Econ 522 – Lecture 15 (March 24 2009)
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Welcome back
Reminder: homework on contract law due next Tuesday
Who would like to move second midterm from Tues April 7 to Thurs April 9?
Let’s begin with a little review.
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We started this class by defining the notion of efficiency
Basically: the idea of maximizing the total surplus realized by everyone in society
o Efficiency requires that scarce resources be owned by whoever values
them the most
o And that any action should be if its total social benefit exceeds its total
social cost
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We made the claim that we’re interested in designing a legal system that leads to
efficient outcomes
What makes this hard?
o Once we set up the rules, we don’t expect individuals to act based on
what’s efficient
o We expect individuals to do whatever is in their own best interest
So the goal is to set up the rules in such a way that people acting in their own best
interest will naturally lead to efficiency
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Coase gives us one way to do this
o Efficiency requires things to be owned by whoever values them the most
o Suppose we set up a legal system where things can be bought and sold
o If I value something more than you, I can buy it from you
o As long as property rights are clearly defined and tradeable, and there
are no transaction costs, people have an incentive to trade until each
resource is owned by whoever values it most
o This argument doesn’t depend on who starts with what – so Coase tells us
that the initial allocation of rights doesn’t matter for efficiency, only for
distribution
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On the other hand, when there are transaction costs – impediments to private
bargaining – we may not get to efficiency this way
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This led us to two different normative views of the legal system:
o One, that the legal system should aim to minimize transaction costs
(“lubricate” private exchange, the normative Coase), since if we make
transaction costs low enough, efficiency will follow
o Or two, that the legal system should aim to allocate rights efficiently (the
normative Hobbes), so that less is lost when private exchange fails
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We then looked in more detail at four questions a property system needs to address:
1. What things can be privately owned?
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One of the motivations for property rights was that without them, common
resources would be overused
We distinguished between public and private goods
General principle: private goods should be privately owned
While public goods should be publicly owned/provided/regulated
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We pointed out that society has an incentive to privatize a resource when the costs
of boundary maintenance are smaller than losses due to overuse of common
resources
o Demsetz: fur trade made furs more valuable and caused overhunting
o Loss due to overuse went up, leading Native Americans to develop private
land rights
o Another neat theory is mentioned in the Friedman book: “we owe
civilization to the dogs”
o When dogs were domesticated, they could be trained to recognize their
owner’s land and guard it, and so private ownership of farmland became
feasible because the cost of boundary maintenance went down
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Property rights over information – patents (to create incentive to innovate),
copyrights (to encourage the supply of a public good)
Different types of public ownership (common access vs regulation vs unanimous
consent)
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2. What can (or can’t) an owner do with their property?
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General principle: maximum liberty
o You can do whatever you want with your property, as long as it doesn’t
infringe on anyone else’s rights or property
Nuisances, public and private nuisances
Other limitations on property rights, and economic rationale for each
o Rules against perpetuities – an owner can’t restrict heirs indefinitely (but
can for one generation)
o Emergency exception to rules against trespass
o Inalienability –some entitlements can’t be sold (or even given away)
o Unbundling – can’t always unbundle property rights
 But in some instances, you can – for example, with land in
Pennsylvania, and with conservation easements in some locations
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3. How are property rights established?
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Fugitive property – paradigms of first possession and tied ownership
o first possession tends to be simpler to implement
o but causes resources to be wasted in trying to gain possession
o example of this: Friedman on Homestead Act, saying that the resources
wasted in starting to farm before it was efficient basically wasted much of
the value of the land (p. 120 in Law’s Order)
First possession versus tied ownership is one example of the general tradeoff
between simple, “bright line” rules versus more complex rules that might be more
costly to implement but create better incentives
o Pierson v Post
o Fast Fish/Loose Fish versus Iron Holds The Whale
Verifying legal ownership (property deeds and car titles), acquiring title
Losing property rights – adverse possession, estray rules
Government’s rights to claim private property – eminent domain/takings,
limitations (public use, just compensation); regulatory takings, abuse of takings
