1. Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 16

2. 1  HW3 due tomorrow night  MT2 November 19 Reminder

3. 2  A few last odds and ends from contract law  The basic economic model we’ll be using for tort law Today

4. 3 Contract Law

5. 4 Repeated games

6. 5 Player 1 (you) Trust meDon’t Player 2 (me) Share profitsKeep all the money (150, 50)(0, 200) (100, 0)  Suppose we’ll play the game over and over  After each game, 10% chance relationship ends, 90% chance we play at least once more…

7. 6  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

8. 7  Suppose you’ve chosen to trust me  Keep all the money: I get $200 today, nothing ever again  Share profits: I get $50 today, $50 tomorrow, $50 day after…  Value of relationship =  Since this is more than $200, we can get cooperation Repeated games

9. 8  Diamond dealers in New York (Friedman) “…people routinely exchange large sums of money for envelopes containing lots of little stones without first inspecting, weighing, and testing each one” “Parties to a contract agree in advance to arbitration; if… one of them refuses to accept the arbitrator’s verdict, he is no longer a diamond merchant – because everyone in the industry now knows he cannot be trusted.” Repeated games and reputation

10. 9  The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions  The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts  Law assigns legal duties to certain long-term relationships  Bank has fiduciary duty to depositors  McDonalds franchisee has certain duties to franchisor Repeated games and reputation

11. 10  Suppose we’ll play agency game 60 times  $50 x 60 = $3,000 > $200, so cooperation seems like no problem  But…  In game #60, reputation has no value to me  Last time we’re going to interact  So I have no reason not to keep all the money  So you have no reason to trust me  But if we weren’t going to cooperate in game #60, then in game #59… Repeated games and the endgame problem

12. 11  Endgame problem: once there’s a definite end to our relationship, no reason to trust each other  Example: collapse of communism in late 1980s  Communism believed to be much less efficient than capitalism  But fall of communism led to decrease in growth  Under communism, lots of production relied on gray market  Transactions weren’t protected by law, so they relied on long-term relationships  Fall of communism upset these relationships Repeated games and the endgame problem

13. 12 One other bit I like from Friedman

14. 13 Friedman on premarital sex

15. 14 Friedman on premarital sex

16. 15  Purposes for contract law:  Encourage cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Provide efficient default rules and regulations  Foster enduring relationships That’s it for contract law End of material on second midterm

17. 16 Tort Law

18. 17  Two liability rules we’ll be looking at  Strict Liability  If I cause an accident, I owe victim damages  (Harm + Causation  Liable)  Negligence  If I cause an accident, I only owe victim damages if I was negligent  (Harm + Causation + Breach of Duty/Negligence  Liable) Monday

19. 18  Harm  Causation  Breach of Duty “Classic” legal theory of torts

20. 19 Element 3: Breach of Duty Harm Causation Breach of duty (fault) Harm Causation NegligenceStrict Liability  When someone breaches a duty he owes to the defendant, and this leads to the harm, the injurer is at fault, or negligent  Injurers owe victims the duty of due care  Negligence rule: I’m only liable if I failed to take the required standard of care – not if I was careful and the accident happened anyway (Sometimes required, sometimes not)

21. 20 “A tree fell on a moving trolly, injuring passengers. One of them sued. He succeeded in demonstrating that in order for the trolly to be where it was when the tree fell on it the driver had to have driven faster than the speed limit at some point during the trip. Breaking the law is per se negligence, so the driver was legally negligent whether or not his driving was actually unsafe. If he had not driven over the speed limit, the trolly would not have been under the tree when it fell, so, the plaintiff argued, the driver’s negligence caused the injury.” Hence the language in the trolly example

22. 21  If I breach my duty of due care and injure you, I am liable  If I exercise the appropriate level of care but still injure you, I’m not liable  How is the standard of care determined?  That is, how careful do I have to be to avoid liability, and who decides?  Is it negligent to drive 40 MPH on a particular road at a particular time of day? What about 41 MPH? 42? So under a negligence rule…

23. 22  Some settings: government imposes safety regulations that are also used as standard for negligence  Speed limits for highway driving  Requirement that bicycles have brakes  Workplace regulations  Some standards are left vague  “Reckless driving” may depend on road, time of day, weather…  Common law focuses on duty of reasonable care  Level of care a reasonable person would have taken  (Civil law relies less on “reasonableness” tests, tries to spell out what level of care is required) How is the standard of care determined?

