then the expected value of V is:
E(V)=∑i=0nvi*pi
Using this formula, the expected value of any event whose probabilities one knows (or can guess) can be determined. This, however, questions the point of insurance. The business success of insurance companies relies on their being able to predict with great accuracy the chances of a certain event happening. With the purchase of insurance comes the certainty that the insurance fee is higher than the expected value of the payout—otherwise the insurance company would go out of business, yet one purchases insurance regardless and considers it the prudent thing to do. Why?
Case Problem
Let’s assume you get offered the following game: Flipping a fair coin will earn you $5 if it lands on heads but nothing if it lands on tails. Playing the game once costs $2. Should you play this game?
Expected Utility
To understand the above dilemma, remember that consumers maximize utility and not gains. Most goods, money included, have diminishing marginal utility; an additional unit is less valuable the more there is of it. Together, these two insights explain the insurance phenomenon well. Relatively wealthy people (whose house hasn’t burned down, car has not been stolen, etc.) will value the same dollar amount less than the (post-tragedy) poor people. To put it in another way, even though one overpays for insurance compared to the likelihood of a damaging event, the event itself can be so disastrous, and the damage so daunting, that it provokes complete willingness to do so. Behavior like this is called risk averse behavior, and entities acting like this are called risk averse.
The opposite example is playing the lottery. The chance of winning is miniscule, the loss is fixed, and the expected value of the gains is usually lower than the cost. At the same time, the cost is usually bearable, and the mere prospect of winning is generally uplifting and mood-altering. The benefit here is twofold. The “rational” part is the expected value of the winning, while the other benefit is the excitement of gambling.
Interrelated Decision Making
One of the many advantages of the market model is that it allows us to ignore all other participants, as they are represented as an aggregate in the supply and demand curves. This makes it possible to focus on one’s own individual costs and benefits and then decide accordingly. In the real world, this model is best applicable in scenarios where the number of participants is large. There are, however, many situations where transactions happen in a one-on-one setting; in that case, the market model could be less helpful. Instead, one can use game theory, a framework developed specifically to analyze decisions in a strategic context. The benefits and costs do not depend just on one’s own actions but also on the actions of others.
Game Theory Basics
In game theory, a game consists of:
Players: The entities who take actions
Actions: All of the possible actions the players can undertake
Payoffs: The outcome of each possible combination of actions
Information: The information available to all players
Games can be cooperative or non-cooperative. A game is cooperative if there is an enforcement mechanism that ensures cooperative behavior. For the rest of the chapter, the focus is on non-cooperative games, to see how the legal environment can impact the outcome.
Simultaneous Games
In simultaneous games, the players have to choose an action before they are aware of the other players’ choices.17 These games (also called normal-form or strategic-form games) are commonly represented with a payoff matrix.18 One player is represented by the rows, the other by the columns, and each row/column represents a possible strategy. The cells of the matrix contain the payoffs for both players. (The first number represents the player in the rows, the second number the player in the columns.)
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
For example, in the game depicted above, there are two players, Player A and Player B. Both have two strategies, denoted A1, A2 for A, and B1, B2 for B. The inside of the matrix contains the payoffs; for example, if Player A plays A1 and Player B plays B1, the payoffs are 10 and 2, so Player A gets 10, and Player B gets 2.
If there is perfect information, both players are aware of all of the payout matrix possibilities and strategies available to each player. In a situation like this, the game is solved by analyzing each player’s potential actions.
Player A’s payouts depend on two things, his own choices and the choices of Player B. While Player A does not know what Player B wants, he can determine what the best choices for himself would be if Player B chooses B1 or B2. If Player B plays B1, then Player A could choose A1 for 10 but selecting A2 would yield him 12, which is better:
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
Similarly, if Player B plays B2, choosing A1 would net Player A 9, but choosing A2 would yield 11, which is better:
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
In this specific game, Player A has a dominant strategy: Playing A2 is better than playing A1 no matter what:
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
Player B’s thinking is the same as Player A’s, so he selects the best strategy for every one of Player A’s potential strategies. If Player A plays A1, Player B must choose between 2 and 10; B2 is better. If Player A chooses A2, Player B chooses between 3 and 0, and B1 is better:
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
As opposed to Player A, Player B has no dominant strategy. B1 is better if Player A plays A2; B2 is better if Player A plays A1.
