Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 15
Reminders
 HW3 due tomorrow Thursday (11:59 p.m.)
 Second midterm Monday March 26


Cumulative – covers property and contract law
No tort law – covers everything through middle of today’s lecture
1
Going back a
month…
2
Intellectual property…
 IP is a tradeoff between…


dynamic (“ex ante”) inefficiency – insufficient incentives for
innovation
static (“ex post”) inefficiency – monopoly deadweight loss
 Article in yesterday’s New York Times




Government of India is forcing Bayer to cheaply license patent for
one of its drugs to a generic manufacturer
Nexavar (sorafenib) – treats advanced kidney and liver cancer
Bayer charges $5,600 a month for the drug, hardly sells any in India
Being forced to license the patent to an Indian company, Natco
Pharma, which will sell drug for $176/month, pay Bayer 6% royalty
3
Results from
Monday’s experiment
4
A two-player game, similar to the
investment/agency game
 Player A starts with $10


Chooses how much of it to give to player B
That money is tripled
 Player B has $10, plus 3x whatever A gave him/her

Chooses how much (if any) to give back to player A
 Four treatments




Anonymous
Private
Face-to-face
Public
5
Results
 In the anonymous version, trust was an issue



On average, player A sent $5.91, so about 60% of the potential
gains were realized
On average, player B sent back $9.35, so average payoffs were
$13.43 and $18.40
Of those player A’s who sent something, 24% got back less than
they sent, and 7% got back nothing
 Knowing who you were playing with helped a lot!




In second version, average A sent $8.70, average B sent $16.21
Two-thirds of A’s sent $10, and 5/6 of those got back $20
Average payoffs of $17.51 and $19.89
Only 4% of player A’s who sent something, got nothing back
6
Results
ANONYMOUS VERSION
(STUDENT ID NUMBERS)
PRIVATE VERSION
(NAMES)
A sent…
# obs
Avg B
% zero
# obs
Avg B
% zero
0
2
$0.00
100%
1
$0.00
100%
1-4
14
$3.02
21%
1
$8.00
0%
5-9
18
$9.11
0%
14
$13.79
0%
10
13
$17.92
0%
31
$18.10
6%
Average
$5.91
$9.34
11%
$8.70
$16.21
6%
(7%)
(4%)
7
Of the Player A’s who sent $10…
Anonymous
Private
# of Player A who sent $10
13
31
% who got back $0 or $5
8%
6%
% who got back $10
0%
3%
% who got back $15 or $17
23%
6%
% who got back $20 or $21
69%
84%
$17.92
$18.10
Average received
8
Results
 Knowing the name of the person you’re playing with helped

Increased trust significantly; increased trustworthiness a little
 Interacting face-to-face completely solved problem

All 5 A’s sent $10, all 5 B’s sent back $20
 That worked even better than playing the game in public!

(Public version: all three A’s sent $10, got back $20, $15, and $0)
9
Returning to
repeated interactions
10
Repeated games and reputation
 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
11
Repeated games and the endgame problem
 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…
12
Repeated games and the endgame problem
 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
13
One other bit
I like from Friedman
14
Friedman on premarital sex
15
Friedman on premarital sex
16
That’s it for contract law
 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
End of material on second midterm
 Wednesday, we begin tort law
17
Let’s recap our
story so far…
18
Our story so far
 Efficiency



Maximizing total surplus realized by everyone in society
Scarce resources are owned by whoever values them most
Actions are taken if social benefit exceeds social cost
 Design a legal system that leads to efficient outcomes



Once we set up the rules, we don’t expect people to act based on
what’s efficient
We expect people to do whatever’s in their own best interest
So the goal is set up the rules such that people acting in their
own best interest will naturally lead to efficiency
19
Our story so far
 Coase gives us one way to do that



If property rights are clearly defined and tradable, and there are
no transaction costs, people have incentive to trade until each
resource is efficiently owned
So initial allocation of rights doesn’t matter for efficiency
But if there are transaction costs, we may not get efficiency this way
 Led us to two normative views of the legal system:


1. Minimize transaction costs (“lubricate” private exchange)
2. Allocate rights as efficiently as possible
 Tradeoff between injunctive relief and damages
20
Our story so far
 Property law works well for simultaneous trade
 Contracts allow for non-simultaneous trade
 Contract law can…






Enable cooperation
Encourage efficient disclosure of information
Secure optimal commitment to performance
Secure efficient reliance
Supply efficient default rules and regulations
Foster enduring relationships
21
Our story so far
 So far, we’ve been talking about voluntary exchange


Coase is predicated on exchange being voluntary for both parties
Contracts are an extension of voluntary trade
 Up next: “involuntary trade”


You’re bicycling to class, I’m texting while driving and I hit you
You didn’t want to deal with me, I didn’t want to deal with you…
22
Our story so far
 To put it another way…
 Property law covers situations where transaction costs are
low enough to get agreement ahead of time

