Econ 522 – Lecture 18 (Nov 13 2008)
Over the last three lectures…






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
Two points I didn’t get to last time:






Cooter and Ulen talk a bit about the different costs of administering different
liability systems
Obviously, it’s simpler to prove just harm and causation than to prove harm,
causation, and negligence
So once a case goes to court, we expect the administrative costs to be higher
under a negligence rule than under strict liability. (More time spent, more
witnesses, etc.)
On the other hand, under a negligence rule, many victims will know they have no
case, and therefore not bring a lawsuit at all; under a strict liability rule, every
accident victim is entitled to damages, so there will be more lawsuits
So strict liability will lead to more cases, but easier cases.
(Obviously, a rule of no liability leads to lower administrative costs than either,
since there’s no work to be done.)
-1-



C and U also point out the tradeoff between rules (such as the legal standard of
care) which are tailored to individual situations, versus broad, simple rules that
apply to many situations
As we’d expect, broad, simple rules are cheaper to create and enforce, but will not
create perfect incentives in every situation; more specific, detailed, “tailored”
rules will be more costly to create and enforce, but will create more efficient
incentives.
(In addition, there is the question of who bears some of these administrative costs.
In some countries, victims who win at trial also have their legal expenses paid by
the injurer; in the U.S., this tends not to be the case.)
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:

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.)
-2-
Schwartz has a funny line toward the end of the paper. He argues that since people do
not respond as precisely to incentives as the model predicts, we shouldn’t spend so much
time trying 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 not work, that simple rules start to make
more sense. He looks at the example of worker’s compensation in the United States.
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 steps that employers can take, and also many things
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.”
Many of the objections Schwartz points out in his paper – 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:
1.
2.
3.
4.
Decision-makers are rational
There are no regulations in place beyond the liability rule
There is no insurance
Injurers pay damages in full (for example, they can’t run out of money and go
bankrupt)
5. Litigation costs are zero
We can relax each of these assumptions in turn, and see what effect this should have.
-3-
Assumption 1. Rationality
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 classic 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 lots of
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
-4-
be well. But if irrational consumers underestimate chainsaw risk, this would lead to too
many accidents.
On the other hand, a strict liability rule (along with the manufacturer knowing that its
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.
-5-
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.
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 regulation, which is the third extension we
consider.
-6-
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 strict 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
-7-

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 also 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.
-8-



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 again the difference 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.
-9-
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, it skews the incentives
in both 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
additional 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 last 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.
- 10 -
Cooter and Ulen 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 through either 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:
- 11 -
“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, which is good, since the patient would have no idea
what had happened while he was unconscious
- 12 -





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.
- 13 -




Note that we’ve now seen three different types of uncertainty relating to the legal
standard of care.
There were errors in setting 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~.
Just like random errors in setting x~, uncertainty in finding liability will cause a
“smoothing out” of the discontinuity in expected costs under a negligence rule
Recall the expected total cost of accidents to an injurer under a negligence 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 negligence rule, and would typically lead lead
to over-precaution.
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.)
- 14 -