Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 17.

Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 17

The story so far

The story so far… Precaution – costly actions that reduce likelihood of an accident Activity – how much a “dangerous” activity is done Liability rules create incentives that can effect both precaution and activity by both injurer and victim

Effects of various liability rules
Injurer Precaution Victim Precaution Injurer Activity Victim Activity No Liability Zero Efficient Too High Efficient Strict Liability Efficient Zero Efficient Too High Simple Negligence Efficient Efficient Too High Efficient Negligence with a Defense of Contributory Negligence Efficient Efficient Too High Efficient Comparative Negligence Efficient Efficient Too High Efficient Strict Liability with Defense of Contributory Negligence Efficient Efficient Efficient Too High

Shavell’s Take

Steven Shavell, Strict Liability Versus Negligence
Focuses on injurer precaution and activity Compares strict liability to negligence rules Accidents between strangers (what we’ve been doing): “Under a negligence rule, all that an injurer has to do to avoid the possibility of liability is to make sure to exercise due care if he engages in his activity. Consequently he will not be motivated to consider the effect on accident losses of his choice of whether to engage in his activity or, more generally, of the level at which to engage in his activity; he will choose his level of activity in accordance only with the personal benefits so derived. But surely an increase in his level of activity will typically raise expected accident losses. Thus he will be led to choose too high a level of activity.” The Shavell paper, “Strict Liability versus Negligence,” is about exactly the incentives we’ve been discussing Shavell refers to the types of cases we’ve been considering so far “accidents between strangers” That is, when a car hits a bicyclist, there is no preexisting relationship between the two parties However, Shavell also looks at cases where the injurer is a business, engaged in selling some product (either to the victim or to someone else) Under the assumption of competitive markets, this changes the story significantly. Shavell assumes it is only injurer precaution that affects the likelihood of accidents – that is, he ignores victim precaution He looks at a number of different cases Under injurer precaution, a rule of no liability is obviously bad, so he focus on comparing negligence to strict liability. And, like we’ve been doing, he assumes there is no insurance. First, as we’ve already seen, is the case of accidents between strangers As he puts it, “injurers and victims are strangers, neither are sellers of a product, and injurers may choose to engage in an activity which puts victims at risk” He gives a nice explanation of what happens under a simple negligence rule: “Under the negligence rule, all that an injurer needs to do to avoid the possibility of liability is to make sure to exercise due care if he engages in his activity. Consequently he will not be motivated to consider the effect on accident losses of his choice of whether to engage in his activity or, more generally, of the level at which to engage in his activity; he will choose his level of activity in accordance only with the personal benefits so derived. But surely any increase in his level of activity will typically raise expected accident losses. Thus he will be led to choose too high a level of activity.”

Whereas under strictly liability… “Because an injurer must pay for losses whenever he in involved in an accident, he will be induced to consider the effect on accident losses of both his level of care and his level of activity. His decisions will therefore be efficient. Because drivers will be liable for losses sustained by pedestrians, they will decide not only to exercise due care in driving but also to drive only when the utility gained from it outweights expected liability payments to pedestrians.” (This is exactly what we had already concluded…)

Injurer Precaution Injurer Activity ACCIDENTS BETWEEN STRANGERS Simple Negligence Efficient Too High Strict Liability Efficient Efficient The other cases Shavell considers are when the injurer is a business, rather than a private citizen The incentives for taking precaution as a business owner are very similar to those of a private citizen But there is a new element – price! Shavell considers businesses in a perfectly competitive industry – that is, he assumes competition drives prices down to marginal cost So if taking precaution increases a business’s costs, that cost is passed on to consumers through higher prices

Next case: accidents between “sellers and strangers”
Injurer is in a competitive business, but not with victim victim is not injurer’s customer, but a stranger Example: taxi drivers provide service to their passengers risk hitting other pedestrians victims are not their own customers Shavell assumes perfect competition Price = marginal cost of “production” Sales = number of passengers who demand rides at that price Next, Shavell considers accidents between sellers and strangers That is, injurers are engaged in some sort of competitive business, but not with their victims He gives the example of taxi drivers – taxis provide a service to passengers, but still run the risk of hitting other pedestrians who aren’t their passengers Shavell assumes that there is perfect competition – taxis lower their prices to compete against each other, up till prices equal the costs of “production”; and the number of passengers who demand rides at those prices determine the level of sales

Accidents between businesses and strangers
Strict liability Taxi drivers pay for accidents, set x = x* to minimize private cost Perfect competition  cost of remaining accidents is built into price Taxi passengers face price that includes cost of accidents Passengers internalize risk of accidents, demand efficient number of rides Negligence rule Taxi drivers still take efficient precaution, to avoid liability But since drivers don’t bear residual risk, cost of accidents not built into price Passengers face prices that are too low (lower than social cost of a taxi ride) Demand for taxi rides inefficiently high For accidents between strangers, strict liability led to efficient precaution and efficient activity For accidents between businesses and strangers, the results are the same, but the reason is different Under strict liability, taxi drivers pay for accidents, so they will take the efficient level of precaution – it’s cheaper for them to take precaution than to pay for more accidents And the expected costs of any remaining accidents is still borne by the taxi drivers So under competition, it is built into the price of a taxi ride (That is, once taxi fares reach the level that just covers costs plus expected damage payments, taxi drivers stop lowering prices, so that sets the price.) This means that taxi passengers face the “socially optimal” price – given efficient precaution, they now internalize the cost of accidents, so they take the efficient number of taxi rides A negligence rule led to efficient precaution but inefficiently high activity for accidents between strangers Here, the result is the again the same, but again, for a different reason Under a negligence rule, taxi drivers take efficient precaution, to avoid liability for any accidents that occur But once they’re taking efficient precaution, they’re no longer liable, so they do not bear the costs of accidents So the cost of accidents is not built into prices So passengers face prices that are too low – taxi passengers don’t internalize the cost of accidents when they decide how often to ride So the demand for taxi rides will be inefficiently high – again, we get an inefficiently high activity level

Injurer Precaution Injurer Activity ACCIDENTS BETWEEN STRANGERS Simple Negligence Efficient Too High Strict Liability Efficient Efficient ACCIDENTS BETWEEN BUSINESSES AND STRANGERS The two cases look exactly the same, but for different reasons Simple Negligence Efficient Too High Strict Liability Efficient Efficient

