Econ 522 – Lecture 19 (Nov 12 2007)
Over the last three lectures…
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we introduced the notion of torts, and several possible rules for when an injurer is
held liable for the harm he caused
we introduced the notion of precaution – costly actions the injurer (or the victim)
could take to reduce the likelihood of an accident – and examined the incentives
for precaution created by various liability rules
we introduced the notion of activity level (which can also be thought of as
unobservable precaution), and the incentives created by the various liability rules
negligence rules must be accompanied by a legal standard for how much care or
precaution is required to avoid negligence; we discussed the rule put forward by
Judge Learned Hand, which held that precaution is required as long as it is costjustified, that is, efficient
and we looked at the effects that errors, both systematic and random, would have
on the incentives each liability rule gives
finally, we re-examined the questions of precaution and activity levels in a market
setting, where expected liability losses would factor into the price of a product,
and considered the outcomes when customers had differing abilities to perceive
the riskiness of their choices
Given all the time that we’ve just spent developing a formal economic model and
examining its implications, I think it’s fair to step back a bit and ask the question: does
the model work? That is, is there any evidence from the real world that a choice of
liability rule affects peoples’ behavior in the way the model predicts? The usual
assumption we make in economics is that if you make something more costly, people will
do less of it. But when people get in their cars, do they really think about the amount
they will have to pay in the event of an accident when deciding how fast and how far to
drive? Do people really think about liability rules when deciding whether to get in a bar
fight?
This is exactly the question (not the bar fight question, the more general question)
addressed in the paper by Gary Schwartz, “Reality in the Economic Analysis of Tort
Law: Does Tort Law Really Deter?” He reviews a wide range of empirical studies in
different areas of tort law, and comes to the following, not that startling conclusion:
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Tort law does affect peoples’ behavior in the direction the economic model
predicts, but not as much as a literal reading of the model would suggest
He points out that most of the academic work prior to that point was either implicitly
assuming that people behaved exactly as in the model; or pointing out various critiques of
the model, and reasons why liability rules would not impact behavior at all; but that the
truth lay somewhere in between.
(One of the obvious ways in which the model is “wrong”: the model suggests that, under
a negligence rule, injurers will always take the mandated level of care – that is, there will
never be any negligence! And yet there are lots of studies showing that negligence is
rampant – in auto accidents, in medical malpractice, and in other areas. Nonetheless,
studies in a variety of industries show that a greater degree of liability does lead to greater
overall levels of precaution.)
Schwartz has a funny line toward the end of the paper, where he argues that since people
do not respond as precisely to incentives as the model predicts, we should put aside
efforts to “fine-tune” the law to achieve perfection:
“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 fine-tuning.”
He also points out, since “fine-tuning” may be impossible, that simple rules start to make
more sense. He looks at the example of worker’s compensation in the U.S. Worker’s
compensation holds the employer liable (whether or not he was negligent) for the
economic costs of on-the-job accidents, while leaving the victim bearing all noneconomic costs such as pain and suffering. Schwartz argues:
“Analyzed in incentive terms, this regime of “shared strict liability” takes for
granted that there are many stpes that employers can take, and also many thigns
that employees can do, to reduce the work accident rate. Yet workers’
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.”
Next week, we’ll hopefully come back to Schwartz’s assessment of the effects of liability
law in various particular areas.
Many of the objections Schwartz points out – reasons that people may not respond to
liability laws in the way the “standard model” predicts – can be seen as violations of what
Cooter and Ulen refer to as the “core assumptions” of the model. Specifically, the model
as we’ve explained it so far assumes:
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Decision-makers are rational
There are no regulations in place beyond the liability rule
There is no insurance
Injurers are solvent and pay damages in full
Litigation costs are zero
We can relax each of these assumptions in turn, and see what effect this should have.
Cooter and Ulen give two examples of ways in which the rationality assumption may be
violated.
