Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 19
Midterm 2
Question 3a
“Explain why expectation damages
lead to efficient breach”
1
In this class, we generally ask two distinct
questions
What actions
would be efficient?
Social
Cost
vs.
Social
Benefit
What do we expect
people to actually do?
Private
Cost
vs.
Private
Benefit
Example: promisor’s decision to perform on contract
Promisor’s
cost of
performing




vs.
Promisee’s
benefit from
performance
Promisor’s
cost of
performing
vs.
Promisor’s
liability from
breach
Expectation damages: set promisor’s liability = promisee’s benefit
Or, make private benefit from performance = social benefit
Promisor “internalizes the externality” caused by breach
This way, promisor’s action matches the efficient one
2
In this class, we generally ask two distinct
questions
What actions
would be efficient?
Social
Cost
vs.
Social
Benefit
What do we expect
people to actually do?
Private
Cost
vs.
Private
Benefit
Another example: injurer precaution under strict liability
Cost of
injurer
precaution




vs.
Reduction in
expected
harm
Cost of
injurer
precaution
vs.
Reduction in
expected
liability
Strict liability + perfect compensation: injurer’s liability = actual harm
Again, private benefit from precaution = social benefit
Injurer internalizes the externality caused by accidents he causes
And so injurer’s level of precaution matches the efficient one
3
Back to work:
more twists on liability
4
Vicarious Liability
 Vicarious liability is when one person is held liable for
harm caused by another


Parents may be liable for harm caused by their child
Employer may be liable for harm caused by employee
 Respondeat superior – “let the master answer”
 Employer is liable for unintentional torts of employee if
employee was acting within the scope of his
employment
5
Vicarious Liability
 Gives employers incentive to...



be more careful who they hire
be more careful what they assign employees to do
supervise employees more carefully
 Employers may be better able to make these decisions
than employees…
 …and employees may be judgment-proof
6
Vicarious Liability
 Vicarious liability can be implemented through…


Strict liability rule: employer liable for any harm caused by
employee (as long as employee was acting within scope of
employment)
Negligence rule: employer is only liable if he was negligent in
supervising employee
 Which is better? It depends.


If proving negligent supervision is too hard, strict vicarious liability
might work better
But an example favoring negligent vicarious liability…
7
Joint and Several Liability
 Suppose you were harmed by accident caused by two
injurers
 Joint liability: you can sue them both together
 Several liability: you can sue each one separately

Several liability with contribution: each is only liable for his share
of damage
 Joint and several liability: you can sue either one for the
full amount of the harm

Joint and several liability with contribution: the one you sued
could then sue his friend to get back half his money
8
Joint and Several Liability
 Joint and several liability holds under common law
when…


Defendants acted together to cause the harm, or…
Harm was indivisible (impossible to tell who was at fault)
 Good for the victim, because…


No need to prove exactly who caused harm
Greater chance of collecting full level of damages

Instead of suing person most responsible, could sue person most likely
to be able to pay
9
Comparative Negligence
 Negligence with a defense of contributory negligence
was dominant liability rule in common law countries



Negligent injurer is liable, unless victim was also negligent
Example: a car going 60 mph hits a car going 35 in a 30-mph zone
Since victim was also negligent, injurer is not liable
 Last 40 years, most U.S. states have adopted a
comparative negligence rule

Usually through legislation, sometimes through judicial decision
 Appealing from fairness point of view
 But any negligence rule leads to efficient precaution
 So how do we explain the move?
10
Comparative Negligence and Evidentiary
Uncertainty
 Evidentiary uncertainty



Given a legal standard for negligence, xn…
…and an actual level of precaution taken, x…
still uncertainty in whether the court will find negligence
 Evidentiary uncertainty, like random errors in setting xn,
leads to over-precaution…
 …but comparative negligence partly mitigates this
11
Simple negligence,
evidentiary uncertainty
$
Comparative negligence,
evidentiary uncertainty
Any negligence rule
Comparative negligence and evidentiary
uncertainty
wx + p(x) A
wx
p(x) A
x*
x
 Comparative negligence mitigates effect of evidentiary
uncertainty
12
Perfect
Compensation
13
Perfect compensation
 Perfect compensatory damages (D = A)