Final case: accidents between businesses and their own customers
Example: restaurants taking precaution to reduce risk of food poisoning How accurately do customers perceive risks? 1. Customers can accurately judge risk of each restaurant 2. Customers can accurately judge average level of risk, but not differences across restaurants 3. Customers ignorant of risks The third case that Shavell considers is that of accidents between sellers and their customers Here, he uses the example of restaurants taking precautions to reduce the risk of food poisoning (He also points out that accidents between sellers and their employees are very similar) In this case, it ends up vitally important how accurately customers perceive risks He looks at three separate cases: customers can accurately perceive the risk of each restaurant customers can accurately perceive the average level of risk, but not differences between different restaurants customers are just generally ignorant of the risks

Accidents between businesses and their own customers: strict liability
Seller bears cost of accidents  efficient precaution Seller bears residual risk  expected cost of accidents is built into prices Even if customers don’t perceive risk, price leads them to make efficient choices Price of shellfish = cost of shellfish + expected cost of food poisoning Even if I don’t know that, I buy shellfish when benefit > price, so I’m forced to choose efficiently Under strict liability, customer perception of risk ends up not mattering after all Under strict liability, the seller bears the cost of accidents, so he takes efficient precaution to prevent them And since he still bears the remaining risk of accidents, their expected cost is built into the price of meals That is, menu prices include a premium for expected damage payments when food poisoning does occur Which means that regardless of whether they perceive risk, customers make efficient choices about how often to eat out, because they explicitly see the cost of risk through prices That is, if I like seafood, I don’t have to know that if I eat raw shellfish, I have a 1-in-100 chance of an unpleasant experience that costs me $500 I don’t need to know this because the cost of a raw shellfish meal is $5 more than it would be otherwise, since the restaurant needs to charge this just to break even since if I ever do get sick, he knows I’ll sue So the prices I face include the expected cost of food poisoning; so even if I don’t realize that, I choose efficiently.

Accidents between businesses and their own customers
Risk Perception? Seller Precaution Buyer Activity Strict Liability Yes Efficient Efficient No Efficient Efficient

Accidents between businesses and their own customers: negligence
Restaurants take efficient precaution, to avoid liability But since they avoid liability, cost of accidents not built into prices If customers perceive risk correctly, no problem Weigh benefit of meal versus price + expected pain due to food poisoning Demand efficient number of meals But if customers don’t perceive risk, they’ll demand inefficiently many dangerous meals Under negligence, however, this doesn’t work Under negligence, restaurants will still take efficient precaution, to avoid liability (they’ll keep the kitchen clean, wash hands after using the bathroom, etc.) But since they then won’t be liable when accidents do occur, prices won’t reflect these risks If customers correctly perceive risks, this won’t matter – customers will consider the money cost of the meal, plus the expected cost due to food poisoning, and will choose efficiently But if customers underestimate the risk of food poisoning, they’ll order an inefficiently large number of risky meals – the level of activity will be too high

Risk Perception? Seller Precaution Buyer Activity Strict Liability Yes Efficient Efficient No Efficient Efficient Negligence Yes Efficient Efficient No Efficient Too High

Accidents between businesses and their own customers: no liability
If customers correctly judge risks… Restaurants take efficient precaution to attract customers And customers demand efficient number of meals If customers can only judge average level of risk… Restaurants take no precautions But customers know this, demand efficient (low) number of meals If customers are oblivious to risk… Cost of food poisoning not built into prices Customers demand inefficiently high number of meals We can also look at what will happen under a rule of no liability If customers correctly judge the risk, then sellers will still take efficient precaution – it gives them a way to attract customers If the restaurant can spend $3 to make a meal $5 cheaper in expected costs, they could charge $4 more for the meal and still get more customers Competition means that this will happen So if risk is judged accurately, sellers will take efficient precautions, and buyers, judging risk correctly, will buy the efficient number of meals Next, suppose customers can accurately judge the average level of risk across all restaurants, but can’t differentiate between restaurants In this case, restaurants have no reason to take precaution – since they won’t be rewarded with higher sales, and they won’t be liable if there are accidents – so precaution will be zero But, at least customers will know that precaution is low and the product is risky, so they’ll eat the efficient number of meals Under no liability in a city without any health inspectors, maybe people don’t eat much sushi Finally, consider the case where customers are just completely oblivious to the risk of the product Like the last case, there is no reason for sellers to take any precaution And since there is no liability, risk will not be built into prices And since customers can’t perceive risk, not only is precaution too low, but activity is too high – customers don’t consider the risks when deciding how often to eat out

Risk Perception? Seller Precaution Buyer Activity Strict Liability Yes Efficient Efficient No Efficient Efficient Negligence Yes Efficient Efficient No Efficient Too High No Liability Yes Efficient Efficient Average None Efficient No None Too High

Next couple lectures… How do we determine legal standard for negligence? What happens if we get it wrong? What happens when the world is more complicated than we’ve been imagining so far?

Due Care and the Hand Rule

Setting the legal standard of care
We’ve been assuming xn = x* court could set legal standard for avoiding negligence equal to efficient level of precaution In some cases, this is what court actually tries to do “Hand Rule” U.S. v Carroll Towing (1947, U.S. Court of Appeals) All our talk about negligence rules, and especially about efficiency, has assumed that courts are able to set a legal standard of care equal to the efficient level That is, a negligence rule leads to an actual level of precaution equal to the legal standard x~ Efficiency requires this to match the level that minimizes the total social cost of accidents, x* So negligence rules are only efficient if x~ = x*. In some cases, this is exactly what the courts try to do This is based on a 1947 case, in which Judge Learned Hand formulated a rule for determining negligence, which came to be known as the Hand Rule The case was United States v Carroll Towing Company, and in very rough terms, the Hand Rule basically says that to avoid negligence, you have to take any precaution that’s efficient