The first is on the basis of a growing literature in behavioral economics that says that
many people systematically misperceive the value of probabilistic events. That is, a
number of experiments have shown that when people evaluate probabilistic events, they
make choices that are not compatible with the usual expected-utility framework.
(One clear example of this comes from a classic paper by Daniel Kahneman and Amos
Tversky, called “Prospect Theory: An Analysis of Decision under Risk.” They found
that given a choice between a 45% chance at $6,000 and a 90% chance at $3,000, most
(86%) of their sample chose the latter; but given a choice between a 0.1% chance of
$6,000 and a 0.2% chance of $3,000, most (73%) chose the former. Under the standard
expected-utility setup, either u(6000) is twice as high as u(3000) or it’s not; here, people
were clearly doing something other than maximizing expected utility; and it seems to do
not with how they evaluate the value of money, but how they evaluate probability.)
(More recent work by the same authors – cited in the textbook – argues that people tend
to overestimate the likelihood of events with well-publicized, catastrophic results, like
accidents at nuclear power plants – the resulting panic makes the few that occur stick in
peoples’ minds, so they imagine them to be more frequent than they actually are.)
(There’s also a chapter in Freakonomics about how people fixate on the “wrong” risks –
that is, people freak out about very unlikely events (leading, say, to regulations about
flame-retardant childrens’ pajamas), while ignoring much more likely risks that seem
more commonplace, such as swimming pool accidents.)
All these examples build the case that maybe people don’t make perfectly rational
expected-gain tradeoffs the way we expect them to. Given that, we wouldn’t expect
people to correctly trade off the expected incremental cost of probabilistic accidents,
– p(x)’ A, against the certain cost of increased precaution, w.
Cooter and Ulen consider the implications of this in a setting of bilateral precaution,
accidents with power tools. Power tools can be designed to be safer, and they can be
used more cautiously. However, suppose consumers underestimate the likelihood of a
power tool accident. (People assume that any product on the market must be very safe,
so they exercise no caution whatsoever.)
A negligence rule with a defense of contributory negligence is common for product
liability. This would lead chainsaw companies to design chainsaws that are perfectly safe
(or at least, efficiently safe) as long as they are not used negligently. Under perfect
rationality, this would lead consumers to take efficient care in using them, and all would
be well. With irrational consumers who underestimate chainsaw risk, this would lead to
too many accidents. On the other hand, a strict liability rule (along with the knowledge
that consumers will be negligent) will lead chainsaw manufacturers to design even safer
chainsaws, which are less likely to cause accidents even when used recklessly; in a world
with irrational consumers, this is a good thing.
(Of course, this is almost completely analogous to the ridiculous-sounding example we
used a few days ago, of forcing car manufacturers to design seatbelts that buckle
themselves. Oh, well.)
The second type of irrationality Cooter and Ulen consider is unintended lapses, that is,
accidental negligence. Rather poetically, they point out that “many accidents results from
tangled feet, quavering hands, distracted eyes, slips of the tongue, wandering minds,
weak wills, emotional outbursts, misjudged distances, or miscalculated consequences,”
all of which they summarize as “lapses”. That is, people try to exercise due care, but
once in a while, they fail.
The example they give is from a world without cruise control. The speed limit on a road
is 70, and so driving faster than that constitutes negligence. A driver intends to drive 65,
but from time to time his mind wanders and he looks down to find himself driving 73. If
one of these times, he’s in an accident, he’s liable.
(On the other hand, a driver who sets out to drive 75, but mistakenly finds himself doing
67 when he hits someone, is not liable, obviously.)
Cooter and Ulen’s discussion here is weirdly moralistic – they seem to take the position,
both that speeding is somehow immoral, and that “not wanting to speed” is somehow
more important than actually not speeding. They point out that a driver who realizes he
may occasionally lapse will rationally target a level of precaution higher than the legal
standard, to lessen the frequency of these lapses taking him below the legal standard x~.
