Hazards Liability and Tort Lecture 8

Outline Another economic role for the government is regulating hazards and risks Factory producing explosives (location & care in operation) Dangerous Dogs Food hygiene Driving How much should we spent on precautions?

Outline Regulating Hazards and Risks Factory producing explosives (location & care in operation) Dangerous Dogs Food hygiene Driving How much should we spent on precautions? Regulating Risk with Liability Liability for costs => incentives for precautionary spending. Is this efficient?

Outline Regulating Hazards and Risks Factory producing explosives (location & care in operation) Dangerous Dogs Food hygiene Driving How much should we spent on precautions? Regulating Risk with Liability Liability for costs=> incentives for precautionary spending. Is this efficient? Liability versus Ex Ante regulation Is it more efficient to regulate hazards ex ante? Or, should we rely on incentives created by liabilities?

A Simple Model Let us suppose: w is the marginal cost of precaution (cost of inspecting food hygiene)

A Simple Model Let us suppose: w is the marginal cost of precaution (cost of inspecting food hygiene) x is the amount of precaution (inspection).

A Simple Model Let us suppose: w is the marginal cost of precaution (cost of inspecting food hygiene) x is the amount of precaution (inspection). p(x) is the probability that an accident occurs.

A Simple Model Let us suppose: w is the marginal cost of precaution (cost of inspecting food hygiene) x is the amount of precaution (inspection). p(x) is the probability that an accident occurs. A is the cost of an accident.

Total Costs x = Amount of precaution p(x)A = Expected Accident costs

Total Costs x = Amount of precaution wx = precaution cost p(x)A = Expected Accident costs

Total Costs x = Amount of precaution wx = precaution cost p(x)A = Expected Accident costs Total Cost = p(x)A + wx

Total Costs x = Amount of precaution wx = precaution cost p(x)A = Expected Accident costs Total Cost = p(x)A + wx Minimum = Efficient amount of precaution x*

The same issue with slopes Marginal Costs x = Amount of precaution Rate at which Accident costs decrease

The same issue with slopes Marginal Costs x = Amount of precaution Marginal cost of precaution Rate at which Accident costs decrease w

The same issue with slopes Marginal Costs x = Amount of precaution Marginal cost of precaution Rate at which Accident costs decrease Minimum = Efficient amount of precaution x* w

Regulating Risk with Liability We will examine the following 2 cases: (1) Strict Liability => Injurer always liable for the costs of any accident.

Regulating Risk with Liability We will examine the following 2 cases: (1) Strict Liability => Injurer always liable for the costs of any accident. (2) Liability Based on Negligence Rule => Injurer is liable for damages only if the court judges that the injurer has been negligent.

1. Precautionary Incentives Under Strict Liability (Strict Liability => Injurer liable for accident damages regardless of level of precaution taken). The cost to the injurer = Precautionary Costs + Accident Costs

1. Precautionary Incentives Under Strict Liability (Strict Liability => Injurer liable for accident damages regardless of level of precaution taken). The cost to the injurer = Precautionary Costs + Accident Costs As a result, costs imposed on victims are internalized by the injurer (the injurer bears these costs too).

1. Precautionary Incentives Under Strict Liability (Strict Liability => Injurer liable for accident damages regardless of level of precaution taken). The cost to the injurer = Precautionary Costs + Accident Costs As a result costs imposed on victims are internalized by the injurer (the injurer bears these costs too).  Strict liability achieves the efficient level of precaution.

1. Precautionary Incentives Under Strict Liability (Strict Liability => Injurer liable for accident damages regardless of level of precaution taken). The cost to the injurer = Precautionary Costs + Accident Costs As a result costs imposed on victims are internalized by the injurer (the injurer bears these costs too).  Strict liability achieves the efficient level of precaution. However, this is not true if victims can affect the probability and size of the injuries!

2. Liability Under a Negligence Rule Injurer is liable for damages only if the court judges the injurer has been “negligent”.

2. Liability Under a Negligence Rule Injurer is liable for damages only if the court judges the injurer has been “negligent”. Negligence  Less precaution is taken than the standard of due care.

2. Liability Under a Negligence Rule Injurer is liable for damages only if the court judges the injurer has been “negligent”. Negligence  Less precaution is taken than the standard of due care. Injurer bears all costs only if found negligent. Otherwise the victim bears these costs.

2. Liability Under a Negligence Rule SDC = “Standard of Due Care” The incentives now depend on the SDC applied by the court. SDC too low => Marginal cost for injurer too low. Too little precaution. The injurer bears none of the accident costs if it has already provided SDC.