4. What remedies are available when property rights are violated?
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injunctions vs damages
o injunctions simpler (cheaper) to implement, create bright-line property
rights to encourage bargaining
o damages more efficient when transaction costs are high (bargaining
unlikely to succeed)
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temporary versus permanent damages
o temporary damages more efficient when damages are easy to calculate
and technology is changing
o permanent damages are more efficient when damages are hard to
calculate and technology is stable
and we called all that “property law”
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Part of what makes property law straightforward is that trade tends to be simultaneous
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I give you an apple, you give me $1
However, in some situations, efficient trade can’t be done simultaneously
o It might be efficient for me to build you an airplane
o But it would be very complicated/costly for you to pay me each day for
that day’s work
Contract law gives us a way to transact when one of us has to depend on a
promise by the other
We motivated contract law by looking at the agency game
o if you can’t trust me to return your money, we miss out on a valuable
investment opportunity
Contracts give a way for a promise to be legally binding, allowing us to
cooperate in instances where we could not have otherwise
The first purpose of contract law: to enable cooperation
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We introduced the Bargain Theory of contracts
o A promise is binding if it was given as part of a bargain
o This requires three elements, offer, acceptance, and consideration
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Unlike the Bargain Theory, efficiency requires enforcing a promise if both the
promisor and the promisee wanted it to be enforceable when it was made
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We gave an example of how private or asymmetric information can disrupt trade
and cause inefficiency
Second purpose of contract law is to encourage efficient disclosure of
information
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We introduced the idea of efficient breach
o Even when a promise is made in good faith, it sometimes becomes
efficient to break the promise
o Breach is efficient when the promisor’s cost of performing is higher than
the promisee’s benefit from performance
o Third purpose of contract law is to secure optimal commitment to
performing
o Expectation damages lead to efficient breach
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We introduced idea of reliance investment
o Investments by the promisee which make performance more valuable
o Fourth purpose of contract law is to secure optimal reliance
o When expected gains from reliance are included in expectation damages,
we get efficient breach but overreliance
o When expected gains from reliance are excluded from expectation
damages, we’ll get efficient reliance but excessive breach
o (This is the paradox of compensation – neither rule leads to efficient
actions on both margins)
o Cooter and Ulen propose modifying expectation damages to cover gains
from only efficient reliance – nice theoretically, hard practically
o Courts tend to reward only foreseeable reliance
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We discussed the notion of default rules – rules that cover gaps in contracts
o We saw two different approaches to default rules
o Cooter and Ulen: set default rule to rule that is efficient in most cases, so
most parties can save transaction costs
o Ayres and Gertner: in some cases, use penalty defaults, to encourage
information disclosure by better-informed party
o Famous case of Hadley v Baxendale as an example
 Baxendale (shipper) is likely the efficient bearer of the risk of
delay, since he can take steps to avoid it
 But the ruling penalized Hadley (the miller) for not disclosing how
urgent the shipment was – to give an incentive to provide that
information
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Also discussed a few immutable rules, or regulations
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Next, we looked at a number of situations where a contract would be
invalidated/not enforced, and economic reasons for why
o Contracts which derogate public policy
o Incompetence (but not drunkenness)
o Dire constraints – duress and necessity
 Contracts extracted under threat of refusing to create value are
enforceable; contracts extracted under threat of destroying value
are not
 Contracts renegotiated under duress are not enforceable; contracts
renegotiated under changed circumstances are
o Impossibility
 When performance becomes impossible, assign liability to the
party that can bear the risk at the least cost
 (either by mitigating it, or by spreading it out over many
transactions)
o Several doctrines having to do with information: fraud, failure to
disclose, frustration of purpose, mutual mistake
 When performance becomes pointless, assign liability to the party
that can bear the risk at the least cost
 Under common law, there is not a general duty to disclose
information about an object for sale
 But there is a duty to disclose information that makes a product
unsafe; and some states have imposed other duties
 While mutual mistake is grounds for voiding a contract, unilateral
mistake is generally not
 Efficiency often requires enforcing contracts which unite
knowledge and control, not those which separate knowledge and
control
 To give an incentive for discovery, efficiency generally requires
enforcing contracts based on one party’s knowledge of
productive information, especially if that knowledge was the
result of active investment; but efficiency need not reward purely
redistributive information
o Vagueness
 In general, this can be seen as a penalty default – by refusing to
enforce vague contracts, the courts force parties to be more clear
o Adhesion and unconscionability (lesion)
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We examined a number of remedies for breach of contract, among them:
o Expectation damages
o Opportunity cost damages
o Reliance damages
o Restitution, disgorgement
o Specific performance
o General unenforceability of penalty clauses in contracts
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We looked at the effects of different remedies on decisions to breach, to invest in
reliance, and to invest in performance
o Just like with injunctions versus damages in nuisance cases: with low
transaction costs, any remedy can lead to efficient breach through
renegotiation
o But with high transaction costs, only expectation damages lead to
efficient breach
o When damages < benefit from performance – for instance, when they
exclude the gains from reliance – we get inefficient breach, or
underinvestment in performance
o When damages include any expected gains from reliance, we get
overreliance by the promisee
o (“Paradox of compensation” – no damage rule that achieves efficient
levels of everything
o Anti-insurance – one cute attempt to solve the problem
o Rewarding only efficient reliance – another.)
