Econ 522
Economics of Law
Dan Quint
Fall 2015
Lecture 18
Logistics
 Second midterm is Wednesday
 Exam is cumulative – includes property and contract law, but not
tort law
 No class next week (either day) – happy Thanksgiving!
 HW4 not due until December 10 – I’ll post after midterm
1
Recapping
 Last week in tort law, we considered the incentives created
by different liability rules for…




Precaution by injurers
Precaution by victims
Activity levels of injurers
Activity levels of victims
 And what changes when these rules are implemented with
errors
 Natural to ask…
2
Does it all
really 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
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
 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
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
“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.”
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
“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 finetuning.”
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
 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.”
Relaxing the assumptions
of our model
9
Our model thus far has assumed…
 So far, our model has assumed:

People are rational

Injurers pay damages in full

They don’t run out of money and go bankrupt

There are no regulations in place other than the liability rule

There is no insurance

Litigation is costless
 We can think about what would happen when each of
these assumptions is violated
10
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
11
Assumption 1: Rationality
 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
12
Assumption 1: Rationality
 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
13
accidents even when used recklessly
Assumption 1: Rationality
 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”
14
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
15
Example of judgment-proofness
(from old final exam)
 Owner of an oil tanker
 Any accident would be an environmental catastrophe,
doing $50,000,000 of harm
 Upgraded navigation system would cost $225,000, and
reduce likelihood of an accident from 1/100 to 1/500


Precaution reduces expected harm from $500,000 to $100,000,
costs $225,000, so efficient to take precaution
If company would be forced to pay $50,000,000 after an accident,
then under strict liability, would choose to buy new nav system
 Suppose the business is only worth $5,000,000



If there’s an accident, pay the $5,000,000 and go out of business
Now nav system reduces expected damages from $50,000 to
$10,000 – not worth the cost
16
So judgment-proof business would take too little precaution
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
 Regulations supply additional incentive to take precaution
17
Continuing the example of judgment-proofness
from before…
 We saw, if business is only worth $5,000,000, liability does
not create enough incentive to upgrade nav system
 Now suppose government passes regulation requiring
modern navigation systems on all oil tankers

If business doesn’t upgrade, 1 in 5 chance of being caught by
safety inspector and having to pay a $1,000,000 fine
 Now, combining liability with regulation…



Upgrade: cost of new nav system is $225,000, expected damages
are $10,000  private cost is $235,000
Don’t upgrade: expected damages are $50,000, expected
government fine is $200,000  private cost is $250,000
Liability + regulation gives enough incentive to take precaution,
even though either one alone would not be enough
18
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
19
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
20
Assumption 4: No 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
21
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
22
An example from Polinsky, “An Introduction
to Law and Economics”
 I hit you with my car and did $10,000 worth of damage





We both know I was negligent
But courts aren’t perfect
If we go to trial, 80% chance I’ll be found liable, 20% I won’t
If I’m held liable, damages are correctly set at $10,000
So on average, if we go to trial, you expect to recover $8,000
 But if we go to trial, we both have to hire lawyers



Suppose this costs us each $3,000
Now your expected gain from going to trial is $8,000 – 3,000 = 5,000
And my expected cost is $8,000 + 3,000 = 11,000
23
Why does costly litigation matter?
 Under strict liability…




We said injurers internalize cost of accidents  efficient precaution
But this assumes cost of being sued = damage done
If courts are unpredictable and litigation is costly, private cost of
being sued for damages could be > or < cost of accident
Which could lead to too much or too little precaution
 But also…



If we can’t settle out of court and cases go to trial…
…then social cost of an accident includes both the harm done,
and the resources expended during the trial!
If trial costs $6,000, then social cost of the accident isn’t $10,000,
but $16,000 – which increases the efficient level of precaution
24
With costly litigation comes possibility of
“nuisance suit”
 Nuisance suit – lawsuit with no legal merit, purely meant to
extract an out-of-court settlement





Suppose trial costs $10,000 for plaintiff but $50,000 for defendant
If case goes to trial, plaintiff will get nothing
Threat points are -10,000 and -50,000
Gains from cooperation if settlement reached are 60,000
If gains are split evenly, defendant pays settlement of $20,000,
even though case had no merit
25
Who pays the costs of a trial?
 In U.K., loser in a lawsuit often pays legal expenses of
winner


Discourages nuisance suits
But also discourages suits where there was actual harm that may
be hard to prove
 In U.S., each side generally pays own legal costs