(This is exactly the same effect as the overprecaution we expect as a result of random
uncertainty about the exact legal standard.)
As they point out, however, a liability rule that required intentional negligence, rather
than accidental negligence, would be almost impossible to enforce – proving intent is
even harder than proving negligence, which was already harder than proving harm and
causation – and would likely lead to most injurers avoiding liability altogether, leading to
no incentives for precaution. They give the rather creepy notion that GPS in cars will
eventually allow us to distinguish the habitual speeder from the “accidental” speeder, and
then move on.
We’ll go out of order and consider bankruptcy next.
We’ve said all along that strict liability causes an injurer to internalize the expected harm
done by accidents, leading to efficient precaution.
However, consider a situation in which a firm’s liability is more than its net worth, that
is, more than the total value of the company. The firm has no way to come up with the
damages owed; so it declares bankruptcy. Thus, bankruptcy places a limit on the
damages that can be paid.
But if the damages that will actually be paid are less than the actual harm, then the firm is
not internalizing the full cost of accidents; as a result, the firm will take inefficiently little
precaution.
The book considers the example of a hazardous waste disposal company. If the company
intends to stay in business forever, it will be very careful in transporting hazardous waste,
in order to avoid accidents/liability. On the other hand, it might take a different strategy:
dump recklessly, earn short-term profits, pay them out to shareholders, remain
undercapitalized, and expect to go bankrupt once an accident occurs and someone sues.
Aside from limiting liability, bankruptcy also has a social cost, since the intangible assets
of the company – its reputation, its employees’ firm-specific knowledge – are destroyed.
Larger companies that want to engage in a risky activity can form a separate subsidiary
company to do this business, limiting liability to that entity. Courts rarely reach past a
subsidiary into a parent company for payment of damages. (Some think courts should,
and some companies have begun to behave as if they will.)
An injurer whose liability is limited by bankruptcy is referred to as being “judgmentproof”, that is, they are immune to judgments beyond a certain level. (We’ll return to this
concept later.) There is no perfect solution to the distortions that this causes, but there are
some ways to reduce them, one of which is the next situation we consider.
The next extension they consider to the “standard” model is of settings which are
governed by both a liability rule and safety regulations. For example, fire regulations
may require a store to have a working fire extinguisher, and fines may be issued to stores
that, upon inspection, fail to meet regulations; but if a fire in the store injures a customer,
the store may still be liable.
Rather than give a general model of how liability and regulation interact, Cooter and
Ulen discuss a few determinants of the plusses and minuses of each.
Administrators who regulate only a single industry can acquire the detailed technical
knowledge needed to set safety standards efficiently, while a court might have trouble
acquiring this level of knowledge on a wide range of industries. In these settings, courts
can adopt the legal standard set by safety regulators; with both standards set the same,
“potential injurers will conform to that standard in order to avoid both ex ante fines and
ex post liability.”
However, they give arguments why a court may feel industry regulators might set safety
standards either too high or too low.
 If regulators are susceptible to political pressure from powerful firms, safety
standards might be set too low to help them avoid liability
 On the other hand, corrupt regulators might set standards too high, to ensure that
bribing them would be cheaper for businesses than complying with the rules
 Standards could also be set high to protect incumbent firms from new competition
Thus, courts may choose to deviate from regulated safety levels in setting the legal
standard for care. When safety regulations and liability law impose different standards,
firms will tend to follow the higher standard, to avoid both liability and fines.
As we just saw, when liability exceeds an injurer’s total wealth, the injurer goes
bankrupt, but cannot be held liable for the full amount of the harm. In settings where
damages would bankrupt a firm, expected damage payments would be lower than p(x)A,
since damages would be limited to an amount less than A. This would lead to
insufficient precaution under a liability rule. However, regulations which hold a firm to
the efficient level of care avoid this problem, since large fines could be assessed to firms
in violation of safety standards before an accident occurs. Thus, in industries where
severe accidents are likely to bankrupt firms, safety regulation may work better than
liability in encouraging precaution.