Setting the legal standard of care
U.S. v Carroll Towing (1947, U.S. Court of Appeals) Several barges secured together to piers Defendant’s tugboat was hired to tow one out to harbor Crew readjusted lines to free barge Adjustment done incorrectly, one barge broke loose, collided with ship, sank Barge owner sued tugboat owner, saying his employees were negligent Tug owner claimed barge owner was also negligent for not having an agent on board the barge to help Question: was it negligent to not have a “bargee” on board? The case (as described in Cooter and Ulen) was this: A number of barges [in New York Harbor] were secured by a single mooring line to several piers. The defendant’s tug was hired to take one of the barges out to the harbor. In order to release the barge, the crew of the defendant’s tug, finding no one aboard in any of the barges, readjusted the mooring lines. The adjustment was not done properly, with the result that one of the barges later broke loose, collided with another ship, and sank with the cargo. The owner of the sunken barge sued the owner of the tug, claiming that the tug owner’s employees were negligent in readjusting the mooring lines. The tug owner replied that the barge owner was also negligent because his agent, called a “bargee,” was not on the barge when the tug’s crew sought to adjust the mooring lines. The bargee could have assured that the mooring lines were adjusted correctly.

“The Hand Rule” Judge Learned Hand, in Carroll Towing decision:
“It appears… that there is no general rule… Since there are occasions when every vessel will break away from her moorings, and since, if she does, she becomes a menace to those around her; the owner’s duty… 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. Perhaps it serves to bring this notion into relief to state it in algebraic terms: if the probability be called P; the injury, L; and the burden, B; liability depends upon whether B is less than L multiplied by P.” Judge Learned Hand, in his decision, wrote the following: It appears from the foregoing review that there is no general rule to determine when the absence of a bargee or other attendant will make the owner of a barge liable for injuries to other vessels if she breaks away from her moorings… Since there are occasions when every vessel will break away from her moorings, and since, if she does, she becomes a menace to those around 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 it in algebraic terms: if the probability be called P; the injury, L; and the burden, B; liability depends upon whether B is less than L multiplied by P.

probability of accident
“The Hand Rule” Failure to take a precaution constitutes negligence if B < L x P So a particular precaution is required to avoid liability if it is cost-justified – its cost is less than its benefit Or, a precaution is required to avoid liability if taking it would have been efficient Hand Rule: “If a precaution is efficient, then you’re negligent if you didn’t take it.” cost of precaution cost of accident probability of accident Thus, Judge Hand argued that if precaution (in this case, having a bargee on board your barge) cost less than its expected benefit, then it was negligent not to do it So the legal standard for what constituted negligence was exactly whether the precaution was efficient (“cost-justified”)

“The Hand Rule” Hand rule: precaution is required to avoid negligence if Cost of precaution < reduction in accidents X size of accident Having/not having a bargee is discontinuous (yes/no) But if precaution were a continuous variable, we could think of these as marginal costs/benefits… Cost is w (marginal cost of precaution) Reduction in accidents is –p’(x) Size of accidents is A Hand Rule says, if w < –p’(x) A, you were negligent, because more precaution would have been efficient Since having an agent on board the barge is a yes-no decision, not a continuous variable, these were stated as absolutes But if we reinterpret them as marginal terms, we get back to our old rule for efficiency If w, the marginal cost of precaution, is less than –p’A, the marginal benefit, the injurer is negligent Implicitly, this is the same as setting the legal standard for care, x~, equal to the efficient level, x*.

So how is legal standard for negligence established?
One way: successive application of Hand Rule Another: laws and regulations can specify legal standard Third: law can enforce social norms or industry best-practices Cooter and Ulen argue that successive application of the Hand rule over time will lead to people figuring out what the legal standard for precaution is. I’m careless, I cause an accident, I get sued. The court rules that a little more precaution would have been justified, so I’m held liable The next guy is a little more careful Eventually, an accident happens, he gets sued, he’s found negligent Eventually, we reach a level of care where a little bit more would not have been cost-justified That guy is found not to be negligent, and not held liable, and then we all know what level of care is required. So that’s one way for the legal standard of care to be worked out Another alternative, of course, is for laws and regulations to specify a legal standard Highway officials could compute the efficient speed for a particular road – accounting for the value of getting somewhere sooner, and the effect of speed on the likelihood of accidents – and set the speed limit to the be efficient speed. And of course, a third alternative is for the law to enforce social norms or best-practices of an industry when it comes to standards of care That is, if a community or an industry has been facing this problem for a long time, and evolved its own norms or practices for what level of care is required, it’s plausible that this level is efficient, and the court may just choose to enforce it The book gives the example of a residential community setting rules concerning the maintenance of steps leading up to houses, or the accounting industry having standards regarding auditing.

Two difficulties in establishing legal standards for negligence
American courts have misapplied Hand Rule To calculate efficient level of precaution, reduction in harm should be based on total social cost of an accident Should include harm to victim (“risk to others”) and to injurer himself (“risk to self”) Courts have tended to only count “risk to others” when calculating benefit of precaution Hindsight bias After something happens, we assume it was likely to occur Hard to get unbiased estimate of probability after something happens – likely to overestimate Cooter and Ulen point out that American courts have consistently made a mistake in the way they’ve applied the Hand rule In terms of calculating the efficient level of precaution, marginal cost should be balanced against the total social benefit of reducing accidents, which includes both the reduction in risk to the plaintiff (“risk to others”) and the risk to the injurer himself (“risk to self”) For example, when I drive recklessly, I risk hitting a pedestrian, and I also risk destroying my own car The reduction in both these risks constitutes the social benefit of driving more carefully However, courts have tended to only consider the reduction in “risk to others” when assessing the benefits of precaution. Cooter and Ulen also point out the idea of “hindsight bias” Once something happens, we tend to assume it was likely to happen That is, if something is extremely low-probability, but then occurs, we may change our mind about how unlikely it initially was to happen (Baruch Fischhoff Nixon study) This would lead to an overestimate after the fact of the probability of an accident

Effect of Errors

Strict liability versus negligence
Negligence rules lead to efficient precaution by both sides But strict liability leads to efficient activity level by injurers Over course of 1900s, strict liability rules became more common Why?

