Econ 522
Economics of Law
Dan Quint
Spring 2011
Lecture 19
Logistics
 MT2 graded, will be returned today
 HW4 (last one) online – due Thurs April 28

Longer than last couple
 No class next Monday (April 18)
1
Last Wednesday’s
experiment
2
Experiment
You have been asked to serve on a jury on a lawsuit dealing with
personal injury. In the case before you, a 50-year-old construction
worker was injured on the job due to the negligence of his employer.
As a result, this man had his right leg amputated at the knee. Due to
this disability, he cannot return to the construction trade and has few
other skills with which he could pursue alternative employment.
The negligence of the employer has been firmly established, and
health insurance covered all of the related medical expenses.
Therefore, your job is to determine how to compensate this worker for
the loss of his livelihood and the reduction in his quality of life.
3
What were we trying to test?
Half of you were asked…
The other half were asked…
(a) Should the plaintiff in this case be
awarded more or less than
$10,000?
(a) Should the plaintiff in this case be
awarded more or less than
$10,000,000?
(b) How much should the plaintiff
receive? (Please give a number.)
(b) How much should the plaintiff
receive? (Please give a number.)
(c)
(c) Are you male or female?
Are you male or female?
 The question: how much did the “suggestion” affect
answers to question (b)?
4
The results
50%
40%
30%
asked 10k
asked 10MM
20%
10%
0%
up to 100k
100k to
300k
300k to
900k
900k to
3MM
3MM to
9MM
more than
9MM
5
The results
Asked
$10,000
Asked
$10,000,000
Ratio
Average
727,750
6,244,444
8.6 x
Geometric Mean
282,367
2,728,640
9.7 x
10,000
400,000
25th Percentile
175,000
1,000,000
Median
300,000
2,250,000
75th Percentile
562,500
5,000,000
5,000,000
50,000,000
80%
11%
Smallest
Largest
Fraction < $1 MM
7.5 x
6
The results
50%
40%
30%
asked 10k
asked 10MM
20%
10%
0%
up to 100k
100k to
300k
300k to
900k
900k to
3MM
3MM to
9MM
more than
9MM
7
What does it mean?
 Nobody knows what a leg is worth
 “Reference point bias”
 “Framing effects”
8
Back to work…
9
Punitive
damages
10
Inconsistency of damages
 Damage awards vary greatly across countries, even across
individual cases
 We saw last week:

As long as damages are correct on average, random inconsistency
doesn’t affect incentives (under either strict liability or negligence)
 But, if appropriate level of damages isn’t well-established,
more incentive to spend more fighting
11
Punitive damages
 What we’ve discussed so far: compensatory damages

Meant to “make victim whole”/compensate for actual damage done
 In addition, courts sometimes award punitive damages


Additional damages meant to punish injurer
Create stronger incentive to avoid initial harm
 Punitive damages generally not awarded for innocent
mistakes, but may be used when injurer’s behavior was
“malicious, oppressive, gross, willful and wanton, or
fraudulent”
12
Punitive damages
 Calculation of punitive damages even less well-defined
than compensatory damages
 Level of punitive damages supposed to bear “reasonable
relationship” to level of compensatory damages


Not clear exactly what this means
U.S. Supreme Court: punitive damages more than ten times
compensatory damages will attract “close scrutiny,” but not explicitly
ruled out
13
Example of punitive damages: Liebeck v
McDonalds (1994) (“the coffee cup case”)
 Stella Liebeck was badly burned when she spilled a cup of
McDonalds coffee in her lap
 Awarded $160,000 in compensatory damages, plus $2.9
million in punitive damages
 Case became “poster child” for excessive damages, but…
14
Liebeck v McDonalds (1994)
 Stella Liebeck dumped coffee in her lap while adding
cream/sugar



Third degree burns, 8 days in hospital, skin grafts, 2 years treatment
Initially sued for $20,000, mostly for medical costs
McDonalds offered to settle for $800
 McDonalds serves coffee at 180-190 degrees




At 180 degrees, coffee can cause a third-degree burn requiring skin
grafts in 12-15 seconds
Lower temperature would increase length of exposure necessary
McDonalds had received 700 prior complaints of burns, and had
settled with some of the victims
Quality control manager testified that 700 complaints, given how
many cups of coffee McDonalds serves, was not sufficient for
McDonalds to reexamine practices
15
Liebeck v McDonalds (1994)
 Rule in place was comparative negligence