Returns victim to original level of well-being
(Works like insurance)
And sets correct incentive for injurers
 But in some cases, hard to determine level
Might be no price at which you’d be willing to give up a leg
 Certainly no price at which a parent would be indifferent toward
losing a child

14
Perfect compensation
 Recommended jury instructions, Massachusetts:




“Recovery for wrongful death represents damages to the survivors
for the loss of value of decedent’s life. There is no special formula
under the law to assess the plaintiff’s damages…
It is your obligation to assess what is fair, adequate, and just.
You must use your wisdom and judgment and your sense of basic
justice to translate into dollars and cents the amount which will fully,
fairly, and reasonably compensate the next of kin for the death of the
decedent.
You must be guided by your common sense and your conscience
on the evidence of the case…”
 And from California:

“…You should award reasonable compensation for the loss of love,
companionship, comfort, affection, society, solace or moral support.”
15
One other odd feature of compensatory
damages…
 Most people would rather be horribly injured than killed
 Which means killing someone does more damage than
injuring someone
 But compensatory damages tend to be lower for a fatal
accident than an accident which crippled someone

When someone is badly injured, may require huge amount of
money to compensate them
In wrongful-death case, damages compensate victim’s loved
ones, but no attempt to compensate victim
 So these damages tend to be smaller

16
What’s a life
worth?
17
What’s a life worth?
 Assessing damages in a wrongful death lawsuit requires
some notion of what a life is worth
 Safety regulators also need some notion of what a life is
worth
 Kip Viscusi, The Value of Risks to Life and Health
Regulation
Estimated cost per life saved
Airplane cabin fire protection
$
200,000
Car side door protection standards
$
1,300,000
OSHA asbestos regulations
$
89,300,000
EPA asbestos regulations
$
104,200,000
Proposed OSHA formaldehyde standard
$72,000,000,000
 Regulators need to decide “where to draw the line”
18
Kip Viscusi, The Value of Risks to Life and
Health
 If w is starting wealth, D is death, p is probability, there
might be some amount of money M such that
p u(D) + (1 – p) u(w + M) = u(w)
When p  1, this breaks down not because you can’t equate death
with compensation, but because the second term vanishes
 So how do we find M?
 Ask a bunch of people how much money they would need to take a
1/1000 chance of death?
 Can’t do a lab experiment where you actually expose people to
a risk of death!


Clever trick: impute how much compensation people require
from the real-life choices they make
19
Kip Viscusi, The Value of Risks to Life and
Health
 Lots of day-to-day choices increase or decrease our risk of
death



Choose between a sports car with fiberglass body and a Volvo
Take a job washing skyscraper windows, or office job that pays less
Buy smoke detectors and fire extinguishers, or don’t
 “Hand Rule Damages”




Hand Rule: precaution is cost-justified if
cost of precaution < reduction in accidents X cost of accident
Suppose side-curtain airbags reduce risk of fatal accident by 1/1000
If someone pays $1,000 extra for a car with side-curtain airbags, it
must mean that
$1,000 < 1/1000 * value of their life
or, they value their life more than $1,000,000
20
Kip Viscusi, The Value of Risks to Life and
Health
 Viscusi surveys lots of existing studies which impute value
of life from peoples’ decisions
 Many use wage differentials: how much higher wages are
required for risky jobs compared to safe jobs?
 Some papers look at other decisions



Decisions to speed, wear seatbelts, buy smoke detectors, smoke
cigarettes
Decision to live in very polluted areas (comparing property values)
Prices of newer, safer cars versus older, more dangerous ones
 Some used surveys to ask people who they would make
hypothetical money-safety tradeoffs
 Each paper reaches some estimate for implicit value people
attach to their lives
21
Kip Viscusi, The Value of Risks to Life and
Health
 What does Viscusi find?