Exceptions to property law – private necessity, eminent domain –
when this isn’t the case
 Contract law covers situations when transaction costs are
low enough for us to agree to a contract, high enough that
we may not want to renegotiate the contract later
 Tort law covers situations where transaction costs are too
high to agree to anything in advance
23
Tort law
24
An example
25
An example
punish the choice
• criminal law
• regulations
Choice
+
Bad Luck

Outcome
26
An example
punish the choice
punish the outcome
• criminal law
• “strict liability”
• regulations
Choice
+
Bad Luck

Outcome
punish the combination of choice and outcome
• “negligence”
27
Tort law
 Tort, noun. from French word meaning injury
 Contract law: situations where someone harms you by
breaking a promise they had made
 Tort law: situations where someone harms you without
having made any promises
 “If someone shoots you, you call a cop. If he runs his car
into yours, you call a lawyer.”
28
As always, we’ll be focused on achieving
efficiency
 I hit you with my car, do $1,000 worth of damage



You’re $1,000 worse off
(No damage to me or my car)
Should I have to pay you damages?
I owe nothing
I owe $1,000
I owe $50,000
–1,000
0
49,000
My payoff
0
–1,000
–50,000
Combined
payoffs
–1,000
–1,000
–1,000
Your payoff
29
Something to remember
distribution
but not
efficiency
efficiency
30
Tort law
 Question: how to structure the law to get people to behave
in a way that leads to efficient outcomes?

Deliberate harms: make punishment severe (criminal law)

Accidental harms: trickier

Goal isn’t “no accidents”; goal is “efficient number of accidents”
31
Tort law
 Question: how to structure the law to get people to behave
in a way that leads to efficient outcomes?

Deliberate harms: make punishment severe (criminal law)

Accidental harms: trickier

Goal isn’t “no accidents”; goal is “efficient number of accidents”

Unlike nuisance law, injunctive relief is not an option

Unlike contract law, no agreement ahead of time

Cooter and Ulen: essence of tort law is “the attempt to make
injurers internalize the externalities they cause, in situations
where transaction costs are too high to do this through
property or contract rights”
32
Cast of characters
 Plaintiff – person who brings a lawsuit
 Defendant – person who is being sued

In a nuisance case, the defendant caused a nuisance, plaintiff was
bothered by it, might be asking for injunction or damages

In a contract case, defendant breached a contract or violated its
terms

In a tort case, defendant caused some harm to plaintiff, plaintiff is
asking for damages

Plaintiff is the victim (person who was harmed)

Defendant is the injurer (person who caused the harm)
33
“Classic” legal theory of torts
 Harm
 Causation
 Breach of Duty
34
Element 1: Harm
 For a tort to exist, the plaintiff needs to have been
harmed
 “Without harm, there is no tort”

Gas company sold gas with a defective additive




Dangerous for cars with turbocharged carburetors
You have a car with normal carburetors
You might be angry; but you weren’t harmed, so you can’t sue
Similarly, no compensation for exposure to risk



Manufacturer exposed workers to some chemical
Exposure will cause 15% of them to develop cancer later in life
Can’t sue now – have to wait, see who gets cancer, then they can sue
35
Element 1: Harm
Money
Health
 Perfect compensation


restores victim to original level of well-being
generally done through money damages
36
Perfect Compensation
Tangible harms
• Medical costs
• Lost income
• Damaged property
Intangible harms
• Emotional harm
• Pain and suffering
• Loss of companionship
 In theory, perfect compensation should cover all losses

Historically, courts have been less willing to compensate for intangible or
hard-to-measure losses
 Over time, U.S. courts have started compensating for more intangible harms
 Pro: the closer liability is to actual harm done, the better the incentive to
avoid these harms
 Con: disparity in award sizes, unpredictability
37
“Classic” legal theory of torts
 Harm
 Causation
 Breach of Duty
38
Element 2: Causation
 For a tort to exist, the defendant needs to have caused the
harm to the plaintiff
 Cause-in-fact

“But for the defendant’s actions, would the harm have occurred?”
39
Element 2: Causation
 For a tort to exist, the defendant needs to have caused the
harm to the plaintiff
 Cause-in-fact

“But for the defendant’s actions, would the harm have occurred?”
 Proximate cause


Immediate cause – defendant’s action can’t be too distant from the
harm
Palsgraf v Long Island Railway (NY Ct Appeals, 1928):