Jury found both parties negligent, McDonalds 80% responsible
Calculated compensatory damages of $200,000
times 80% gives $160,000
Added $2.9 million in punitive damages
Judge reduced punitive damages to 3X compensatory, making total
damages $640,000
During appeal, parties settled out of court for some smaller amount
 Jury seemed to be using punitive damages to punish
McDonalds for being arrogant and uncaring
16
What is the economic purpose of punitive
damages?
 We’ve said all along: with perfect compensation, incentives
for injurer are set correctly. So why punitive damages?
 Example…







Suppose manufacturer can eliminate 10 accidents a year, each
causing $1,000 in damages, for $9,000
Clearly efficient
If every accident victim would sue and win, company has incentive to
take this precaution
But if some won’t, then not enough incentive
Suppose only half the victims will bring successful lawsuits
Compensatory damages would be $5,000; company is better off
paying that then taking efficient precaution
One way to fix this: award higher damages in the cases that are
brought
17
This suggests…
 Punitive damages should be related to compensatory
damages, but higher the more likely injurer is to “get away
with it”




If 50% of accidents will lead to successful lawsuits, total damages
should be 2 X harm
Which requires punitive damages = compensatory damages
If 10% of accidents lead to awards, damages should be 10 X harm
So punitive damages should be 9 X compensatory damages
 Seems most appropriate when injurer’s actions were
deliberately fraudulent, since may have been based on costbenefit analysis of chance of being caught
18
Some empirical observations
about tort system in the U.S.
19
U.S. tort system
 In 1990s, tort cases passed contract cases as most
common form of lawsuit


Most handled at state level: in 1994, 41,000 tort cases resolved in
federal courts, 378,000 in state courts in largest 75 counties
Most involve a single plaintiff (many contract cases involve multiple
plaintiffs)
 Among tort cases in 75 largest U.S. counties…




60% were auto accidents
17% were “premises liability” (slip-and-fall in restaurants,
businesses, government offices, etc.)
5% were medical malpractice
3% were product liability
20
U.S. tort system
 Punitive damages historically very rare



1965-1990, punitive damages in product liability cases were
awarded 353 times
Average damage award was $625,000, reduced to $135,000 on
appeal
Average punitive damages only slightly higher than compensatory
 In many states, punitive damages limited, or require higher
standard of evidence


Civil suits generally require “preponderance of evidence”
In many states, punitive damages require “clear and convincing”
evidence
21
U.S. tort system
 Medical malpractice



New York study in 1980s: 1% of hospital admissions involved
serious injury due to negligent care
Some estimates: 5% of total health care costs are “defensive
medicine” – procedures undertaken purely to prevent lawsuits
Some states have considered caps on damages for medical
malpractice
22
U.S. tort system
 Product liability

Recent survey of CEOs: “liability concerns caused 47% of those
surveyed to drop one or more product lines, 25% to stop some
research and development, and 39% to cancel plans for a new
product.”
 Liability standard for product-related accidents is “strict
products liability”




Manufacturer is liable if product determined to be defective
Defect in design
Defect in manufacture
Defect in warning
23
Vaccines
 Most vaccines are weakened version of disease itself



Make you much less likely to acquire the disease
But often come with very small chance of contracting disease
directly from vaccine
Sabin polio vaccine wiped out polio, but caused 1 in 4,000,000
people vaccinated to contract polio
 1974 case established maker had to warn about risk



Since then, some people were awarded damages after their
children developed polio from vaccine
If liability can’t be avoided, built into cost of the drug
And discourages companies from developing vaccines
24
Mass torts
 Since health risks of asbestos understood, over 600,000
people have brought lawsuits against 6,000 defendants
 DES (drug administered to pregnant women in 1950s)


Impossible to establish which firm produced dose given to a
particular woman
California Supreme Court introduced “market share liability”
 Class action lawsuit




Small, dispersed harms – no plaintiff might find it worthwhile to sue
Class action suits allow large lawsuits with lots of plaintiffs
Give more incentive for precaution against diffuse harms
But…
25
Cooter and Ulen’s overall assessment of
U.S. tort system
 Critics claim juries routinely hand out excessive awards
and tort system is out of control…
 …but actually it functions reasonably well
 Outside of occasional, well-publicized outliers, damage
awards are generally reasonable…
 …and liability has led to decreases in accidents in many
industries
26
To wrap up tort law, a funny story from
Friedman…
“A tort plaintiff succeeded in collecting a large damage judgment.
The defendant’s attorney, confident that the claimed injury was
bogus, went over to the plaintiff after the trial
and warned him that if he was ever seen out of his wheelchair
he would be back in court on a charge of fraud.
The plaintiff replied that to save the lawyer the cost of having
him followed, he would be happy to describe his travel plans.
He reached into his pocket and drew out an airline ticket –
to Lourdes, the site of a Catholic shrine famous for miracles.”
27
The legal
process
28
Over the last 2 ½ months, we have…
 Developed theories of property/nuisance law, contract law,
and tort law
 Looked at how rules of legal liability create incentives
 Thought about how these rules can be chosen to try to
achieve efficient outcomes
29
Over the last 2 ½ months, we have…
 To achieve efficiency, we’ve generally tried to set a party’s
liability equal to the harm he caused someone else