Wide range of results
Most suggest value of life between $1,000,000 and $10,000,000
Many clustered between $3,000,000 and $7,000,000
 Even with wide range, he argues this is very useful:




“In practice, value-of-life debates seldom focus on whether the
appropriate value of life should be $3 or $4 million…
However, the estimates do provide guidance as to whether risk
reduction efforts that cost $50,000 per life saved or $50 million per
life saved are warranted.”
“The threshold for the Office of Management and Budget to be
successful in rejecting proposed risk regulations has been in excess
of $100 million.”
C&U: National Highway Traffic Safety Administration uses $2.5
22
million for value of traffic fatality in cost-benefit analysis
Viscusi’s findings: papers using wage
differentials
23
Viscusi’s findings: papers using wage
differentials
24
Viscusi’s results: papers using other
tradeoffs
25
Viscusi’s results: papers using survey data
26
Back to
other topics
27
Inconsistency of damages
 Damage awards vary greatly across countries, even across
individual cases
 We saw last week:

As long as damages are correct on average, random inconsistency
doesn’t affect incentives (under either strict liability or negligence)
 But, if appropriate level of damages isn’t well-established,
more incentive to spend more fighting
28
Punitive damages
 What we’ve discussed so far: compensatory damages

Meant to “make victim whole”/compensate for actual damage done
 In addition, courts sometimes award punitive damages


Additional damages meant to punish injurer
Create stronger incentive to avoid initial harm
 Punitive damages generally not awarded for innocent
mistakes, but may be used when injurer’s behavior was
“malicious, oppressive, gross, willful and wanton, or
fraudulent”
29
Punitive damages
 Calculation of punitive damages even less well-defined
than compensatory damages
 Level of punitive damages supposed to bear “reasonable
relationship” to level of compensatory damages


Not clear exactly what this means
U.S. Supreme Court: punitive damages more than ten times
compensatory damages will attract “close scrutiny,” but not explicitly
ruled out
30
Example of punitive damages: Liebeck v
McDonalds (1994) (“the coffee cup case”)
 Stella Liebeck was badly burned when she spilled a cup of
McDonalds coffee in her lap
 Awarded $160,000 in compensatory damages, plus $2.9
million in punitive damages
 Case became “poster child” for excessive damages, but…
31
Liebeck v McDonalds (1994)
 Stella Liebeck dumped coffee in her lap while adding
cream/sugar



Third degree burns, 8 days in hospital, skin grafts, 2 years treatment
Initially sued for $20,000, mostly for medical costs
McDonalds offered to settle for $800
 McDonalds serves coffee at 180-190 degrees




At 180 degrees, coffee can cause a third-degree burn requiring skin
grafts in 12-15 seconds
Lower temperature would increase length of exposure necessary
McDonalds had received 700 prior complaints of burns, and had
settled with some of the victims
Quality control manager testified that 700 complaints, given how
many cups of coffee McDonalds serves, was not sufficient for
McDonalds to reexamine practices
32
Liebeck v McDonalds (1994)
 Rule in place was comparative negligence






Jury found both parties negligent, McDonalds 80% responsible
Calculated compensatory damages of $200,000
times 80% gives $160,000
Added $2.9 million in punitive damages
Judge reduced punitive damages to 3X compensatory, making total
damages $640,000
During appeal, parties settled out of court for some smaller amount
 Jury seemed to be using punitive damages to punish
McDonalds for being arrogant and uncaring
33
What is the economic purpose of punitive
damages?
 We’ve said all along: with perfect compensation, incentives
for injurer are set correctly. So why punitive damages?
 Example…







Suppose manufacturer can eliminate 10 accidents a year, each
causing $1,000 in damages, for $9,000
Clearly efficient
If every accident victim would sue and win, company has incentive to
take this precaution
But if some won’t, then not enough incentive
Suppose only half the victims will bring successful lawsuits
Compensatory damages would be $5,000; company is better off
paying that then taking efficient precaution
One way to fix this: award higher damages in the cases that are
brought
34
This suggests…
 Punitive damages should be related to compensatory
damages, but higher the more likely injurer is to “get away
with it”