Regulation may also be better than liability when accidents impose only a small harm on
a large group of people: since going to trial is costly, it may not be worth it for victims
suffering only a small harm, and firms might escape liability because nobody finds it
worthwhile to sue. (Class action lawsuits get around this problem – we’ll get to that
later.) In these cases, liability alone might also lead to insufficient precaution, while
regulation can enforce the efficient level of care.
Going back to the fundamental assumptions we’ve been making in tort law… If I drive
more carefully, I cause fewer accidents. If I face greater liability when I cause accidents,
I choose to drive more carefully.
On the other hand, if I have insurance that covers me when I cause accidents, then the
liability rule chosen may not affect me, only my insurance company.
The third assumption we made in the original model was that either the victim or the
injurer bears the cost of the accident – that is, neither side has insurance.
In reality, the victim might buy insurance for harm caused by accidents, and the injurer
might buy insurance to cover his liability.
Insurance may not be complete. The victim’s car insurance may include a deductible (the
insurer doesn’t pay the first $500 of damage), coinsurance or copayment (the insurer pays
some fraction of damage rather than the full amount), and coverage may only be for
tangible losses, not all damage. The injurer’s liability insurance may also be incomplete
– in addition to deductibles or coinsurance, an accident may cause his future premiums to
go up, so the injurer is not completely insulated from the cost of the accident.
If both sides had complete insurance, then neither the injurer nor the victim would bear
the cost of accidents: the injurer’s liability would be covered by insurance; the victim
would recover the full amount of his losses; and the two insurance companies would fight
it out between them for who bears the costs.
Insurance companies take in revenues, in the form of premiums; and they pay out claims
and administrative costs. If insurance markets are perfectly competitive, then profits will
be 0; premiums will exactly balance (on average) claims plus other costs. Earlier, we
described the goal of tort law as minimizing the sum of the cost of accidental harm, the
cost of preventing accidents, and the costs of administration. Translated into a world
with insurance, this becomes…
In a system of universal insurance and competitive insurance markets, the goal of tort
law can be described as minimizing the total cost of insurance to policyholders.
(The costs of precaution seem to have vanished from this formulation, but with perfect
insurance, neither side has any incentive to take precautions.)
Consider the different between no-liability and strict liability. Under no liability, injurers
have no need for insurance, and victims buy accident insurance. Under strict liability,
injurers buy liability insurance and victims have no need for insurance.
Considering which one is more efficient basically recasts our earlier analysis on tort law
incentives in terms of insurance.
Insurance reduces the incentives to take precaution. In insurance, this is referred to as
moral hazard. (If I insure my car against theft, I don’t worry as much about where I park
it.) Insurance companies have lots of ways to reduce moral hazard, mostly ones we’ve
already mentioned – deductibles, coinsurance, and making a customer’s premiums
depend on his past driving performance. Nonetheless, insurance clearly leads to lower
levels of precaution.
To deal with this, liability insurers may impose safety standards that policyholders must
meet. For example, a fire insurance company may require its customers to maintain fire
extinguishers. Like before with safety regulators, insurance companies can impose ex
ante standards – or, to put it in our terms, they can make even insured customers face
liability if they are negligent.
The book goes on for a while about insurance – trying to use insurance to argue whether
strict liability or no liability is better. They point out that in a strict liability world with
insurance, a manufacturer who makes a lot of defective products might find their
insurance rates going up over time, giving an incentive to reduce defects. In addition, if a
manufacturer buys liability insurance, the insurance company would have an incentive to
monitor the manufacturer and make sure they’re making safe products.
(They also mention two reasons the insurance industry is thought to be “unstable” – the
fact that correlated losses may exhaust reserves, and the problem of adverse selection.)
The final assumption Cooter and Ulen relax is the assumption that litigation costs
nothing. They point out that if litigation is costly on both sides, the two incentives move
in opposite directions.
