Econ 522
Economics of Law
Dan Quint
Fall 2010
Lecture 17
Logistics
 Midterm on Wednesday, in 272 Bascom
 HW3 (and solutions) returned today
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The story so far
2
The story so far…
 Precaution – costly actions that reduce the likelihood of an
accident
 Activity – how much a “dangerous” activity is done
 Effects of different liability rules on precaution and activity
levels
3
Accidents between strangers…
 Strict liability…



Injurer internalizes cost of accidents he causes
Efficient precaution and efficient activity by injurers
Victim is “fully insured” – too little precaution, too much activity
 Simple negligence…



Injurer takes required level of care to avoid liability – efficient injurer
precaution
Injurer is then “safe” – too much activity
Victim bears residual risk of accidents – efficient precaution,
efficient activity
 Other negligence rules – similar to simple negligence
4
Accidents between strangers
take precaution only
to AVOID liability
precaution is efficient, but
activity level is too high
Injurer
Precaution
Victim
Precaution
Injurer
Activity
Victim
Activity
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
No Liability
5
Accidents between strangers
precaution and activity level
are both efficient
to reduce accidents,
since he bears their cost
Injurer
Precaution
Victim
Precaution
Injurer
Activity
Victim
Activity
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
No Liability
6
When injurer is a business…
 Strict liability…



Injurer takes efficient precaution to minimize costs
Perfect competition  “residual risk” built into price of good/service
Customers internalize risk through price, demand efficient amount
of good/service – whether or not they’re the ones at risk, whether or
not they understand risk
 Simple negligence…



Injurer takes efficient precaution to avoid liability
“Residual risk” not built into price
Customers demand too much of good/service if they’re not the one
at risk, or if they don’t perceive risks
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When injurer is a business and victim is not
customer
Injurer
Precaution
Injurer
Activity
Simple Negligence
Efficient
Too High
Strict Liability
Efficient
Efficient
8
When injurer is a business and victim is its
customer
Strict Liability
Negligence
No Liability
Risk
Perception?
Seller
Precaution
Buyer
Activity
Yes
Efficient
Efficient
No
Efficient
Efficient
Yes
Efficient
Efficient
No
Efficient
Too High
Yes
Efficient
Efficient
Average
None
Efficient
No
None
Too High
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Due Care and
the Hand Rule
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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







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 mooring lines to free barge, adjustment done
incorrectly, one barge broke loose, collided with ship, sank
Barge owner sued tug owner, saying his employees were negligent
Tug owner claimed barge owner was also negligent for not having
an agent on board to help
Question: was it negligent to not have a “bargee” on board?
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“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.”
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“The Hand Rule”
 Failure to take a precaution constitutes negligence if
B
<
LxP
cost of precaution
cost of accident
probability of accident
 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.”
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“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
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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 bestpractices
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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
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Effect of Errors
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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?
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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”
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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
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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
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Effect of errors and uncertainty under strict
liability
$
wx + p(x) D
p(x) D
wx + p(x) A
wx
p(x) A
x
x*
Precaution (x)
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Effect of errors and uncertainty under strict
liability
 Under strict liability:

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
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What about under a negligence rule?
$
wx + p(x) D
wx + p(x) A
p(x) D
wx
p(x) A
xn = x*
x
 Under a negligence rule, small errors in damages have no
effect on injurer precaution
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What about errors in setting xn?
$
wx + p(x) A
wx
p(x) A
xn
x*
xn
x
 Under a negligence rule, injurer’s precaution responds
exactly to systematic errors in setting the legal standard
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What about random errors in setting xn?
$
wx + p(x) A
wx
p(x) A
x* x
x
 Under a negligence rule, random errors in the legal
standard of care lead to increased injurer precaution
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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 27
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
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Does it all
matter?
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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
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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
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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.”
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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.”
33
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.”
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Relaxing the
assumptions
of our model
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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
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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
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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
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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
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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”
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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
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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
42
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
43
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
44
Assumption 4: No insurance
 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
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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
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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!
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