Econ 522
Economics of Law
Dan Quint
Spring 2010
Lecture 18
Logistics
 Midterm 2 will be returned today
 HW 3 is online – due Friday April 30
 Highly recommend skydiving problem from old exam as
practice of incentives we’ve looked at last two lectures
 Today:




Results of Monday’s experiment
How is standard of care determined?
A reality check
Effect of errors, what happens when our assumptions are violated
1
Results of
Monday’s experiment
2
Tuesday’s 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 did you all say a leg was worth?
10
9
8
7
6
5
4
3
2
1
0
less than
100,000
100,000 to
249,999
250,000 to
499,999
500,000 to
999,999
1,000,000 to
1,999,999
2,000,000 to
3,999,999
4,000,000 to
5,999,999
at least
6,000,000
4
What were we actually 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)?
5
So, how much did question (a) affect your
answers to question (b)?
9
8
7
6
5
asked $10k
asked $10MM
4
3
2
1
0
less than
100,000
100,000 to
249,999
250,000 to
499,999
500,000 to 1,000,000 to 2,000,000 to 4,000,000 to
999,999
1,999,999
3,999,999
5,999,999
at least
6,000,000
6
Or to put it another way…
Asked
$10,000
Sample Size
Asked
$10,000,000
Ratio
23
21
Average
798,041
3,919,048
4.9 x
Geometric Mean
165,461
2,381,247
14.4 x
0
250,000
87,500
1,000,000
200,000
3,000,000
75th Percentile
1,000,000
5,000,000
Largest
5,000,000
20,000,000
Smallest
25th Percentile
Median
15 x
7
But the picture’s so cool, I’ll show it again
9
8
7
6
5
asked $10k
asked $10MM
4
3
2
1
0
less than
100,000
100,000 to
249,999
250,000 to
499,999
500,000 to 1,000,000 to 2,000,000 to 4,000,000 to
999,999
1,999,999
3,999,999
5,999,999
at least
6,000,000
8
And another version…
16
14
12
10
asked $10k
8
asked $10MM
6
4
2
0
less than 500,000
500,000 to 3,999,999
at least 4,000,000
9
What does it mean?
 Nobody knows what a leg is worth
 “Reference point bias”
 “Framing effects”
10
Back to work…
11
So far…
 We’ve discussed a bunch of liability rules



No liability
Strict liability
Various versions of a negligence rule
 And the effect of each rule on several incentives:




Injurer precaution
Victim precaution
Injurer activity level
Victim activity level
 Negligence rule requires court to specify a standard of care

Next topic: how is this determined?
12
Due Care and
the Hand Rule
13
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?
14
“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.”
15
“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.”
16
“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
17
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
18
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
19
Effect of Errors
20
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?
21
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”
22
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
23
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
24
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)
25
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
26
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
27
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
28
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
29
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 30
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
31
Does it all
matter?
32
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
33
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
34
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.”
35
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.”
36
Relaxing the
assumptions
of our model
37
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
38
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
39
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
40
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
41
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”
42
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
43
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
44
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
45
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
46
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
47
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
48
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!
49
Second Midterm
50
Midterm
 A little harder than first one
 Mean 79, median 81
 Again, not actually assigning letter grades till after final…
 …but to have an approximate idea of where you stand…
85+
roughly AB or A
75-85
roughly B
65-75
roughly BC
55-65
roughly C
A-H
I-P
Q-Z
51