24. 23  Strict liability rule: plaintiff must prove harm and causation  Negligence rule: must prove harm, causation, and negligence  A little history  Early Europe: strict liability was usual rule  By early 1900s, negligence became usual rule  Second half of 1900s, strict liability became more common again, especially for manufacturer liability in American consumer products  U.S. manufacturers now held liable for harms caused by defective products, whether or not they were at fault Strict liability versus negligence

25. 24  Like with contract law, our main concern is with the incentives created by liability rules  So… what incentives are we interested in? Next question

26. 25 Precaution

27. 26  The more carefully I drive, the less likely I am to hit you  But, driving more carefully is also more costly to me  Must be some efficient level of care  Similarly…  Construction company can reduce accidents with better safety equipment, better training, working shorter days, all of which cost money  Manufacturer can reduce accidents by designing/inspecting products more carefully – again, more expensive Precaution

28. 27 Actions by both injurer and victim impact number of accidents drive carefully drive drunk while texting careful quality control cheap, hasty manufacturing install smoke detectors, other safety equipment save money drive slowly speed like hell wear helmet and use light bicycle at night wearing black GREATER EFFORT TO PREVENT ACCIDENTS LESS EFFORT TO PREVENT ACCIDENTS “MORE PRECAUTION”“LESS PRECAUTION”

29. 28  Precaution: anything either injurer or victim could do to reduce likelihood of an accident (or damage done)  The next two questions should be obvious…  How much precaution do we want?  What is efficient level of precaution?  How do we design the law to get it? We will call all these things precaution

30. 29  Car hits a bicycle  In real life: driver probably has insurance  In real life: some damage to bicycle, some damage to driver’s car  In real life: driver and bicyclist may not even know what the law is  We’ll simplify things a lot, by assuming…  Only one party is harmed  Parties know the law, don’t have insurance (for now)  We’ll focus on one party’s precaution at a time To answer these questions, we’ll introduce a very simple model of accidents

31. 30 Simple economic model for thinking about tort law

32. 31  Unilateral harm – just one victim  Precaution – costly actions that make accident less likely  Could be taken by either victim or injurer  We’ll consider both, but one at a time  Notation  x – the amount of precaution that is taken  w – the cost of each “unit” of precaution  so total cost of precaution is wx  p(x) – probability of an accident, given precaution x  p is decreasing in x  A – cost of accident (to victim)  so expected cost of accidents is p(x) A Model of unilateral harm x level of precaution w marginal cost of precaution p(x) probability of an accident A cost of an accident

33. 32 Model of unilateral harm x level of precaution w marginal cost of precaution p(x) probability of an accident A cost of an accident Precaution (x) $ p(x) A (Cost of Accidents) wx (Cost of Precaution) wx + p(x) A (Total Social Cost) x* (Efficient Level of Precaution) efficient precaution: min x { wx + p(x) A } w + p’(x) A = 0 w= – p’(x) A marginal social cost of precaution marginal social benefit of precaution x < x*x > x*

34. 33  We know what’s efficient  Level of precaution that minimizes total social cost = wx + p(x) A  We’ll consider what happens if there is…  no liability rule in place  a strict liability rule  a negligence rule Effect of liability rules on precaution

35. 34 Benchmark: what happens without any liability rule?

36. 35  In a world with no liability…  Injurer does not have to pay for accidents  So, bears cost of any precautions he takes, but does not receive any benefit  Injurer has no incentive to take precaution  Victim bears cost of any accidents, plus cost of precaution he takes  (Victim precaution imposes no externality on injurer)  Victim precaution will be efficient Benchmark: No Liability

37. 36  Injurer’s private cost is just wx  Minimized at x = 0  Victim’s private cost is p(x) A + wx  Minimized at efficient precaution level x = x*  So rule of no liability leads to efficient precaution by victims, no precaution by injurers Benchmark: No Liability x $ p(x) A wx wx + p(x) A x* Private cost to injurer Private cost to victim

38. 37 Benchmark: No Liability EfficientZeroNo Liability Victim Precaution Injurer Precaution