Guard pushed a passenger to help him onto train, passenger dropped
fireworks he was carrying, they went off, explosion knocked down
scales at the other end of the platform, which fell on Mrs. Palsgraf
Guard’s actions were not the proximate cause
40
Element 2: Causation
“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.”
 Court ruled driver’s negligence “had not caused the accident in
the legally relevant sense”
41
“Classic” legal theory of torts
 Harm
 Causation
 Breach of Duty
42
Element 3: Breach of Duty
(Sometimes required, sometimes not)
Strict Liability
• Harm
• Causation
Negligence
• Harm
• Causation
• Breach of duty (fault)
 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
43
Hence the language in the trolly example
“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.”
44
So under a negligence rule…
 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?
45
How is the standard of care determined?
 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)
46
Strict liability versus negligence
 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
47
“Classic” legal theory of torts
 Harm
 Causation
 Breach of Duty
48
Economic model
(didn’t get to this)
49
Precaution
 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
50
Actions by both injurer and victim impact
number of accidents
• speed like hell
• drive slowly
• drive drunk while texting
• drive carefully
• cheap, hasty manufacturing
• careful quality control
• save money
• install smoke detectors, other
safety equipment
• wear helmet and use light
• bicycle at night wearing black
LESS EFFORT TO
PREVENT ACCIDENTS
“LESS PRECAUTION”
GREATER EFFORT TO
PREVENT ACCIDENTS
“MORE PRECAUTION”
51
We will call all these things precaution
 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?
52
To answer these questions, we’ll introduce a
very simple model of accidents
 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
53
Model of unilateral harm
x
w
p(x)
A
level of precaution
marginal cost of precaution
probability of an accident
cost of an accident
 Unilateral harm – just one victim
 Precaution – costly actions that make accident less likely


Could be taken by either victim or injurer
We’ll focus on one at a time
 Notation


x – the amount of precaution that is taken
w – the cost of each “unit” of precaution


p(x) – probability of an accident, given precaution x


so total cost of precaution is wx
p is decreasing in x
A – cost of accident (to victim)

so expected cost of accidents is p(x) A
54
Model of unilateral harm
x
w
p(x)
A
level of precaution
marginal cost of precaution
probability of an accident
cost of an accident
efficient precaution: minx { wx + p(x) A }
$
w + p’(x) A
marginal
social cost
of precaution
w
marginal social
benefit of
precaution
=
0
=
– p’(x) A
wx + p(x) A
(Total Social Cost)
wx (Cost of Precaution)
p(x) A (Cost of Accidents)
x* (Efficient Level
of Precaution)
x < x*
x > x*
Precaution (x)
55
Model of unilateral harm
 We haven’t yet said who is taking precaution

Some situations, only injurer can reduce accidents

Some situations, victim can too

Bilateral precaution – we’ll look at the two parties one at a time
 Wednesday: consider effect of different liability rules on
precaution
56
Effect of Liability Rules
on Precaution
(won’t get to this)
57
Effect of liability rules on precaution
 Three rules we’ll consider:

No liability

Strict liability

Negligence
58
Rule 1: No Liability
 In a world with no liability…


Victim bears the cost of any accidents, plus the cost of any
precaution he takes
Injurer bears cost of any precaution he takes, does not have to pay
for accidents
59
Rule 1: No Liability
Injurer precaution
$
Private cost to injurer
wx + p(x) A
wx
p(x) A
x*
x
 Injurer’s private cost is just wx
 Injurer minimizes private cost by setting x = 0
60
Rule 1: No Liability
Victim precaution
$
Private cost to victim
wx + p(x) A
wx
p(x) A
x*
x
 Victim’s private cost is wx + p(x) A
 To minimize this, victim takes efficient level of precaution 61
Rule 1: No Liability
 So in a world with no liability…
 Injurer takes inefficiently low level of precaution

(zero, or minimal amount)
 Victim takes efficient amount of precaution
62
Rule 2: Strict Liability
 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
Victim pays only for his precaution
63
Rule 2: Strict Liability
Injurer precaution
$
Private cost to injurer
wx + p(x) A
wx
p(x) A
x*
x
 Injurer’s private cost is wx + p(x) A
 Injurer minimizes this by taking efficient level of precaution
64
Rule 2: Strict Liability
Victim precaution
$
Private cost to victim
wx + p(x) A
wx
p(x) A
x*
x
 Victim’s private cost is wx
 No incentive to take any precaution, victim sets x = 0
65
Effect of liability rules on precaution
No Liability
Strict Liability
Victim
precaution
Injurer
precaution
Efficient
Zero
Zero
Efficient
66
So for accidents with unilateral precaution…
 When it’s the injurer who can take precautions, a rule of
strict liability is more efficient
 When it’s the victim who can take precautions, a rule of
no liability is more efficient
 Each rule works well for one incentive, poorly for other


Similar to paradox of compensation we saw in contract law
Negligence rule may allow us to get both incentives right
67
Rule 3: Simple Negligence
 “Simple Negligence” rule
 Legal standard of care xn
 Injurer is liable for damages if precaution level was below
the legal standard of care


x < xn  D = A
x  xn  D = 0
 So on our graph from before, private cost to injurer is…


wx + p(x) A
wx
for x < xn
for x  xn
68
Rule 3: Simple Negligence
Injurer precaution
$
Private cost to injurer
wx + p(x) A
wx
p(x) A
xn = x*
x
 Private cost is wx + p(x) A if x < xn, only wx otherwise
 If standard of care is set efficiently (xn = x*), injurer
minimizes private cost by taking efficient precaution
69
Rule 3: Simple Negligence
Victim precaution
 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)
wx + p(x) A
wx
p(x) A
x*
70
Effect of liability rules on precaution
No Liability
Strict Liability
Simple Negligence,
with xn = x*
Victim
precaution
Injurer
precaution
Efficient
Zero
Zero
Efficient
Efficient
Efficient
71