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THE LAW AND ECONOMICS OF IRRATIONAL BEHAVIOR

Stanford University Press

Contents

List of Tables and Figures................................................................................................................................................ixAcknowledgments...........................................................................................................................................................xiiiContributors..............................................................................................................................................................xvIntroduction Francesco Parisi and Vernon Smith...........................................................................................................................1PART 1 IRRATIONALITY AND BOUNDED RATIONALITY IN LAW, PSYCHOLOGY, AND ECONOMICSChapter 1 Departures from Rational Choice: With and Without Regret Robert H. Frank.......................................................................................13Chapter 2 Is the Mind Irrational or Ecologically Rational? Gerd Gigerenzer...............................................................................................37Chapter 3 Lessons from Neuroeconomics for the Law Kevin McCabe, Vernon Smith, and Terrence Chorvat.......................................................................68Chapter 4 Treating Yourself Instrumentally: Internalization, Rationality, and the Law Robert Cooter......................................................................95PART 2 THE ECONOMICS OF IRRATIONAL BEHAVIORChapter 5 Addiction, Choice, and Irrationality Ole-Jrgen Skog...........................................................................................................111Chapter 6 Revenge and Retaliation Vincy Fon and Francesco Parisi.........................................................................................................141Chapter 7 What Makes Trade Possible? Elizabeth Hoffman, Kevin McCabe, and Vernon Smith...................................................................................169Chapter 8 Satisfaction and Learning: An Experimental Game to Measure Happiness Marco Novarese and Salvatore Rizzello.....................................................186Chapter 9 The Market for Laughter F. H. Buckley..........................................................................................................................208PART 3 THE JURISPRUDENCE OF IRRATIONAL BEHAVIOR: RETHINKING LAW AS A BEHAVIORAL INSTRUMENTChapter 10 The Jurisprudence of Craziness Stephen J. Morse...............................................................................................................225Chapter 11 On Law Enforcement with Boundedly Rational Actors Christine Jolls.............................................................................................268Chapter 12 The Biology of Irrationality: Crime and the Contingency of Deterrence Michael E. O'Neill......................................................................287Chapter 13 Analyzing Illicit Drug Markets When Dealers Act with Limited Rationality Jonathan Caulkins and Robert MacCoun.................................................315Chapter 14 On the Psychology of Punishment Cass R. Sunstein..............................................................................................................339Chapter 15 Some Well-Aged Wines for the "New Norms" Bottles: Implications of Social Psychology for Law and Economics Yuval Feldman and Robert MacCoun.....................358PART 4 IRRATIONAL BEHAVIOR AND THE DESIGN OF LAWChapter 16 Human Fallibility and the Forms of Law: The Case of Traffic Safety Thomas S. Ulen.............................................................................397Chapter 17 The Free Radicals of Tort Mark F. Grady.......................................................................................................................425Chapter 18 Probability Errors: Some Positive and Normative Implications for Tort and Contract Law Eric A. Posner.........................................................456Chapter 19 Threatening an "Irrational" Breach of Contract Oren Bar-Gill and Omri Ben-Shahar..............................................................................474Chapter 20 Regulating Irrational Exuberance and Anxiety in Securities Markets Peter H. Huang.............................................................................501Chapter 21 In Praise of Investor Irrationality Gregory La Blanc and Jeffrey J. Rachlinski................................................................................542Index.....................................................................................................................................................................589

Chapter One

Robert H. Frank

Among interdisciplinary marriages, the contemporary law and economics movement has clearly been one of the most fruitful on record. As the following passage from Richard Posner's (1983) foreword to The Encyclopedia of Law and Economics suggests, the movement's tireless practitioners have left few significant areas of legal scholarship untouched by economic analysis: "Apart from the obvious examples-areas such as taxation and antitrust and securities regulation and (other) regulated industries and commercial law, all areas where the law is explicitly engaged in regulating economic activity-recent decades have seen a broadening of interest to include tort, contract, family, intellectual property, constitutional, criminal, admiralty, labor, arbitration, and antidiscrimination law, among others" (http://allserv.rug.ac.be/~gdegeest/foreword.htm).

Although the movement has become more methodologically diverse in recent years, its analytical core remains the Chicago-style price theory approach outlined in the first edition of Posner's (1973) pioneering text. Scholars in this tradition almost invariably assume that individuals are narrowly self-interested, well informed, well disciplined, and possessed of sufficient cognitive capacity to solve relatively simple optimization problems.

During recent decades, however, theoretical and empirical developments in economics and psychology have challenged each of these core assumptions. The challenges fall into three broad categories: (1) we often make systematic cognitive errors that prevent us from discovering which choices will best promote our interests; (2) even when we can discern which choices would be best, we often have difficulty summoning the willpower to execute them; and (3) we often pursue goals that appear inconsistent with self-interest, narrowly understood. I will consider each challenge in turn.

1.1 BOUNDED RATIONALITY

The late Nobel laureate Herbert Simon (1984) was the first to impress upon economists that human beings are incapable of behaving like the rational beings portrayed in standard rational choice models. Simon, a pioneer in the field of artificial intelligence, stumbled upon this realization in the process of trying to instruct a computer to "reason" about a problem. He discovered that when we ourselves confront a puzzle, we rarely reach a solution in a neat, linear fashion. Rather, we search in a haphazard way for potentially relevant facts and information and usually quit once our understanding reaches a certain threshold. Our conclusions are often inconsistent, even flatly incorrect. But much of the...