Strict liability versus negligence: information
Relatively easy to prove harm and causation Harder to prove negligence If negligence is hard enough to prove, injurers might avoid liability altogether… …in which case they have no incentive to take precaution “Negligence requires me to figure out the efficient level of care for Coca-Cola; strict liability only requires Coca-Cola to figure out the efficient level of care” The answer may have to do with information It’s relatively easy to prove harm and causation A coke bottle explodes and takes out my left eye Clearly, I got hurt; and clearly, the bottle did it. But it’s very hard to prove that Coca-Cola was negligent in their bottling process I’d have to understand their whole manufacturing process understand the likelihood of accidents how the likelihood of accidents responds to precautionary measures they could have taken how much those actions would have cost and so on. Under a negligence rule, it might be too hard to prove negligence And so under a negligence rule, the manufacturer might not have to take precautions, because they know they can avoid liability anyway. On the other hand, under strict liability, the company bears the cost of accidents So it faces the incentive to reduce accidents directly, not just avoid having appeared negligent To put it another way, negligence requires me to figure out the efficient level of care Coca-Cola should have taken; strict liability only requires Coca-Cola to figure out the efficient level of care If Coca-Cola has better knowledge of their manufacturing process than I do, this might be better. And if manufacturing processes became more complex and technical over the course of the 1900s, this may explain why strict liability rules became more common

Errors and uncertainty in evaluating damages
Random mistakes Damages could be set too high or too low, but on average are correct Textbook calls these uncertainty Systematic mistakes Damages are set incorrectly on average – consistently too high, or consistently too low Textbook calls these errors This leads us to the topic of errors and uncertainty in evaluating damages For now, let’s put aside the question of whether or not someone is liable, and think only about the problem of calculating the amount of damages owed There are two types of mistakes a court can make: systematic mistakes, and random mistakes Random mistakes mean that, if an accident caused $10,000 in harm, the court may end up setting damages either higher or lower than $10,000, but on average will get it right Systematic mistakes are when damages, on average, are set incorrectly – that is, they’re either biased to be consistently too high, or consistently too low C and U refer to systematic mistakes as errors, and to random mistakes as uncertainty

Effect of errors and uncertainty under strict liability
Strict liability rule: injurer minimizes wx + p(x) D Perfect compensation: D = A Leads injurer to minimize social cost wx + p(x) A Under strict liability, random errors in damages have no effect on incentives Injurer only cares about expected level of damages As long as damages are right on average, injurers still internalize cost of accidents, set efficient levels of precaution and activity First, let’s look at the effects of errors under a strict liability rule Under a strict liability rule, the injurer minimizes the sum of two things: cost of precaution, plus expected damage payments (or, wx + p(x) D) (With perfect compensation, damage payments = cost of accidents, and so the injurer minimizes the total social cost of accidents.) Random errors in damages awarded have no effect on injurer incentives under a strict liability rule This is because the injurer is only concerned with the expected level of damages he will have to pay As long as damages are right on average, he will still internalize the expected cost of accidents, and still take the same level of precaution On the other hand, systematic errors in calculating damages will skew the injurer’s incentives If damages are consistently set too low, then the injurer will internalize less than the entire social cost of accidents; so precaution will be set too low. (DRAW IT.) If damages are consistently set too high, the injurer will internalize more than 100% of the social cost of accidents, so precaution will be set too high So under strict liability, systematic errors in setting damages will cause the injurer’s precaution level to respond in the same direction as the error random errors in setting damages will have no effect

$ wx + p(x) D p(x) D wx + p(x) A On the other hand, systematic errors in calculating damages will skew the injurer’s incentives Consider our graph before – expected cost of accidents, cost of precaution, total social cost If damages are consistently set too low, we get a new curve – expected level of damages, p(x) D, which is below p(x) A And the private cost to the injurer, wx + p(x)D, is lower than the social cost And most importantly, it bottoms out at a lower level Damages which are consistently set too low lead the injurer to internalize less than the entire social cost of accidents; so precaution will be set too low. If damages were consistently set too high, the opposite would happen The injurer will internalize more than 100% of the social cost of accidents And precaution will be set too high So under strict liability, systematic errors in setting damages will cause the injurer’s precaution level to respond in the same direction as the error random errors in setting damages will have no effect wx p(x) A x x* Precaution (x)

random errors in setting damages have no effect systematic errors in setting damages will skew the injurer’s incentives if damages are set too low, precaution will be inefficiently low if damages are set too high, precaution will be inefficiently high failure to consistently hold injurers liable has the same effect as systematically setting damages too low if not all injurers are held liable, precaution will be inefficiently low So under strict liability, random errors in setting damages will have no effect systematic errors in setting damages will cause the injurer’s precaution level to respond in the same direction as the error Another way the court could err is to fail to find injurers liable when it should If the probability of being found liable is less than 100%, this has the same effect as lowering the expected level of damages that the injurer has to pay The injurer is indifferent between paying $10,000 in damages half the time, or paying $5,000 in damages for sure. So a failure to consistently hold injurers liable has the same effect as a systematic error in setting damages too low Under strict liability, systematic failures to hold all injurers liable leads to less injurer precaution

What about under a negligence rule?
$ wx + p(x) D wx + p(x) A p(x) D wx Recall how a negligence rule works: Injurers are responsible for accidents if they took less than the legally required level of precaution So for x to the left of the threshold, private cost = social cost Injurers are not liable if they took at least the required level of precaution So the to right of the threshold, private cost is only the cost of precaution Which leads injurers to take the correct level of precaution Suppose damages are systematically set too low Again, we get a new curve, expected damages, p(x) D, lower than the true one We can graph wx + p(x) D Under a liability rule, the injurer owes wx + p(x) D if he’s negligent And wx if he’s not So as long as the difference between A and D is not too great, the error has no effect on precaution – the injurer still minimizes private costs by taking efficient precaution If damages are systematically set too high, the same thing happens – costs will be too high for injurers who are negligent, but correct for injurers who are not, so injurers will still take efficient precaution, to avoid liability So “modest” errors – either systematic or random – in setting damages will have no effect on precaution under a negligence rule Under a negligence rule, modest errors in setting damages will not affect injurer precaution. Similarly, occasional failures to hold negligent injurers liable will also not affect injurer precaution, as long as they are occasional If you have a 90% chance of being held liable when negligent, it’s the same as being charged 90% of the proper level of damages; it may not be enough to change your behavior under a negligence rule. Of course, large enough errors in either measure could cause the p(x) D curve to dip below the level of w x*, in which case they would have an effect. (C and U also point out that these errors can be thought of as court errors in setting appropriate damages, or as injurer errors in predicting the level of damages. Again, neither one leads to a change in precaution level under a negligence rule, so long as the errors are not too large.) p(x) A xn = x* x Under a negligence rule, small errors in damages have no effect on injurer precaution

