ec476 contracts and organizations, part iii: lecture 4econ.lse.ac.uk/staff/lfelli/teach/ec476 slides...

EC476 Contracts and Organizations, Part III:Lecture 4

Leonardo Felli

32L.G.06

2 February 2015

Benjamin Cardozo — 1921

“Law never is, but is always about tobe. It is realized only when embodiedin a judgment, and in being realized,expires. There are no such things asrules or principles: there are onlyisolated dooms. [...]

[...] No doubt the ideal system, if itwere attainable, would be a code atonce so flexible and so minute, as tosupply in advance for every conceivablesituation the just and fitting rule. Butlife is too complex to bring theattainment of this ideal within thecompass of human powers”.

Leonardo Felli (LSE) EC476 Contracts and Organizations, Part III 2 February 2015 2 / 45

Common Law — 1066-1189

The English system of Common Law, originallypure Case Law was established during the 11th

or 12th centuries.

In particular it was spread at the beginning ofthe reign of William the Conqueror, 1066.

It was fully established by the end of the reignof Henry II, 1189.


Justinian — AD 529

537 years earlier — Justinian had quite adifferent idea of what the Law ought to be.

The “Corpus Juris Civilis” in Englishtranslation adds up to 5,818 pages.

Table VIII — Law VIII — Where a road runsin a straight line, it shall be eight feet, andwhere it curves, it shall be sixteen feet in width.


Code Napoleon — 1804

I “By virtue of its simplicity, my one codewas the source of more good in Francethan all the laws which preceded me.”(Bas-relief in Les Invalides, Paris.)

I The Code Napoleon (renamed the CivilCode) was promulgated in 1804.

I The Code Napoleon has served as themodel for the codes of law of more thantwenty nations.


Law of the Italian Republic — AD 2000

If the birth takes place during a railway trip, thedeclaration must be rendered to the railroad officerresponsible for the train, who will draw a transcript ofverbal declarations, as prescribed for birth certificates.Said railroad officer will hand over the transcript to thehead of the railroad station where the train next stops.The head of such station will transmit the documentsto the local registrar’s office to be appropriatelyrecorded.

This is Article 40 of the regulations for registrar’s offices, issued

as Decree Number 393 of November 3rd 2000 of the President of

the Republic of Italy. Regulations issued to ensure the

streamlining of procedures, as prescribed by Article 2, comma 12,

of Law Number 15 of May 1997 of the Republic of Italy.


Motivation

I There is a large empirical literature that shows that legalorigin matters (La Porta, Lopez-de-Silanes, Shleifer, andVishny 1997,1998, 1999, 2002, La Porta, Lopez-de-Silanesand Shleifer 2005, etc.) known as Law and Finance.

I Identify a stylized model of both Case Law and Statute Law.

I Compare the two systems and provide conditions under whichone legal system dominates the other.


Stylized differences between legal systems

I Statute Law is a legislator-made Law: judges apply thestatute.

I In the Case Law, there is (implicit) delegation of thelaw-making power to judges.

I In Case-law we have the rule of precedent (stare decisis) thatcommits future judges to the decisions of past judges, but notin Statute Law.


A Big Caveat

I Can we reinterpret this comparison in terms of Civil Law vs.Common Law?

I To some extent, clearly yes (at least historically) ... but this iscontroversial (Hatfield, 2006, Whitman 2006).

I Common Law countries have accumulated a lot of statutesthrough time.

I In Civil Law judges have some leeway as well and precedentsplay some role (especially in Germany).


The Question

I Is the pragmatism of Case Law simply always superior to therigidity of Statute Law?

I Are there universes in which Statute Law is instead superior?

I Or is it the case that the ascent of Case Law is like a scientificdiscovery?

I It just was not known before the 11th or 12th century, andthose who discovered it and started using it becameunambiguously better off.


Case Law vs Statute Law: A First Answer

I Premise: “[...] life is too complex [...]” Laws are bound to beIncomplete (impossible to fully describe/conceive ex-ante).