But some states have rules that change this under certain
circumstances
26
Who pays the costs of a trial?
 Rule 68 of Federal Rules of Civil Procedure
“At any time more than 10 days before the trial begins, a party
defending against a claim may serve upon the adverse party an
offer [for a settlement]…
If the judgment finally obtained by the offeree is not more
favorable than the offer, the offeree must pay the costs
incurred after the making of the offer.”
 “Fee shifting rule”
 Example




I hit you with my car, you sue
Before trial, I offer to settle for $6,000, you refuse
If you win at trial, but damages are only $5,000…
…then under Rule 68, you would have to pay me for all my legal
expenses after I made the offer
27
Who pays the costs of a trial?
 Rule 68 does two things to encourage settlements:


Gives me added incentive to make a serious settlement offer
Gives you added incentive to accept my offer
 But not actually as generous as it sounds

Not all expenses are covered
 Asymmetric


Plaintiff is penalized for rejecting defendant’s offer
Defendant is not penalized for rejecting offer from plaintiff
28
A clever (but 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!
29
Perfect
Compensation
30
Perfect compensation
 Perfect compensatory damages (D = A)



Returns victim to original level of well-being
(Works like insurance)
And sets correct incentive for injurers
 But in some cases, hard to determine level


Might be no price at which you’d be willing to give up a leg
Certainly no price at which a parent would be indifferent toward
losing a child
31
Perfect compensation
 Recommended jury instructions, Massachusetts:




“Recovery for wrongful death represents damages to the survivors
for the loss of value of decedent’s life. There is no special formula
under the law to assess the plaintiff’s damages…
It is your obligation to assess what is fair, adequate, and just.
You must use your wisdom and judgment and your sense of basic
justice to translate into dollars and cents the amount which will fully,
fairly, and reasonably compensate the next of kin for the death of the
decedent.
You must be guided by your common sense and your conscience
on the evidence of the case…”
 And from California:

“…You should award reasonable compensation for the loss of love,
companionship, comfort, affection, society, solace or moral support.”
32
One other odd feature of compensatory
damages…
 Most people would rather be horribly injured than killed
 Which means killing someone does more damage than
injuring someone
 But compensatory damages tend to be lower for a fatal
accident than an accident which crippled someone



When someone is badly injured, may require huge amount of
money to compensate them
In wrongful-death case, damages compensate victim’s loved ones,
but no attempt to compensate victim
So these damages tend to be smaller
33
What’s a life
worth?
34
What’s a life worth?
 Assessing damages in a wrongful death lawsuit requires
some notion of what a life is worth
 Safety regulators also need some notion of what a life is
worth
 Kip Viscusi, The Value of Risks to Life and Health
Regulation
Estimated cost per life saved
Airplane cabin fire protection
$
200,000
Car side door protection standards
$
1,300,000
OSHA asbestos regulations
$
89,300,000
EPA asbestos regulations
$
104,200,000
Proposed OSHA formaldehyde standard
$72,000,000,000
 Regulators need to decide “where to draw the line”
35
Kip Viscusi, The Value of Risks to Life and
Health
 Let w be starting wealth, p probability of death
 There might be some amount of money M such that
p u(death) + (1 – p) u(w+M) = u(w)
 Breaks down when p = 1 not because can’t equate death
with compensation, but because second term vanishes
 If we can find M, we can “solve for” u(death)!



Ask a bunch of people how much money they would need to take a
1/1000 chance of death?
Do a lab experiment where you expose people to a risk of death?
Better idea: impute how much compensation people require from
the real-life choices they make
36
Kip Viscusi, The Value of Risks to Life and
Health
 Lots of day-to-day choices increase or decrease our risk of
death



Choose between Volvo and sports car with fiberglass body
Take a job washing skyscraper windows, or office job that pays less
Buy smoke detectors and fire extinguishers, or don’t
 “Hand Rule Damages”




Hand Rule: precaution is cost-justified if
cost of precaution < reduction in accidents X cost of accident
Suppose side-curtain airbags reduce risk of fatal accident by 1/1000
If someone pays $1,000 extra for a car with side-curtain airbags, it
must mean that
$1,000 < 1/1000 * value of their life
or, implicitly, they value their life more than $1,000,000
37
Kip Viscusi, The Value of Risks to Life and
Health
 Viscusi surveys lots of existing studies which impute value
of life from peoples’ decisions
 Many use wage differentials