What about errors in setting xn?
$ wx + p(x) A wx Under a negligence rule, in addition to calculating damages, the court also has to rule on whether the legal standard of care was met that is, the court has to compare the care the injurer took, x, to the legal standard, xn, which we hope is set equal to the efficient level, x* Systematic errors in the standard of care have a very direct effect on injurer precaution In general, under a negligence rule, the injurer’s level of precaution responds exactly to systematic court errors in setting the legal standard (DRAW IT) p(x) A xn x* xn x Under a negligence rule, injurer’s precaution responds exactly to systematic errors in setting the legal standard

What about random errors in setting xn?
$ wx + p(x) A wx What about random errors? p(x) A x* x x Under a negligence rule, random errors in the legal standard of care lead to increased injurer precaution

To sum up the effects of errors and uncertainty…
Under strict liability: random errors in setting damages have no effect systematic errors in setting damages will skew the injurer’s incentives in the same direction failure to consistently hold injurers liable lead to less precaution Under negligence: small errors, random or systematic, in setting damages have no effect systematic errors in the legal standard of care have a one-to-one effect on precaution random errors in the legal standard of care lead to more precaution So… when court can assess damages more accurately than standard of care, strict liability is better when court can better assess standards, negligence is better when standard of care is vague, court should err on side of leniency To sum up everything we’ve learned about errors and uncertainty… Given these results, when courts are able to assess damages more accurately than standards of care, a strict liability rule is better when a court can assess standards more accurately than damages, a negligence rule is better also, when the standard of care is vague – that is, when there is uncertainty about what does and does not constitute negligence – the court should err on the side of leniency, so as not to further aggravate the problem of excessive precaution. (The book does a little aside on “bright-line” rules, like speed limits, versus vague standards, like “don’t drive recklessly”. In certain settings, laws won’t be enforced if they’re overly vague. Off-topic a bit, but California helmet law.)

What about relative administrative costs of the two systems?
Negligence rules lead to longer, more expensive trials Simpler to just prove harm and causation But negligence rules lead to fewer trials Not every victim has a case, since not every injurer was negligent Unclear which system will be cheaper overall We can think quickly about the relative costs of administering the different liability rules Obviously, it’s simpler to prove just harm and causation than to prove harm, causation, and negligence So once a case goes to court, we expect the administrative costs to be higher under a negligence rule than under strict liability (More time spent, more witnesses, etc.) On the other hand, under a negligence rule, many victims will know they have no case, and therefore not bring a lawsuit at all Under a strict liability rule, every accident victim is entitled to damages, so there will be more lawsuits So strict liability will lead to more cases, but easier cases So it’s not clear which will be cheaper (Obviously, a rule of no liability leads to lower administrative costs than either, since there’s no work to be done) There is also a tradeoff between rules (such as the legal standard of care) which are tailored to individual situations, versus broad, simple rules that apply to many situations As we’d expect, broad, simple rules are cheaper to create and enforce, but will not create perfect incentives in every situation More specific, detailed, “tailored” rules will be more costly to create and enforce, but will create more efficient incentives

Does it all matter?

Gary Schwartz, Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter?
Reviews a wide range of empirical studies Finds: tort law does affect peoples’ behavior, in the direction the theory predicts… …but not as strongly as the model suggests Next question: does it all matter? That is, given all the time that we’ve just spent developing a formal economic model and examining its implications, it’s fair to step back a bit and ask the question: does the model work? Is there any evidence from the real world that a choice of liability rule affects peoples’ behavior in the way the model predicts? The usual assumption we make in economics is that if you make something more costly, people will do less of it. But when people get in their cars, do they really think about the amount they will have to pay in the event of an accident when deciding how fast and how far to drive? Do people really think about liability rules when deciding whether to get in a bar fight? This is exactly the question (not the bar fight question, the more general question) addressed in the paper by Gary Schwartz, “Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter?” He reviews a wide range of empirical studies in different areas of tort law, and comes to the following, not that startling conclusion: Tort law does affect peoples’ behavior, in the direction the economic model predicts, but not as much as a literal reading of the model would suggest

Reviews a wide range of empirical studies Finds: tort law does affect peoples’ behavior, in the direction the theory predicts… …but not as strongly as the model suggests Most academic work either… took the model literally, or pointed out reasons why model was wrong and liability rules might not affect behavior at all Schwartz: the truth is somewhere in between He points out that most of the academic work prior to that point was either implicitly assuming that people behaved exactly as in the model; or pointing out various critiques of the model, and reasons why liability rules would not impact behavior at all but that the truth lay somewhere in between. One of the obvious ways in which the model is “wrong”: the model suggests that, under a negligence rule, injurers will always take the mandated level of care – that is, there will never be any negligence and yet there are lots of studies showing that negligence is rampant in auto accidents, in medical malpractice, and in other areas Nonetheless, studies in a variety of industries show that a greater degree of liability does lead to greater overall levels of precaution.

“Yet between the economists’ strong claim that tort law systematically deters and the critics’ response that tort law rarely if ever deters lies an intermediate position: tort law, while not as effective as economic models suggest, may still be somewhat successful in achieving its stated deterrence goals. …The information [in various studies] suggests that the strong form of the deterrence argument is in error. Yet it provides support for that argument in its moderate form: sector-by-sector, tort law provides something significant by way of deterrence.”