However, this is perfect information. Player B not only knows his own payoffs, he knows Player A’s payoffs as well. Because of this, Player B also knows that Player A has a dominant strategy, A2. This knowledge enables Player B to select the best outcome possible for himself, B1:
| Player B | |||
| Strategy B1 | Strategy B2 | ||
| Player A | Strategy A1 | 10, 2 | 9, 10 |
| Strategy A2 | 12, 3 | 11, 0 |
In the above game, the A2, B1 combination is what is called a Nash-equilibrium. In a Nash-equilibrium, neither player can unilaterally improve their own position. In the above example, if Player A plays A1 instead of A2, he loses 2; if Player B plays B2 instead of B1, he loses 3.
Note that this is not the socially optimal outcome. The combined gains for the two participants is 15 while playing A2B1, but it would be 19 while playing A1B2, which would be a 27% increase. However, that point is not reachable, because for Player A, it is better to stick to A2. If, however, some kind of mediation is available for Player B, the game could be changed for a greater combined outcome beneficial to both players.
Case Problem
In the game above, a mediation service is available. Both participants are aware of the service and trust the service provider. Assume further that the mediation costs 1. How much will Player B end up with?
Sequential Games
In sequential games (or extensive form games), the players take turns acting. This means that they are not only aware of the strategies and the payoffs but also the prior actions of all players.
Extensive form games can be depicted by a tree graph. Each node (or vertex) represents a choice for a player. The player is depicted on each node, the choices are on the edges leading out of the nodes, the payoffs are written on the “leaves,” at the end of each tree branch.
In the example above, Player 1 moves first, potentially choosing between 1a and 1b. If Player 1 chooses 1a, he goes to the upper node 2, giving Player 2 the options 2a or 2b. Had Player 1 chosen 1b, then Player 2 could choose between 2c and 2d.
Solving an extensive form game starts from the outcome leaves. Player 1 knows that Player 2 will choose the outcome that is more beneficial for him, so if Player 2 has to choose between 2a (a payout of 2) and 2b (a payout of 3), he will choose 2b. Similarly, if Player 2 has to choose between 2c and 2d, he will choose 2d. At that point, all Player 1 has to do is to compare their payoffs at the leaf nodes of 2b (a payout of 3) and 2d (a payout of 2) to find the best option. He will play 1a, 2b, with payouts of 3 and 3. As long as there is no mechanism for the two players to trust each other, they will keep playing such (self-serving) strategies. This outcome is by far the worst for their society; the sum of the payouts is 6, while the other options offer 12, 22, or 29. Again, it is clear that a mediation system could benefit both participants.
Moral Philosophy
There are several moral philosophies that have evolved into legal philosophies that can be useful for assessing risk in legal situations. Moral philosophy begins with whether universal moral rules exist or they do not exist. Moral relativism is the theory that universal moral rules do not exist and what is right simply depends on a large number of factors in a particular situation. Moral relativism was the most dominant legal theory until about the twentieth century. Judges simply made decisions as to who was right and who was wrong and that was that.
The problem with moral relativism is that it leads to arbitrary decision making. An arbitrary rule is one that lacks reasoning. Arbitrary rules necessarily treat people differently and are problematic for that reason. One of the goals of any justice system is to find a system to treat everyone equally. Such a system developed throughout the twentieth century in the United States and is still developing today. Managers can study this system in order to assess risk.
One way to assess risk and liability is utilitarianism. Utilitarianism states that the right decision creates the greatest good for the greatest number. Law and Economics is a legal theory that the right decision creates the greatest market efficiency.