Damages in nuisance law
Expectation damages in contract law
Compensatory damages in tort law
That way, he internalizes the externality he imposes, leading to
efficient decisions
 In doing this, we’ve been making two big assumptions:


The legal system works flawlessly
The legal system costs nothing
30
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
31
An example from Polinsky, “An Introduction
to Law and Economics”
 So…


Going to trial gains you $5,000 (in expectation)
Going to trial costs me $11,000 (in expectation)
 Maybe we can settle out of court


If we avoid going to court and I pay you any settlement between
$5,000 and $11,000, we’re both better off
So maybe this happens
 But…
32
An example from Polinsky, “An Introduction
to Law and Economics”
 Suppose I’m more pessimistic about my chances than you


You think I’m 80% likely to be found liable
I think I’m 90% likely to be found liable
 You think your expected gain is $8,000 – 3,000 = $5,000
 I think my expected cost is $9,000 + 3,000 = $12,000
 Now the range of possible settlements is even wider


Any settlement between $5,000 and $12,000 is a Paretoimprovement over going to trial
So settling is more likely
33
An example from Polinsky, “An Introduction
to Law and Economics”
 Now instead, suppose I’m more optimistic about my
chances than you


You think I’m 80% likely to be found liable
I think I’m only 10% likely to be found liable
 You think your expected gain is $8,000 – 3,000 = $5,000
 I think my expected cost is $1,000 + 3,000 = $4,000
 Now an out-of-court settlement is impossible

There are no settlements that you and I would both agree to
34
An example from Polinsky, “An Introduction
to Law and Economics”
 And, even if our beliefs are compatible and there are
settlements that we would both prefer to trial…
 …private information might lead to failure to reach a
settlement

Remember from before: if our threat points are private
information, we might fail to reach an agreement because each of
us is holding out for too big a share
 So even if we had the same beliefs about what will happen
at trial, private information could prevent settlement
35
An example from Polinsky, “An Introduction
to Law and Economics”
 So when litigation is costly…




If the two parties agree on the likely outcome of a trial, there are
gains from settling out of court, and a range of settlements they
would both prefer to going to trial
If the two parties are relatively pessimistic, settlement is even
more likely
If the two parties are relatively optimistic, settlement may be
impossible
Even if the two have the same beliefs or are relatively pessimistic,
private information may lead to failures in bargaining
36
So what?
 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 settlement talks break down and cases go to trial…
…then total social cost of an accident includes 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!
37
The legal
process
38
The legal process
 Once an accident has happened…

Victim could sue or not sue

The victim and injurer might quickly settle out of court

If the case proceeds to trial, the first step (in the U.S.) is a pre-trial
exchange of information

After that, victim and injurer might still settle out of court

If the case goes to trial, victim (now plaintiff) might win or lose

Losing side at trial can choose to appeal (or not)
39
The goal of the legal process
 Tort law: efficiency meant minimizing the total social cost
of accidents


Actual cost of accidents
Plus cost of actions taken to prevent them (precaution)
 Goal of the legal process: minimize its social costs


Direct (administrative) costs
Error costs
40
Administrative costs and error costs
 Administrative costs


Hiring judges, building courthouse, paying jurors…
More complex process  higher cost
 Error costs





Any legal process is imperfect
Errors are any judgments that differ from theoretically perfect ones
An error in computing damages after the fact only affects
distribution, not efficiency
But anticipated errors affect incentives, which may lead to
actions which aren’t efficient
Error costs are costs of distortions in actions people take
(precaution, activity levels, etc.) due to flaws in legal system
41
The goal of the legal process
 So theoretically, the efficient legal process is the one that
minimizes the sum of…

The direct costs of administering the system, and

The economic effects of errors due to that process not being
perfect
42
Midterm
 Nice job!
 Mean and median 84, std dev 8
 Again, not actually assigning letter grades till after final…
 …but to have an approximate idea of where you stand, for
the scores on this exam, I’d think of…
70s
roughly C or BC
80s
roughly B
88+
roughly AB or A
A-G
H-P
Q-Z
43