I Leaving things to the Courts is a way to delay the decisions towhen more detailed information is available: ex-post.

I What are the Courts’ objectives? They are “ruling overothers” so we should be sure they have “social welfare” inmind.

I If the Courts’ motives are “right” then the Case Law regimeought to be superior.


Punch-Line

I In some cases Statute Law is instead superior.

I This is because the Case Law advantage — ex-post decisions— may also be a disadvantage.

I Case Law Courts may suffer from time inconsistency (presentbias) due to the timing of their decisions.

I In a dynamic framework this time-inconsistency problem isunavoidable.

I When cases are sufficiently homogeneous, the draw-backs ofincompleteness (Statute Law) are outweighed by the costs oftime-inconsistency (Case Law).


Laws

I With “fully contingent” (complete) Laws, “[...] a code atonce so flexible and so minute, as to supply in advance forevery conceivabe situation the just and fitting rule [...]” theStatute Law is clearly the ideal regime.

I “[...] But life is too complex [...]” hence laws are not flexible,at least not as much as Courts decisions that occur after thefact and hence can depend on the details of the realizedcontingency.

I Statutes are incomplete laws: fix rules that do not depend onthe realized contingencies.


Time Inconsistent Courts: Examples

I Patent policy: wide breadth is optimal ex ante to giveincentives, but inefficient ex post.

I Investor Protection: ex ante borrowers are in favor of stronginvestor protection to have cheap credit, but not ex post.

I Disclosure: Court’s decision may induce the parties to disclosetheir private information at the ex-ante stage at the cost ofpreventing profitable ex-post trades.

I Three strikes you are out: long Sentences deters crime exante. Ex post, the deterrent effect does not play any role.


Preliminaries

I Infinite-period-lived Courts and sets of one-period-livedparties.

I Courts can either take a weak decision (W) or a toughdecision (T ).

I Parties take private decisions based on the Court’s expectedruling (in equilibrium, perfect foresight).

I Two states of natures : the complex state C (with prob. ρ)and the simple state S (with prob. 1− ρ).


Simple Environment S, probability (1− ρ)

I Π denotes Court’s ex-ante payoffs (social welfare), Π denotesCourt’s ex-post payoffs.

I In environment S it is optimal for the Court to choose Wex-ante:

Π(S, T ) < Π(S,W)

I In environment S it is also optimal for the Court to choose Wex post:

Π(S, T ) < Π(S,W)

I Clearly in this environment there exists no time inconsistency.


Complex Environment C, probability ρ

I In environment C it is optimal for the Court to commitex-ante to choose T

Π(C, T ) > Π(C,W)

I However, ex post, after private decisions have been made, it isoptimal for the Court to choose W

Π(C, T ) < Π(C,W)

I This is the source of the Court’s time inconsistency.

I The present-bias temptation is therefore

Π(C,W)− Π(C, T ) > 0.


Setup

I At the beginning of each period Nature:

I determines whether the environment is C or S with probabilityρ, 1− ρ,

I in the Case Law regime draws `S and `C (more below)

I The common discount factor of the Legislator and the Courtis δ < 1 (chance that the same case occurs next period).


Case Law: Preliminaries

I Court can pick a different ruling in the two environments (Sor C) unless it is constrained by precedents (stare decisis).

I Everyone (Parties and Court) knows whether precedents arebinding.

I Precedents are a quadruple J = (τS , ωS , τC , ωC) satisfyingthe restrictions τS < ωS and τC < ωC . Let ω0

E = 0, τ0E = 1,E ∈ {S, C}.

I At the beginning of each period a random variable is realized:`S or `C , uniformly distributed over [0, 1].

I The, say, C Court is free to choose if `C ∈ (τC , ωC). It isbound to W if `C ∈ [ωC , 1]. It is bound to T if `C ∈ [0, τC].