“Much of the modern economic analysis, then, is a worthwhile endeavor because it provides a stimulating intellectual exercise rather than because it reveals the impact of liability rules on the conduct of real-world actors. Consider, then, those public-policy analysts who, for whatever reason, do not secure enjoyment from a sophisticated economic proof – who care about the economic analysis only because it might show how tort liability rules can actually improve levels of safety in society. These analysts would be largely warranted in ignoring those portions of the law-and-economics literature that aim at fine-tuning.” Schwartz has a funny line toward the end of the paper He argues that since people do not respond as precisely to incentives as the model predicts, we shouldn’t spend so much time trying to “fine-tune” the law to achieve perfection: “Much of the modern economic analysis, then, is a worthwhile endeavor because it provides a stimulating intellectual exercise rather than because it reveals the impact of liability rules on the conduct of real-world actors. Consider, then, those public-policy analysts who, for whatever reason, do not secure enjoyment from a sophisticated economic proof – who care about the economic analysis only because it might show how tort liability rules can actually improve levels of safety in society. These analysts would be largely warranted in ignoring those portions of the law-and-economics literature that aim at fine-tuning.”

Worker’s compensation rules in the U.S. Employer is liable – whether or not he was negligent – for economic costs of on-the-job accidents Victim still bears non-economic costs (pain and suffering, etc.) “…Worker’s compensation disavows its ability to manipulate liability rules so as to achieve in each case the precisely efficient result in terms of primary behavior; It accepts as adequate the notion that if the law imposes a significant portion of the accident loss on each set of parties, these parties will have reasonably strong incentives to take many of the steps that might be successful in reducing accident risks.” He also points out, since “fine-tuning” may not work, that simple rules start to make more sense He looks at the example of worker’s compensation in the United States Worker’s compensation holds the employer liable (whether or not he was negligent) for the economic costs of on-the-job accidents, while leaving the victim bearing all non-economic costs such as pain and suffering Schwartz argues: “Analyzed in incentive terms, this regime of “shared strict liability” takes for granted that there are many steps that employers can take, and also many things that employees can do, to reduce the work accident rate. Yet workers’ compensation disavows its ability to manipulate liability rules so as to achieve in each case the precisely efficient result in terms of primary behavior; it accepts as adequate the notion that if the law imposes a significant portion of the accident loss on each set of parties, these parties will have reasonably strong incentives to take many of the steps that might be successful in reducing accident risks.”

Relaxing the assumptions of our model (we won’t get to this Monday)
Many of the objections Schwartz points out in his paper – reasons that people may not respond to liability laws in the way the “standard model” predicts – can be seen as violations of some of the assumptions that we’ve implicitly been making in the way we set up our model

Our model thus far has assumed…
So far, our model has assumed: People are rational There are no regulations in place other than the liability rule There is no insurance Injurers pay damages in full They don’t run out of money and go bankrupt Litigation costs are zero We can think about what would happen when each of these assumptions is violated Many of the objections Schwartz points out in his paper – reasons that people may not respond to liability laws in the way the “standard model” predicts – can be seen as violations of what Cooter and Ulen refer to as the “core assumptions” of the model Specifically, the model as we’ve explained it so far assumes: Decision-makers are rational There are no regulations in place beyond the liability rule There is no insurance Injurers pay damages in full (for example, they can’t run out of money and go bankrupt) Litigation costs are zero We can relax each of these assumptions in turn, and see what effect this will have.

Assumption 1: Rationality
Behavioral economics: people systematically misjudge value of probabilistic events Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk” 45% chance of $6,000 versus 90% chance of $3,000 Most people (86%) chose the second 0.1% chance of $6,000 versus 0.2% chance of $3,000 Most people (73%) chose the first But under expected utility, either u(6000) > 2 u(3000), or it’s not So people don’t actually seem to be maximizing expected utility And the “errors” have to do with how people evaluate probabilities Assumption 1. Rationality Cooter and Ulen give two examples of ways in which the rationality assumption may be violated. The first is on the basis of a growing literature in behavioral economics that says that many people systematically misperceive the value of probabilistic events That is, a number of experiments have shown that when people evaluate probabilistic events, they make choices that are not compatible with the usual expected-utility framework. One classic example of this comes from a classic paper by Daniel Kahneman and Amos Tversky, called “Prospect Theory: An Analysis of Decision under Risk.” They found that given a choice between a 45% chance at $6,000 and a 90% chance at $3,000, most (86%) of their sample chose the latter; but given a choice between a 0.1% chance of $6,000 and a 0.2% chance of $3,000, most (73%) chose the former. Under the standard expected-utility setup, either u(6000) is twice as high as u(3000) or it’s not; here, people were clearly doing something other than maximizing expected utility; and it seems to do not with how they evaluate the value of money, but how they evaluate probability.

People seem to overestimate chance of unlikely events with well-publicized, catastrophic events Freakonomics: people fixate on exotic, unlikely risks, rather than more commonplace ones that are more dangerous More recent work by the same authors – cited in the textbook – argues that people tend to overestimate the likelihood of events with well-publicized, catastrophic results, like accidents at nuclear power plants The resulting panic makes the few that occur stick in peoples’ minds, so they imagine them to be more frequent than they actually are. (There’s also a chapter in Freakonomics about how people fixate on the “wrong” risks That is, people freak out about very unlikely events, leading to lots of regulations about flame-retardant childrens’ pajamas But they ignore much more likely risks that seem more commonplace, such as swimming pool accidents.) All these examples build the case that maybe people don’t make perfectly rational expected-gain tradeoffs the way we expect them to Given that, we wouldn’t expect people to correctly trade off the expected incremental cost of probabilistic accidents, – p(x)’ A, against the certain cost of increased precaution, w.

People seem to overestimate chance of unlikely events with well-publicized, catastrophic events Freakonomics: people fixate on exotic, unlikely risks, rather than more commonplace ones that are more dangerous How to apply this: accidents with power tools Could be designed safer, could be used more cautiously Suppose consumers underestimate risk of an accident Negligence with defense of contributory negligence: would lead to tools which are very safe when used correctly But would lead to too many accidents when consumers are irrational Strict liability would lead to products which were less likely to cause accidents even when used recklessly Cooter and Ulen consider the implications of this in a setting of bilateral precaution, accidents with power tools Power tools can be designed to be safer, and they can be used more cautiously. However, suppose consumers underestimate the likelihood of a power tool accident (People assume that any product on the market must be very safe, so they exercise no caution whatsoever.) A negligence rule with a defense of contributory negligence is common for product liability This would lead chainsaw companies to design chainsaws that are perfectly safe (or at least, efficiently safe) as long as they are not used negligently Under perfect rationality, this would lead consumers to take efficient care in using them, and all would be well But if irrational consumers underestimate chainsaw risk, this would lead to too many accidents On the other hand, a strict liability rule – along with the manufacturer knowing that its consumers will be negligent – will lead chainsaw manufacturers to design even safer chainsaws, which are less likely to cause accidents even when used recklessly In a world with irrational consumers, this is a good thing.