If the SDC is too low: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Total Costs Minimum = Efficient amount of precaution x*

If the SDC is too low: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Minimum = Efficient amount of precaution x* SDC

If the SDC is too low costs are as before for low levels of precaution: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Minimum = Efficient amount of precaution x* SDC

If the SDC is low costs jump down at SDC: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Minimum = Efficient amount of precaution x* SDC

If the SDC is too low don’t pay accident costs if satisfy SDC: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Total Costs Minimum = Efficient amount of precaution x* SDC

On the other hand… If the SDC is too high  May get optimal precaution if the SDC is set just right. However,  May get excessive investment in precaution and an inefficient outcome if it is unclear what the SDC is. “Hand Rule” formulated in US Gov. versus Carroll Towing Company applies a cost-benefit test on precaution to determine the SDC.

If the SDC is high: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Total Costs Minimum = Efficient amount of precaution x* SDC

If the SDC is high can get excessive caution: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Total Costs Minimum = Efficient amount of precaution x* SDC

If the SDC is high or can get efficient caution: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs Total Costs Minimum = Efficient amount of precaution x* SDC

Judge Learned Hand “Since there are occasions when every vessel will break from her moorings, and since, she becomes a menace to those about her; the owner’s duty, as in other similar situations, to provide against resulting injuries is a function of three variables: (1) The probability that she will break away; (2) The gravity of the resulting injury, if she does; (3) The burden of adequate precautions. Possibly it serves to bring this notion into relief to state in algebraic terms: if the probability be called P; the injury L; the burden B; liability depends upon whether …B<PL.”(1947)

What he is saying… If the party’s cost of preventing accidents (burden) is less than the expected losses from accidents that party should be deemed negligent. Otherwise it is better for accidents to occur and the party to compensate accordingly.

Comparing Strict Liability (SL) and Negligence (N) Who bears the costs of the accident differs. N- Victim sometimes bears the cost. SL- Injurer always bears the cost. What are the Incentives?

Comparing Strict Liability (SL) and Negligence (N) Who bears the costs of the accident differs. N- Victim sometimes bears the cost. SL- Injurer always bears the cost. What are the Incentives? If victims cannot affect risks: Both could be efficient but need to get SDC just right and consistent for N to be efficient.

Comparing Strict Liability (SL) and Negligence (N) Who bears the costs of the accident differs. N- Victim sometimes bears the cost. SL- Injurer always bears the cost. What are the Incentives? If victims cannot affect risks: Both could be efficient but need to get SDC just right and consistent for N to be efficient. If victims can affect risks: SL is inefficient as the victim has no incentive to exert precaution and because injurer has excessive incentive. N could be more efficient as it provides incentives for victim precaution too.

Ex Ante Regulation or Ex Post Liability Liability -Avoids potentially complex legislation.

Ex Ante Regulation or Ex Post Liability Liability -Avoids potentially complex legislation. -Regulations may give inadequate weight to particular and even unforeseen circumstances.

Ex Ante Regulation or Ex Post Liability Liability -Avoids potentially complex legislation. -Regulations may give inadequate weight to particular and even unforeseen circumstances. -Regulation reduces the incentives to innovate in precautionary technology.

Ex Ante Regulation or Ex Post Liability Pro-Regulation (1) Not everyone can bring court cases. (Litigation costs, free rider problems in class actions, causality is often hard to prove).

Ex Ante Regulation or Ex Post Liability Pro-Regulation (1) Not everyone can bring court cases (Litigation costs, free rider problems in class actions, causality is often hard to prove) (2) Bankruptcy limits individual’s potential liability costs

If A > value of the firm. => F is the most the firm can pay Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs=A p(x) Total Costs Minimum = Efficient amount of precaution x* Actual Payout when accident = F p(x)

Originally: Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs=A p(x) Total Costs Minimum = Efficient amount of precaution x*

If A > value of the firm. => F is the most the firm can pay Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs=A p(x) Total Costs Minimum = Efficient amount of precaution x* Actual Payout when accident = F p(x)

Resulting in inefficient amounts of precaution Total Costs x = Amount of precaution wx = precaution cost Expected Accident costs=A p(x) Total Costs Minimum = Efficient amount of precaution x* Actual Payout when accident = F p(x)

Bankruptcy under Liability Bankruptcy 1.Reduces the incentives for taking care. 2.Firms may escape the consequences of litigation if they go bankrupt while the trial proceeds. 3.Corporate restructuring can allow firms to escape consequences of litigation.

Uncertainty about the legal process If the legal process or the standard applied in the courts in unclear or uncertain, then This introduces

Uncertainty about the legal process If the legal process or the standard applied in the courts in unclear or uncertain, then this introduces (1)a potential risky decision for claimants – benefiting injurers and reducing the incentives for care.

Uncertainty about the legal process If the legal process or the standard applied in the courts in unclear or uncertain, then this introduces (1)a potential risky decision for claimants – benefiting injurers and reducing the incentives for care. (2)a potential of escaping even when negligent again reducing the incentives for care.

Ex Post and Ex Ante Together Often these may be complementary rather than substitute policy choices. If injurer may not be held liable, or does not correctly asses the probabilities of being held liable, then a little ex ante regulation may push him in the right direction!