Case Law: Precedents

τC ωC0 1

constrained to T constrained to W

discretion


Case Law: Precedents (cont)

I In each period — Case Law Court takes precedents J t asgiven and is either bound or not bound by them.

I The ruling of today’s (period t) Case Law Court, if it hasdiscretion, affects the body of precedents for tomorrow’s(period t + 1) Case Law Court: J t+1.

I Each Case Law Court — if it has discretion — can alsochoose the breadth of its ruling bt ∈ {0, 1}.

I Narrow Ruling bt = 0 ⇒ Small effect on precedents.

I Broad Ruling bt = 1 ⇒ Larger effects on precedents.


Benchmark Case: No Rule of Precedents

Assume first no rule of precedents: J t+1 does not depend on(J t , bt).

Case Law Court’s problem if it has discretion:

maxRt∈{T ,W}

(1− δ) Π(E t ,Rt) + δ{Zt+1(J t+1,σ, ρ)

}

Lemma

In the absence of the rule of precedents the Case Law courtchooses Rt =W for every E ∈ {S, C} and every t.

Case Law does not evolve: the Case Law Court is completelymyopic.


Assumptions on precedents technology J t+1(J t , bt)

Assumption

I Case Law Court always has discretion:

ωtS−τ tS > 0, ωt

C−τ tC > 0 ⇒ ωt+1S −τ

t+1S > 0, ωt+1

C −τt+1C > 0.

I Case Law Courts can choose rulings that have no effect onprecedents. Zero breadth: bt = 0 ⇒ J t = J t+1. Restrictthe holding to the facts of the case/ Summary order.

“Our consideration is limited to the present circumstances, for theproblem of equal protection in election processes generally presentsmany complexities.” Bush v. Gore (00-949). US Supreme Court Per Curiam


Case Law: Judge’s Problem

Case Law Court’s problem if it has discretion:

maxRt∈{T ,W},bt∈[0,1]

(1− δ) Π(E t ,Rt) + δ{Zt+1(J t+1(J t , bt),σ, ρ)

}

Lemma

Expected welfare in Case Law is weakly monotonically increasing.

Case Law evolves for the better (thanks to zero breadth) (Posner1973, Rubin 1977).


Evolving Case Law

Proposition

Consider any realized path of the Case Law equilibriumenvironment. Then there exists an integer m such that:

Along any such path the Court will rule T in environmentC when it has discretion for a total of at most m times.

After a finite number of periods the Case Law Court when in Creverts to take the weak decision W whenever it has discretion:Case Law eventually stops evolving.


Case Law Evolution: Intuition

I Under Case Law, the Court wants to take the timeinconsistent decision (W) if it looks only at today’s case.

I If it looks forward, via precedents, it wants to take the “right”decision (T in environment C).

I The effect it can have via precedents is marginal.

I What matters is the change in the body of precedents.

I The present-bias temptation is equal to the differenceΠ(C,W)− Π(C, T ) > 0 (does not changes through time).

I Therefore, when the marginal effect becomes ”small” (DRSand monotonicity), the Case Law will stop “evolving.”.

I At some point all Case Law Courts with discretion choose thetime-inconsistent decision W and zero breadth.


Well Behaved Precedent Technology

Assumption

I The precedent technology—the cutoffs τE(τ, ωR, 1) andωE(τ, ω,R, 1)—are monotonic (continuous) in τ and ω,respectively, in both states E ∈ {S, C};

I The precedent technology satisfies “no cross-state effects,”e.g. at t if the state is C then τ tS = τ t+1

S and ωtS = ωt+1

S ;

I The precedent technology satisfies “reversibility,” e.g. if at t aCourt takes decision (T , b = 1) and at t + 1 decision(W, b = 1) then τ tE = τ t+2

E , ωtE = ωt+2

E ;

I The cutoff τC(τ, ω,R, 1) satisfies DRS in τ and “independentimpact” from ω;

I The cutoffs τ tS and ωtC have “no interior asymptotes.”


How Does the Equilibrium Look like?