If 50% of accidents will lead to successful lawsuits, total damages
should be 2 X harm
Which requires punitive damages = compensatory damages
If 10% of accidents lead to awards, damages should be 10 X harm
So punitive damages should be 9 X compensatory damages
 Seems most appropriate when injurer’s actions were
deliberately fraudulent, since may have been based on costbenefit analysis of chance of being caught
35
Some empirical observations
about tort system in the U.S.
36
U.S. tort system
 In 1990s, tort cases passed contract cases as most
common form of lawsuit


Most handled at state level: in 1994, 41,000 tort cases resolved in
federal courts, 378,000 in state courts in largest 75 counties
Most involve a single plaintiff (many contract cases involve multiple
plaintiffs)
 Among tort cases in 75 largest U.S. counties…




60% were auto accidents
17% were “premises liability” (slip-and-fall in restaurants,
businesses, government offices, etc.)
5% were medical malpractice
3% were product liability
37
U.S. tort system
 Punitive damages historically very rare



1965-1990, punitive damages in product liability cases were
awarded 353 times
Average damage award was $625,000, reduced to $135,000 on
appeal
Average punitive damages only slightly higher than compensatory
 In many states, punitive damages limited, or require higher
standard of evidence


Civil suits generally require “preponderance of evidence”
In many states, punitive damages require “clear and convincing”
evidence
38
U.S. tort system
 Medical malpractice



New York study in 1980s: 1% of hospital admissions involved
serious injury due to negligent care
Some estimates: 5% of total health care costs are “defensive
medicine” – procedures undertaken purely to prevent lawsuits
Some states have considered caps on damages for medical
malpractice
39
U.S. tort system
 Product liability

Recent survey of CEOs: “liability concerns caused 47% of those
surveyed to drop one or more product lines, 25% to stop some
research and development, and 39% to cancel plans for a new
product.”
 Liability standard for product-related accidents is “strict
products liability”




Manufacturer is liable if product determined to be defective
Defect in design
Defect in manufacture
Defect in warning
40
Vaccines
 Most vaccines are weakened version of disease itself



Make you much less likely to acquire the disease
But often come with very small chance of contracting disease
directly from vaccine
Salk polio vaccine wiped out polio, but caused 1 in 4,000,000
people vaccinated to contract polio
 1974 case established maker had to warn about risk



Since then, some people were awarded damages after their
children developed polio from vaccine
If liability can’t be avoided, built into cost of the drug
And discourages companies from developing vaccines
41
Mass torts
 Since health risks of asbestos understood, over 600,000
people have brought lawsuits against 6,000 defendants
 DES (drug administered to pregnant women in 1950s)


Impossible to establish which firm produced dose given to a
particular woman
California Supreme Court introduced “market share liability”
 Class action lawsuit




Small, dispersed harms – no plaintiff might find it worthwhile to sue
Class action suits allow large lawsuits with lots of plaintiffs
Give more incentive for precaution against diffuse harms
But…
42
Cooter and Ulen’s overall assessment of
U.S. tort system
 Critics claim juries routinely hand out excessive awards
and tort system is out of control…
 …but actually it functions reasonably well
 Outside of occasional, well-publicized outliers, damage
awards are generally reasonable…
 …and liability has led to decreases in accidents in many
industries
43
To wrap up tort law, a funny story from
Friedman…
“A tort plaintiff succeeded in collecting a large damage judgment.
The defendant’s attorney, confident that the claimed injury was
bogus, went over to the plaintiff after the trial
and warned him that if he was ever seen out of his wheelchair
he would be back in court on a charge of fraud.
The plaintiff replied that to save the lawyer the cost of having
him followed, he would be happy to describe his travel plans.
He reached into his pocket and drew out an airline ticket –
to Lourdes, the site of a Catholic shrine famous for miracles.”
44