Another type of irrationality: unintended lapses “Many accidents result from tangled feet, quavering hands, distracted eyes, slips of the tongue, wandering minds, weak wills, emotional outbursts, misjudged distances, or miscalculated consequences” The second type of irrationality Cooter and Ulen consider is unintended lapses, that is, accidental negligence Rather poetically, they point out that “many accidents results from tangled feet, quavering hands, distracted eyes, slips of the tongue, wandering minds, weak wills, emotional outbursts, misjudged distances, or miscalculated consequences” All of which they summarize as “lapses” The idea: people try to exercise due care, but once in a while, they fail. The example they give is from a world without cruise control The speed limit on a road is 70, and so driving faster than that constitutes negligence A driver intends to drive 65, but from time to time his mind wanders and he looks down to find himself driving 73 If one of these times, he’s in an accident, he’s liable. (On the other hand, a driver who sets out to drive 75, but mistakenly finds himself doing 67 when he hits someone, is not liable) Cooter and Ulen’s discussion here is weirdly moralistic They seem to take the position, both that speeding is somehow immoral, and that “not wanting to speed” is somehow more important than actually not speeding They point out that a driver who realizes he may occasionally lapse will rationally target a level of precaution higher than the legal standard, to lessen the frequency of these lapses taking him below the legal standard x~ (This is exactly the same effect as the overprecaution we expect as a result of random uncertainty about the exact legal standard.) As they point out, however, a liability rule that required intentional negligence, rather than accidental negligence, would be almost impossible to enforce Proving intent is even harder than proving negligence, which was already harder than proving harm and causation Such a rule would likely lead to most injurers avoiding liability altogether, leading to no incentives for precaution They give the rather creepy notion that GPS in cars will eventually allow us to distinguish the habitual speeder from the “accidental” speeder, and then move on.

Assumption 2: Injurers pay damages in full
Strict liability: injurer internalizes expected harm done, leading to efficient precaution But what if… Harm done is $1,000,000 Injurer only has $100,000 So injurer can only pay $100,000 But if he anticipates this, he knows D << A… …so he doesn’t internalize full cost of harm… …so he takes inefficiently little precaution Injurer whose liability is limited by bankruptcy is called judgment-proof One solution: regulation We’ve said all along that strict liability causes an injurer to internalize the expected harm done by accidents, leading to efficient precaution However, consider a situation in which a firm’s liability is more than its net worth, that is, more than the total value of the company The firm has no way to come up with the damages owed; so it declares bankruptcy Thus, bankruptcy places a limit on the damages that can be paid But if the damages that will actually be paid are less than the actual harm, then the firm is not internalizing the full cost of accidents As a result, the firm will take inefficiently little precaution. The book considers the example of a hazardous waste disposal company If the company intends to stay in business forever, it will be very careful in transporting hazardous waste, in order to avoid accidents/liability On the other hand, it might take a different strategy: dump recklessly earn short-term profits pay them out to shareholders remain undercapitalized and expect to go bankrupt the first time an accident happens An injurer whose liability is limited by bankruptcy is referred to as being judgment-proof That is, they are immune to judgments beyond a certain level If I have $100,000 in the bank and I cause an accident causing $1,000,000 in harm, I expect to only pay $100,000 So my incentive to take precautions is much lower There is no perfect solution to the distortions that this causes But there are some ways to reduce them One of which is regulation, which is the third extension we consider

Assumption 3: No regulation
What stops me from speeding? If I cause an accident, I’ll have to pay for it Even if I don’t cause an accident, I might get a speeding ticket Similarly, fire regulations might require a store to have a working fire extinguisher When regulations exist, court could use these standards as legal standard of care for avoiding negligence Or court might decide on a separate standard The next extension they consider to the “standard” model is of settings which are governed by both a liability rule and safety regulations For example, if I speed and cause a car accident, I may be liable But if I get caught speeding, I’ll get a ticket, even if I didn’t cause an accident Similarly, fire regulations may require a store to have a working fire extinguisher, and fines may be issued to stores that fail safety inspections But on top of the regulations, if a fire in the store injured a customer, the store would still be liable When there is both liability and safety regulation, courts could adopt the safety standards as the required standard of care Administrators who regulate only a single industry can acquire the detailed technical knowledge needed to set safety standards efficiently While a court might have trouble acquiring this level of knowledge on a wide range of industries In these settings, courts can adopt the legal standard set by safety regulators With both standards set the same, “potential injurers will conform to that standard in order to avoid both ex ante fines and ex post liability.” However, C&U also offer arguments why a court might fear industry regulators would set safety standards either too high or too low If regulators are susceptible to political pressure from powerful firms, safety standards might be set too low to help them avoid liability On the other hand, corrupt regulators might set standards too high, to ensure that bribing them would be cheaper for businesses than complying with the rules Standards could also be set high to protect incumbent firms from new competition Thus, courts may choose to deviate from regulated safety levels in setting the legal standard for care When safety regulations and liability law impose different standards, firms will tend to follow the higher standard, to avoid both liability and fines.

Assumption 3: No regulation
When liability > injurer’s wealth, liability does not create enough incentive for efficient precaution Regulations which require efficient precaution solve the problem Regulations also work better than liability when accidents impose small harm on large group of people As we just saw, when liability exceeds an injurer’s total wealth, the injurer goes bankrupt, but cannot be held liable for the full amount of the harm In settings where damages would bankrupt a firm, expected damage payments would be lower than p(x)A, since damages would be limited to an amount less than A. This would lead to insufficient precaution under a strict liability rule However, regulations which hold a firm to the efficient level of care avoid this problem, since large fines could be assessed to firms in violation of safety standards before an accident occurs Thus, in industries where severe accidents are likely to bankrupt firms, safety regulation may work better than liability in encouraging precaution. Regulation may also be better than liability when accidents impose only a small harm on a large group of people: since going to trial is costly, it may not be worth it for victims suffering only a small harm, and firms might escape liability because nobody finds it worthwhile to sue. (Class action lawsuits also get around this problem – we’ll get to that later.) In these cases, liability alone might also lead to insufficient precaution, while regulation can enforce the efficient level of care.