I We construct a Markov Perfect equilibrium (with statevariable J t).

I Consider first state S:

I the Court takes decision W whether it has discretion or not,the breath b is indeterminate.

I The steady-state Court’s decision is W.

I Consider now state C:

I notice first that the Court’s decision (W, bt = 1) is strictlydominated.

I We can focus on the two Court’s decisions:

(T , bt = 1) (W, bt = 0).


How Does the Equilibrium Look like? (cont)

I There exist a unique threshold τ such that the Court isindifferent between the two decisions above:

(1− δ)[Π(W)− Π(T )] = ρ δ[τC(τ , T , 1)− τ ] [Π(T )− Π(W)]

I When (τ tC > τ), precedents do not move, (W, bt = 0), thesystem is in steady state.

I When (τ tC < τ), precedents move (they improve) towards asteady state, (T , bt = 1).

I The Markov perfect equilibrium cannot be in pure strategies.If there exist a last period in which the Court chooses T andb = 1 procrastination is a profitable deviation for the Court.



τC0 1

τ0C

s U ?

ττ

steady statediscretion

>



Proposition (Equilibrium Characterization)

There exists a Markov perfect equilibrium in mixed strategies inwhich the Court is indifferent at any t such that τ tC < τ .

In this case the Court randomizes with probability pt between(T , bt = 1) (evolution of precedents) and (W, bt = 0) (noevolution).

At any t such that τ tC > τ the Court chooses (W, bt = 0)(steadystate).

We interpret randomizing Court as a situation in which the body ofprecedents is ambiguous (incentives to transact and go to Court).


Case Law: Welfare

ρ

10

6

-

WCL

WCL

ρ

W


Statute Law: The Problem

I By incompleteness of laws, Statute Law can select a singleruling regardless of environment: either T or W.

I The optimal Statute Law solves:

maxR∈{T ,W}

(1− δ)∞∑t=0

δt [(1− ρ)Π(S,R) + ρΠ(C,R)]

I ormax

R∈{T ,W}[(1− ρ)Π(S,R) + ρΠ(C,R)]


Statute Law: Characterization

Proposition

Choose W if S is more likely: ρ < ρ∗SL.

Choose T if C is more likely: ρ > ρ∗SL.

Where ρ∗SL is such that:

(1− ρ∗SL) Π(S,W) + ρ∗SL Π(C,W) =

= (1− ρ∗SL) Π(S, T ) + ρ∗SL Π(C, T )

Denote the maximized welfare WSL(ρ).


Statute Law: Welfare

ρ

10 ρ∗SL

6

-

WSL

W


Statute Law vs. Case Law

Proposition (Statute Law Dominance)

Statute Law may dominate Case Law: There exists a ρ∗CL ∈ (0, 1)such that for every ρ ∈ (ρ∗CL, 1] we have that

WSL(ρ) >WCL(J 0, ρ).

Proposition (Case Law Dominance)

Case Law may dominates Statute Law in a neighborhood of ρ∗SL,(for δ high enough):

WSL(ρ∗SL) <WCL(J 0, ρ∗SL).


Welfare under Statute Law and Case Law.

ρ

10

6

-

WCL

WCL

ρ

W



ρ

10 ρ∗SL

6

-

ρ

W

WSL = WCL

WSL

WCL

ρ∗CL

�



ρ

10 ρ∗SL

6

-

ρ

W

WSL = WCL WSLWCL

ρ∗CL


Statute Law Dominance: Intuition

I The dominance of Statute Law is due to the lack of evolutionof the Case Law.

I Eventually, Courts that have discretion take the present-biaseddecision (W).

I This stops the evolution of case law implying that the parties’welfare under case law is bounded away from the first bestwelfare.

I Clearly, time consistency problems have bite when theenvironment is C. This happens a fraction ρ of the times.

I When ρ is close to one the “lack of flexibility” of Statute Lawmatters less: Statute Law dominates.