If suing for damages is costly for victims, we would expect them to bring fewer suits; this
means more accidents would go “unpunished”, providing less incentive for precaution.
On the other hand, if being sued for damages is costly for injurers, this adds an addition
cost to the damages they expect to pay; this increases the incentives to avoid trial in the
first place by preventing the accident, leading to greater precaution.
They also give a funny example of how litigation costs could be reduced, if all we’re
concerned about is maintain the right incentives. Consider a world where any time
someone sues for damages, a coin is flipped. With probability ½, the case is dismissed
immediately, before the trial begins. With probability ½, the case goes to trial, and
whatever damages are deemed fair, they are doubled.
Beforehand, the injurer faces the exact same level of expected damages, and so he
behaves exactly the same. After the fact, however, we’ve reduced the number of costly
trials by 50%.
Obviously, this isn’t likely to happen. (In fact, a Virginia judge was removed from the
bench earlier this year for, among other things, deciding which parent would have
visitation rights for Christmas by coin flip. The judge apparently had other problems too,
though.) When we get to criminal law, we’ll look at the tradeoff between probability of
enforcement and severity of punishment, and the effect this has on criminal behavior.
Cooter and Ulen also discuss three other ways to complicate (or extend) our basic model.
The first of these is called vicarious liability: these are instances when someone is held
responsible for harm caused by someone else. One example of this is parents being held
liable for harm caused by their child; the most common version, however, is an employer
being held liable for harm caused by an employee.
The legal doctrine is referred to as respondeat superior, “let the master answer”.
Roughly, an employer will be held liable for unintentional torts of his employees if the
employee was “acting within the scope of his employment”. For example, I hire
someone to deliver packages in a company truck; he speeds, and causes an accident; I am
held liable. (If I hire someone to deliver packages and he goes quail hunting during his
lunch break and shoots another hunter, I am not liable; quail hunting is outside the scope
of his employment.)
Might have been before your time, but in the early 90’s, Domino’s had a thirty-minutesor-less guarantee or your pizza was free. A few accidents caused by speeding delivery
drivers, a few lawsuits finding Domino’s liable, end of the guarantee.
Obviously, a rule of respondeat superior gives employers incentives to take greater care
in who they hire, and what they assign them to do. If employers are better positioned to
make these decisions than employees, this may result in greater efficiency.
Vicarious liability can be implemented either through a strict liability or a negligence
rule. Under strict vicarious liability, an employer would be liable for any harms caused
by their employees. Under negligent vicarious liability, the employer is only liable if he
was negligent in supervising the employee.
Which rule is better depends on the situation. Proving negligence is always harder than
just proving harm and causation; if proving negligent supervision is too hard, then a rule
of vicarious liability is worthless, since it will never be successfully applied. The book
gives the example of a negligent nurse in a hospital; proving that the hospital was
negligent in supervising the nurse adequately might be nearly impossible, so negligent
vicarious liability would lead to no incentives for the hospital to supervise its staff
properly, while strict vicarious liability would lead the hospital to reduce accidents.
For an example favoring a negligence rule, the book gives the following example:
“A sailor on a tanker might negligently discharge oil onto a public beach at night.
Informing the authorities quickly about the accident will reduce the resulting
harm and the cost of the cleanup. The employer might be the only person besides
the sailor who knows that the harm occurred or who can prove that pollution came
from its ship. Strict vicarious liability gives the employer an incentive to remain
silent in the hope of escaping detection. In contrast, a rule of negligent vicarious
liability gives the employer an incentive to reveal the harm to the authorities
immediately in order to show that it carefully monitors its sailors.”
The next extension is joint and several liability. Suppose that you are injured in an
accident caused by two injurers. For example, a friend and I are drag-racing our cars, and
one of us hits you. Suppose the total harm done is $1,000.
We are jointly liable if you can sue both of us at once, naming us as co-defendants and
recovering $1,000 from us together.