39. 38  Precaution – actions which make an activity less dangerous  Driving carefully  Wearing bright-colored clothing while bicycling  The amount we do each activity also affects the number of accidents  I decide how much to drive  You decide how much to bicycle  Liability rules create incentives for activity levels as well as precaution Precaution isn’t the only thing that determines number of accidents

40. 39  With no liability, I’m not responsible if I hit you  I don’t consider cost of accidents when deciding how fast to drive…  …and I also don’t consider cost of accidents when deciding deciding how much to drive  So I drive too recklessly, and I drive too much  (or: if there is no liability, social cost of driving includes cost of accidents, but private cost to me does not;  driving imposes negative externality, so I do it too much)  So with no liability, injurer’s activity level is inefficiently high With no liability rule…

41. 40  With no liability, victim bears full cost of accidents  Greater activity by victim (more bike-riding) leads to more accidents  Victim weighs cost of accidents when deciding how carefully to ride, and when deciding how much to ride  (Private cost = social cost)  Victim takes efficient level of precaution, and efficient level of activity  A rule of no liability leads to an inefficiently high level of injurer activity, but the efficient level of victim activity What about victims?

42. 41 Benchmark: No Liability EfficientToo HighEfficientZeroNo Liability Victim Activity Injurer Activity Victim Precaution Injurer Precaution

43. 42 Next: what happens under a strict liability rule?

44. 43  Perfect compensation: damages D = A  Under strict liability…  Injurer pays damages for any accidents he causes  So injurer bears cost of accidents, plus his own precaution  Injurer internalizes externality his actions cause  chooses efficiently  Victim is fully insured, no incentive for precaution Strict Liability

45. 44  (Damages = A)  Injurer’s private cost is p(x) A + wx  Minimized at efficient precaution level x = x*  Victim’s private cost is just wx  Minimized at x = 0  So rule of strict liability leads to efficient precaution by injurers, no precaution by victims Strict Liability x $ p(x) A wx wx + p(x) A x* Private cost to injurer Private cost to victim

46. 45 Strict Liability ZeroEfficientStrict Liability EfficientToo HighEfficientZeroNo Liability Victim Activity Injurer Activity Victim Precaution Injurer Precaution

47. 46  Under strict liability, injurer internalizes cost of accidents  Weighs benefit from driving against cost of accidents  Takes efficient activity level  Under strict liability, victim does not bear cost of accidents  Ignores cost of accidents when deciding how much to bike  Sets inefficiently high activity level  A rule of strict liability leads to the efficiently level of injurer activity, but an inefficiently high level of victim activity What about activity level?

48. 47 Strict Liability Too HighEfficientZeroEfficientStrict Liability EfficientToo HighEfficientZeroNo Liability Victim Activity Injurer Activity Victim Precaution Injurer Precaution

49. 48  For both precaution and activity level…  “No liability” leads to inefficient behavior by injurer, efficient behavior by victim  “Strict liability” leads to efficient behavior by injurer, inefficient behavior by victim  Reminiscent of paradox of compensation  One rule sets multiple incentives…  …can’t get them all right  But in tort law, we have a trick… So…

50. 49 Negligence (won’t get to)

51. 50  Negligence rule: injurer is liable if he breached the duty of due care  Within our model:  Legal standard of care x n  Injurer owes damages if precaution level was below that level  x < x n  D = A  x  x n  D = 0  So on our graph from before, private cost to injurer is…  wx + p(x) Afor x < x n  wxfor x  x n  Best shot at achieving efficiency is to set x n = x* Negligence Rule

52. 51 “Simple Negligence”: Injurer precaution x $ p(x) A wx wx + p(x) A x n = x*  Private cost is wx + p(x) A if x < x n, only wx otherwise  If standard of care is set efficiently (x n = x*), injurer minimizes private cost by taking efficient precaution Private cost to injurer

53. 52 “Simple Negligence”: Victim precaution $ p(x) A wx wx + p(x) A x*  What about victim?  We just said, injurer will take efficient precaution  Which means injurer will not be liable  So victim bears costs of any accidents  (Victim bears residual risk)  So victim’s private cost is wx + p(x) A  Victim minimizes private cost by taking efficient level of precaution too! Private cost to victim (assuming injurer takes efficient level of precaution and is therefore not liable for damages)