Case Law Dominance: Intuition

I Recall when ρ = ρ∗SL the Statute Law legislators are indifferentbetween W or T .

I The Parties’ expected welfare is

WSL(ρ∗SL) = ρ∗SL Π(C,W) + (1− ρ∗SL)Π(S,W)

I Consider state S: Common Law and Statute Law welfarecoincides.

I Consider state C: let τ be the steady state cutoff, τ ≥ τ . TheParties’ steady state expected welfare is:

WCL(J 0, ρ∗SL) = ρ∗SL [τ Π(C, T )+(1−τ)Π(C,W)]+(1−ρ∗SL)Π(S,W)

I Clearly: [τ Π(C, T ) + (1− τ)Π(C,W)] > Π(C,W)


Some Evidence...

I Niblett, Posner, and Shleifer (2010) investigate theapplication of the ”Economic Loss Rule” (ELR) in 465appellate decisions over 35 years.

I Economic Loss Rule implies that one cannot sue in tort for“economic loss” unless that loss is accompanied by personalinjury or property damage (with standard exceptions, fraud).

I ”Tort law is a superfluous and inapt tool for resolving purelycommercial disputes. We have a body of law designed forsuch disputes. It is called contract law.” (902 F.2d 573, 574 ,7th Cir. 1990).

I ELR encourages parties to solve their potential problemsthrough contracts. It is widely recognized as the (ex-ante)efficient rule.


Some Evidence... (cont.)

I However, ex-post the judge may have sympathy for wrongedplaintiffs (for ex. because warranty has expired) and makeexceptions to the ELR.

I The initial twenty years after the Seely decision are bestdescribed as years of growing acceptance of the ELR.

I In the final decade of the sample, however, courts moved awayfrom strict application of the ELR and invoked more and moreidiosyncratic exceptions.


Percentage of Tort wins across statesIllinois is considerably lower but growing. In Florida, the increase in the frequency of

tortwin since the early 1980s is extremely significant (t = 3.49).

0.2

.4.6

.81

% o

f cas

es

1970 1980 1990 2000 2010Year

California FloridaIllinois New YorkOhio

Figure 5.3: Tortwin over time in the five states with the highest caseloads

Unlike the overall tortwin pattern, the proportion of cases that apply exceptions

that are idiosyncratic is influenced by caseload. This inverse relation is significant (t = -

2.85) and is illustrated in Figure 5.4. The implication is that idiosyncratic exceptions are

more likely to be introduced when courts have less of their own experience in this area.

This hypothesis is supported by a comparison of the first 10 decisions heard in each state

with the subsequent decisions in those states (if the state hears at least 10 cases). 15.81%

of the “early” cases in these states applied exceptions that are idiosyncratic, compared to

just 8.02% of the “later” cases. This difference is significant (t = -2.56).

36


Justinian

The Appian Way was built approximately in300 BC and was fully replaced 2,084 years laterin AD 1784.

A “slow changing” environment: a very high(or very low) ρ above.

The Statute Law regime is likely to be superior.


Cardozo

I Edison’s “improved” stock ticker was introduced in 1871, thelast mechanical stock ticker was introduced in 1960, thewireless device in 1996.

I A fast changing environment: intermediate values, ρ = ρ∗SL.(La Porta et al, Law and Finance — but Rajan and Zingales2003 and Lamoreaux and Rosenthal 2005.).

I Statute Law is likely to be inferior because of its lack offlexibility.


Cardozo: pessimism

I Cardozo was also pessimistic

“[...] there are only isolated dooms.”

I In our framework, this statement can bereinterpreted as:

Case Law is “doomed” to become mature,and after maturing to succumb to thetime-inconsistency problem.

I Case Law improves through time (zerobreadth), but it does not reach fulloptimality (Posner, 1973, 1990, 2003,Rubin 1977, Gennaioli and Shleifer 2005).


ec476 contracts and organizations, part iii: lecture 4econ.lse.ac.uk/staff/lfelli/teach/ec476 slides...

Documents