Assumption 4: No insurance
We assumed injurer or victim actually bears cost of accident When injurer or victim has insurance, they no longer have incentive to take precaution But, insurance tends not to be complete insurance Going back to the fundamental assumptions we’ve been making in tort law… If I drive more carefully, I cause fewer accidents If I face greater liability when I cause accidents, I choose to drive more carefully On the other hand, if I have insurance that covers me when I cause accidents, then the liability rule chosen may not affect me, only my insurance company The third assumption we made in the original model was that either the victim or the injurer bears the cost of the accident – that is, neither side has insurance. In reality, the victim might buy insurance for harm caused by accidents, and the injurer might buy insurance to cover his liability. However, insurance tends not to be complete The victim’s car insurance may include a deductible (the insurer doesn’t pay the first $500 of damage), coinsurance or copayment (the insurer pays some fraction of damage rather than the full amount), and coverage may only be for tangible losses, not all damage. The injurer’s liability insurance may also be incomplete – in addition to deductibles or coinsurance, an accident may cause his future premiums to go up, so the injurer is not completely insulated from the cost of the accident.

If both victims and injurers had complete insurance… Neither side would bear cost of accidents If insurance markets were competitive, premiums would exactly balance expected payouts (plus administrative costs) We said earlier, goal of tort law was to minimize sum of accidental harm, cost of preventing accidents, and administrative costs In a world with universal insurance and competitive insurance markets, goal of tort law can be described as minimizing cost of insurance to policyholders Under strict liability, only injurers need insurance; under no liability, only victims need insurance If both sides had complete insurance, then neither the injurer nor the victim would bear the cost of accidents the injurer’s liability would be covered by insurance the victim would recover the full amount of his losses and the two insurance companies would fight it out between them for who bears the costs Insurance companies take in revenues, in the form of premiums; and they pay out claims and administrative costs If insurance markets are perfectly competitive, then profits will be 0; premiums will exactly balance (on average) claims plus other costs Earlier, we described the goal of tort law as minimizing the sum of the cost of accidental harm, the cost of preventing accidents, and the costs of administration. Translated into a world with insurance, this becomes… In a system of universal insurance and competitive insurance markets, the goal of tort law can be described as minimizing the total cost of insurance to policyholders. (The costs of precaution seem to have vanished from this formulation, but with perfect insurance, neither side has any incentive to take precautions.) Consider again the difference between no-liability and strict liability Under no liability, injurers have no need for insurance, and victims buy accident insurance Under strict liability, injurers buy liability insurance and victims have no need for insurance. Considering which one is more efficient basically recasts our earlier analysis on tort law incentives in terms of insurance.

Insurance reduces incentive to take precaution Moral hazard Insurance companies have ways to reduce moral hazard Deductibles, copayments Increasing premiums after accidents Insurers may impose safety standards that policyholders must meet Insurance reduces the incentives to take precaution. In insurance, this is referred to as moral hazard. (If I insure my car against theft, I don’t worry as much about where I park it.) Insurance companies have lots of ways to reduce moral hazard, mostly ones we’ve already mentioned – deductibles, coinsurance, and making a customer’s premiums depend on his past driving performance. Nonetheless, insurance clearly leads to lower levels of precaution. To deal with this, liability insurers may impose safety standards that policyholders must meet. For example, a fire insurance company may require its customers to maintain fire extinguishers. Or a car insurance policy might not cover you if you’re driving drunk Like before with safety regulators, insurance companies can impose ex ante standards – or, to put it in our terms, they can make even insured customers face liability if they are negligent The book goes on for a while about insurance – trying to use insurance to argue whether strict liability or no liability is better. They point out that in a strict liability world with insurance, a manufacturer who makes a lot of defective products might find their insurance rates going up over time, giving an incentive to reduce defects. In addition, if a manufacturer buys liability insurance, the insurance company would have an incentive to monitor the manufacturer and make sure they’re making safe products. (They also mention two reasons the insurance industry is thought to be “unstable” – the fact that correlated losses may exhaust reserves, and the problem of adverse selection.)

Assumption 5: Litigation costs nothing
If litigation is costly, this affects incentives in both directions If lawsuits are costly for victims, they may bring fewer suits Some accidents “unpunished”  less incentive for precaution But if being sued is costly for injurers, they internalize more than the cost of the accident So more incentive for precaution A clever (unrealistic) way to reduce litigation costs At the start of every lawsuit, flip a coin Heads: lawsuit proceeds, damages are doubled Tails: lawsuit immediately dismissed Expected damages are the same  same incentives for precaution But half as many lawsuits to deal with! The final assumption Cooter and Ulen relax is the assumption that litigation costs nothing They point out that if litigation is costly on both sides, it skews the incentives in both directions If suing for damages is costly for victims, we would expect them to bring fewer suits; this means more accidents would go “unpunished”, providing less incentive for precaution. On the other hand, if being sued for damages is costly for injurers, this adds an additional cost to the damages they expect to pay; this increases the incentives to avoid trial in the first place by preventing the accident, leading to greater precaution. They also give a funny example of how litigation costs could be reduced, if all we’re concerned about is maintain the right incentives. Consider a world where any time someone sues for damages, a coin is flipped. With probability ½, the case is dismissed immediately, before the trial begins. With probability ½, the case goes to trial, and whatever damages are deemed fair, they are doubled. Beforehand, the injurer faces the exact same level of expected damages, and so he behaves exactly the same. After the fact, however, we’ve reduced the number of costly trials by 50%. Obviously, this isn’t likely to happen In fact, a Virginia judge was removed from the bench last year for, among other things, deciding which parent would have visitation rights for Christmas by coin flip The judge apparently had other problems too, though. When we get to criminal law, we’ll look at the tradeoff between probability of enforcement and severity of punishment, and the effect this has on criminal behavior.

Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 17.

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Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 17.

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