How much higher are wages for risky jobs compared to safe jobs?
 Others look at…



Decisions to speed, wear seatbelts, buy smoke detectors, smoke
cigarettes
Decision to live in very polluted areas (comparing property values)
Prices of newer, safer cars versus older, more dangerous ones
 Some used surveys to ask how people would make tradeoffs
between money and safety
 Each paper reaches some estimate for implicit value people
attach to their lives
38
What does Viscusi find?
39
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What does Viscusi find?
24 studies based on wage differentials
20,000,000
15,000,000
10,000,000
5,000,000
0
40
What does Viscusi find?
7 studies using other risk-money tradeoffs
Nature of Risk,
Year
Component of the
Monetary Tradeoff
Implicit Value of life
($ millions)
Highway speed-related
accident risk, 1973
Value of driver time based on
wage rates
0.07
Automobile death risks, 1972
Estimated disutility of seat
belts
1.2
Fire fatality risks without smoke
detectors, 1974-1979
Purchase price of smoke
detectors
0.6
Mortality effects of air pollution,
1978
Property values in Allegheny
Co., PA
0.8
Cigarette smoking risks, 1980
Estimated monetary
equivalent of effect of risk info
0.7
Fire fatality risks without smoke
detectors, 1968-1985
Purchase price of smoke
detector
2.0
Automobile accident risks,
1986
Prices of new automobiles
4.0
41
What does Viscusi find?
6 studies based on surveys
Nature of
Risk
Survey
Methodology
Implicit Value of Life
($ millions)
Improved ambulance service,
post-heart attack lives
Willingness to pay question, door-to-door
small (36) Boston sample
Airline safety and locational
life expectancy risks
Mail survey willingness to accept increased
risk, small (30) U.K. sample, 1975
Job fatality risk
Willingness to pay, willingness to accept
change in job risk in mail survey, 1984
3.4 (pay),
8.8 (accept)
Motor vehicle accidents
Willingness to pay for risk reduction, U.K.
survey, 1982
3.8
Automobile accident risks
Interactive computer program with pairwise
auto risk-living cost tradeoffs until
indifference achieved, 1987
Traffic safety
Series of contingent valuation questions,
New Zealand survey, 1989-1990
0.1
15.6
2.7 (median)
9.7 (mean)
1.2
42
What does Viscusi find?
 Wide range of results


Most suggest value of life between $1,000,000 and $10,000,000
Many clustered between $3,000,000 and $7,000,000
 Even with wide range, he argues this is very useful:





“In practice, value-of-life debates seldom focus on whether the
appropriate value of life should be $3 or $4 million…
However, the estimates do provide guidance as to whether risk
reduction efforts that cost $50,000 per life saved or $50 million per
life saved are warranted.”
“The threshold for the Office of Management and Budget to be
successful in rejecting proposed risk regulations has been in excess
of $100 million.”
C&U: NHTSA uses $2.5 million for value of traffic fatality
Current: EPA $9.1 MM, FDA $7.9 MM, Transpo Dept $6 MM
43
More twists
on liability
(probably won’t get to)
44
Vicarious Liability
 Vicarious liability is when one person is held liable
for harm caused by another


Parents may be liable for harm caused by their child
Employer may be liable for harm caused by employee
 Respondeat superior –
“let the master answer”
 Employer is liable for torts
of employee if employee
was acting within the
scope of his employment
45
Vicarious Liability
 Gives employers incentive to...



be more careful who they hire
be more careful what they assign employees to do
supervise employees more carefully
 Employers may be better able to make these decisions
than employees…
 …and employees may be judgment-proof
46
Vicarious Liability
 Vicarious liability can be implemented through…


Strict liability rule: employer liable for any harm caused by
employee (as long as employee was acting within scope of
employment)
Negligence rule: employer is only liable if he was negligent in
supervising employee
 Which is better? It depends.


If proving negligent supervision is too hard, strict vicarious liability
might work better
But an example favoring negligent vicarious liability…
47
Joint and Several Liability
 Suppose you were harmed by accident caused by two
injurers
 Joint liability: you can sue them both together
 Several liability: you can sue each one separately

Several liability with contribution: each is only liable for his share
of damage
 Joint and several liability: you can sue either one for the
full amount of the harm

Joint and several liability with contribution: the one you sued
could then sue his friend to get back half his money
48
Joint and Several Liability
 Joint and several liability holds under common law
when…


Defendants acted together to cause the harm, or…
Harm was indivisible (impossible to tell who was at fault)
 Good for the victim, because…


No need to prove exactly who caused harm
Greater chance of collecting full level of
damages

Instead of suing person most responsible,
could sue person most likely to be able to pay
49