Another moral theory is theological volunteerism. Theological volunteerism is the view that God has intimate knowledge of humans and has created the best possible set of rules to govern disputes. All one must do is follow those rules. In legal theory, legal positivism states that people have elected rulers and whatever rules those leaders select, provided those rules comport with moral minimums, are just. A common complaint of theological volunteerism is that the rules created are either arbitrary or justified by some other line of reasoning. The same would hold true of rules made by legislators. The difference is that legislators can lose elections and those rules can be undone. Whereas God cannot be unelected. For the manager, legal positivism supersedes law and economics. Legislatures can make inefficient rules that would contradict a court’s reasoning on a matter.
The next moral theory is natural law. Natural law states that knowledge can be determined by studying the nature and capacity of humans very closely to determine what is foundational to survival and what can lead humans to virtue. The threshold requirement of law enabling foundational existence is identical to the moral minimum in positive law. For the manager, being aware of these foundational requirements of human dignity that cannot be crossed without creating liability is a good way to avoid risk.
The final moral theory is based on deontology or “duty-based” ethics. In particular is Immanuel Kant’s second formulation of the categorical imperative. This states that humans should be treated as an end in themselves and not as a means to an end. For the manager, the law imposes certain responsibilities as hurdles that must be overcome in order to engage in some conduct. Being aware of the hurdles and jumping over them is emphasized as a preferred course to conduct over pretending hurdles do not apply or do not exist.
1Reservation price—the maximum amount a person is willing to pay for a good or service.
2A collection of all the benefits obtained by a decision.
3The term marginal utility refers to the incremental utility gain which diminishes as consumption is increased.
4The first is called the income effect, and the second is the substitution effect of the price change. Both happen simultaneously when the price of a product changes, and in simple cases it is sufficient to just concentrate on the overall effect.
5Many economic laws are not like physical laws; they frequently represent what tends to happen, not what always happens. In case of certain goods where price signifies exclusivity, and exclusivity is important to consumers, a drop in price might discourage some consumers from buying the product. This is because in case of these goods, collectively called Veblen-goods, the consumer actually purchases two different benefits: not just the core service the product offers, but also a strong indicator of status. The lower price decreases the subjective benefit of the latter, potentially making the product less desirable, thus violating the law of demand.
6There are different reasons for this; the most obvious is that at higher revenue levels, the producer can afford to hire additional (potentially less efficient) resources to increase output.
7Market demand and supply can be calculated by adding up their respective individual curves horizontally, which means that all the quantities are totaled for every price.
8If the same market operates for Alice and Bob (in Figures 4 and 5), it means that out of the 1,500 hamburgers in the marketplace, Alice can buy 8, and Bob can supply 225.
9Alice, for example, was willing to eat burgers 9.5 times at $4. When the price increases to $5, she will still eat burgers, but only 8 times a week.
10Abba P. Lerner, The Economics of Control (1944).
11It is important to note, that in an unregulated environment lower resource usage might be—and frequently is—the result of the utilization of environmentally and or socially harmful production technologies, which can cause externalities; discussed below.
12Chapter 4 provides an exception relating to agreements that are unreasonable restraints of trade.
13Chapter 4 explains an exception relating to agreements that are so unfair they are not enforceable.
14Bell Atl. Corp. v. Twombly, 550 U.S. 544 (2007) (“sparse competition among large firms dominating separate geographical segments of the market could very well signify illegal agreement….”) This is difficult to plead. Twombly is discussed in more detail in Chapter 2.
15E. R.R. Presidents Conference v. Noerr Motor Freight, Inc., 365 U.S. 127 (1964).
16Berkey Photo, Inc. v. Eastman Kodak Company, 603 F.2d 263 (2d Cir. 1979).
17This can happen because they choose an action simultaneously or simply without knowledge of the choice of the other player.
18This is most convenient when the number of players is two. For more players, the matrix becomes multidimensional, which can be depicted in two dimensions, but the size can grow rather quickly.