54. 53 Simple Negligence Efficient Simple Negligence, x n = x* Too HighEfficientZeroEfficientStrict Liability EfficientToo HighEfficientZeroNo Liability Victim Activity Injurer Activity Victim Precaution Injurer Precaution

55. 54  Rule we just saw is called “simple negligence”  Only consider injurer’s actions in determining liability  But we could also consider whether victim was negligence in deciding whether injurer is liable  “Negligence with a defense of contributory negligence” – injurer owes nothing if victim was also negligent  “Comparative negligence” – if both were negligent, share cost  “Strict liability with defense of contributory negligence” – injurer is liable (even if he wasn’t negligence), unless victim was negligent  Any of these rules (with efficient standard of care) will lead to efficient precaution by both parties! Other negligence rules

56. 55  No “levels” of precaution – each party can either take precaution or not  Each accident causes $1,000 of harm  Precaution costs $20 for each party  Chance of an accident is  10% if nobody takes precaution  6% if one party takes precaution  2% if both parties take precaution  Note that precaution is efficient for both parties  Costs $20; reduces expected accidents by 4% X $1,000 = $40 Discrete example of bilateral precaution A$1,000 w$20 for either party p10% / 6% / 2%

57. 56 Different negligence rules NoYesNo Negligence with Defense of Contributory Negligence Yes No Simple Negligence Both parties negligent? Only injurer negligent? Only victim negligent? Neither party negligent? Does injurer owe victim damages when… A$1,000 w$20 for either party p10% / 6% / 2%

58. 57  Injurer is liable if he failed to take precaution…  Unless victim did too  Precaution is always best-response for victim  If injurer is not taking precaution, victim wants to avoid liability  If injurer is taking precaution, victim bears residual risk, wants to minimize accidents  For injurer, precaution is the best-response to precaution  “Both take precaution” is the only Nash equilibrium  And, is the efficient outcome Negligence with a Defense of Contributory Negligence -20, -40-20, -60 -60, -200, -100 PrecautionNone Precaution None Victim Injurer A$1,000 w$20 for either party p10% / 6% / 2% injurer pays for precaution, not liable for accidents victim pays for precaution, and any accidents that happen

59. 58 Different negligence rules PartialYesNo Comparative Negligence NoYesNo Negligence with Defense of Contributory Negligence Yes No Simple Negligence Both parties negligent? Only injurer negligent? Only victim negligent? Neither party negligent? Does injurer owe victim damages when… A$1,000 w$20 for either party p10% / 6% / 2%

60. 59  If both parties were negligent…  …divide cost proportionally  Precaution is again a dominant strategy for victim  Now it’s a dominant strategy for injurer too  Again, “both take precaution” is the only equilibrium  (And the efficient outcome) Comparative Negligence -20, -40-20, -60 -60, -20-50, -50 PrecautionNone Precaution None Victim Injurer A$1,000 w$20 for either party p10% / 6% / 2%

61. 60 Different negligence rules NoYesNoYes Strict Liability with Defense of Contributory Negligence PartialYesNo Comparative Negligence NoYesNo Negligence with Defense of Contributory Negligence Yes No Simple Negligence Both parties negligent? Only injurer negligent? Only victim negligent? Neither party negligent? Does injurer owe victim damages when… A$1,000 w$20 for either party p10% / 6% / 2%

62. 61  Now, injurer is liable, regardless of whether he took precaution…  …unless victim was negligent  Once again, “both take precaution” is the only equilibrium Strict Liability with a Defense of Contributory Negligence -40, -20-20, -60 -60, -200, -100 PrecautionNone Precaution None Victim Injurer A$1,000 w$20 for either party p10% / 6% / 2%

63. 62 Negligence Efficient Negligence with a Defense of Contributory Negligence Efficient Strict Liability with Defense of Contributory Negligence Efficient Comparative Negligence Efficient Simple Negligence Too HighEfficientZeroEfficientStrict Liability EfficientToo HighEfficientZeroNo Liability Victim Activity Injurer Activity Victim Precaution Injurer Precaution assuming all relevant standards of care are set to the efficient levels