We are severally liable if you can sue each of us separately. Several liability with
contribution is when each of us is only liable for a share of the damage, or your total
recoveries are limited to the total harm done. Several liability without contribution would
be if you could sue us each separately for the full $1000, but this is generally not allowed.
We are jointly and severally liable if you can sue either one of us for the full amount of
damages, $1,000. With contribution would mean that if you sued me and won $1,000, I
could then sue my friend to pay me back his share of it.
Joint and several liability holds under the common law in two situations:
1. The defendants acted together to cause the harm, or
2. The harm was indivisible, that is, it’s impossible to tell who was actually at fault.
(For example, the two hunters simultaneously shoot the third guy.)
There are several advantages to joint and several liability from the victim’s point of view.
First, the victim does not need to prove exactly who caused the harm. The book gives the
example of an anesthetized patient being injured during an operation; under joint and
several liability, he or she could sue anyone in the operating room at the time.
Joint and several liability also increases the victim’s chances of collecting the full level of
damages, because instead of going after the person most directly responsible for the
harm, he can go after the person most likely to be able to pay, that is, the one with the
deep pockets. For example, suppose an uninsured drunk driver blows a stop sign and hits
you. You claim that the driver and the state highway department are jointly responsible,
the driver for the obvious reasons, and the highway department because the stop sign was
not placed in the right location or did not use proper reflective paint. Under joint and
several liability, you need only convince the court that the state was 1% responsible, then
you could still recover 100% of damages from the state, leaving the state to try to recover
the other 99% from the driver. (Cooter and Ulen seem to push this as a good thing;
others argue this as a negative.)
Finally, Cooter and Ulen reconsider the rule of comparative negligence. For a long
time, negligence with contributory negligence was the dominant liability rule in most of
the common law countries. However, in the last 40 years, most states have adopted
comparative negligence for non-product-related accidents. (This has generally been done
by legislation, although in some cases by judicial decision.)
Under negligence with contributory negligence, a negligent victim could not collect any
damages, even if the injurer was negligent and even if his own negligence was very
minor in comparison. (The book gives the example of a car going 35 in a 30-mph zone
colliding with a car going 60.) Under a comparative negligence rule, if both parties were
negligent, the injurer owes damages in less than the full amount. Comparative
negligence is appealing from a fairness point of view – if both parties were responsible
for the accident, let both bear the costs, in proportion to their negligence.
However, our original model suggested that any liability rule led to the same efficiency
results, so in order to defend the move to contributory negligence on economic grounds,
we need to modify the original model in some way. Cooter and Ulen do this by
considering evidentiary uncertainty – the idea that there is uncertainty in how the court
will interpret evidence, and therefore whether the court will find a party negligent.
Note that we’ve now seen three different types of uncertainty relating to the legal
standard of care. There were errors in the standard of care, x~ (both systematic and
random); there were lapses, which led a party’s actual level of care to deviate from his
intended level; and now, even given a particular level of care x and standard x~, we are
introducing uncertainty as to whether the court will interpret the evidence correctly and
find the correct relationship between x and x~.
Uncertainty in the court’s interpretation of the evidence will cause a “smoothing out” of
the discontinuity in expected costs. Recall the expected total cost of accidents to an
injurer under a liability rule, as a function of precaution:
wx + p(x) A
wx
x~ = x*
precaution
Under evidentiary uncertainty, (DRAW IT)
This would be the case under any liability rule, and would typically lead lead to overprecaution. Cooter and Ulen argue that the effect would be less under contributory
negligence, because each party knows that even if they are found partly liable, the effect
would not be 100% liability, but only partial liability. Thus, they argue that contributory
negligence causes less overprecaution, and is therefore more efficient, when there is
evidentiary uncertainty.
(To be honest, I don’t find their argument all that convincing; I think that whether or not
contributory negligence is more efficient, courts like it because they are more
comfortable having the parties share the blame than have to assign either 100% or 0%
liability.)