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And we wrapped up contract law by discussing repeated games
o In the agency game we started with, repeated interactions can lead to
trust
o Promisor gets more future value by keeping his promise
o This gives promisee a reason to trust him
o The sixth purpose of contract law is to foster enduring relationships,
which solve the problem of cooperation with less reliance on courts for
enforcement
o But we also saw that trust based on repeated interactions can break down
when the relationship is expected to end on a certain date
and that brings us up to date
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Today, we begin tort law
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The word tort is from French, and means injury
With contract law, we studied situations where someone injured you by breaking
a promise they had made
With tort law, we will look at situations where someone harmed you without
having made any promises.
A line I like from the Friedman book:
“If someone shoots you, you call a cop. If he runs his car into yours, you call a lawyer.”
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The line between the two isn’t always that clear
Some torts are crimes as well – if someone assaults you, they may go to jail, and
you may also sue them for damages
o (Plus, there’s the OJ Simpson case.)
We’ll get to criminal law in a few weeks; for now we’ll focus on the tort side.
Before we get to the material, though, I’d like to do a quick experiment.
As with nuisance law and contract law, our focus in torts will not be on fairness or equity,
but on efficiency
That is, our goal is to structure the law in a way that provides incentives for people to
behave in a way that leads to efficiency
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For deliberate harms, this will usually be fairly simple
o If we don’t want people to get in bar fights and break each others’ noses,
we can just make the penalty for being in a bar fight very severe
o This is roughly the intent of criminal law
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For accidental harms, though, setting the correct incentive to avoid harm is tricky
o We could prevent all traffic accidents by outlawing cars
o We could prevent all construction injuries by outlawing construction
o But this would clearly be inefficient
o What we want, instead, is the “efficient number of accidents”
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Unlike in nuisance law, when it comes to torts, injunctive relief is usually not an option
 Much as we’d like to imagine that nobody could run into your car without
negotiating for permission, it doesn’t work that way
Unlike with contract law, there is no promise or agreement made ahead of time;
something happens, and then we deal with it.
 Tort cases may involve parties who are complete strangers
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We can think of tort law as covering the situations where transaction costs were
too high to allow for bargaining
o it’s impossible to negotiate with every driver for the right to hit you
o it’s not always possible to bargain with an angry drunk about whether or
not he breaks your nose.
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Thus, Cooter and Ulen define the economic essence of tort law this way:
o the attempt to make injurers internalize the externalities they cause,
in situations where transaction costs are too high to do this through
property or contract rights
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With contract law, we started out by discussing a “classic” legal theory of
contracts (the bargain theory), and then moved on to an economic analysis
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With torts, we’ll do the same
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The traditional theory of tort liability was developed about 100 years ago
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It specified three key elements of a tort, which must be present for he plaintiff to
recover damages:
o harm
o causation
o breach of duty
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harm
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First, and simplest, the plaintiff needs to have been harmed.
Without harm, there is no tort
An example from the textbook:
o A gas company sold gas with a defective additive
o It had no effect on cars with normal carburetors, but was dangerous in cars
with turbocharged carbs
o The owner of a car with a normal carburetor might be outraged by the
situation
o But since the gas did no damage to his car, he cannot sue
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Similarly, traditional tort theory does not compensate for exposure to risk.
o Suppose a manufacturer accidentally exposed a bunch of workers to some
chemical
o Doctors agree the exposure will cause 15% of them to develop liver cancer
later in life
o Under traditional tort doctrine, the victims must wait and see who gets
cancer before suing
o Similarly, if I do something negligent that causes you a 50% chance of
dying, but you get lucky and escape the situation, I’m generally not liable
for any damages.
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(So far, U.S. courts have been reluctant to allow tort actions on the basis of
exposure to harm, although some believe they should
Thus, safety regulation, administered by a government agency, is typically used
instead of tort law to deal with exposure to low-probability harms.)
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In theory, harm has a simple economic interpretation: a downward shift in the
victim’s utility
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Like in the hairy hand case, we can imagine a victim has some utility function
over health and money, with some sort of indifference curves:
$
Health
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A car accident might lower my wealth
o because my car is worth less
And also lower my health
o because I got whiplash
So now I’m on a lower indifference curve
Perfect compensation should theoretically restore me to my original level of
utility.
Money damages are typically how this is done.
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Obviously, some amount of money can get me back to my original level of wealth
o By repairing whatever broke on my car, or allowing me to buy a new car
If there is medical care available that would restore me to my original level of
health, then the cost of this treatment would get me back to my original level of
health as well, so I’d be back where I started.
Of course, there are some harms that can’t be undone
o the amputated leg in the experiment, or other permanent injury
But there may be some amount of money that would compensate for it, by getting
me back to the same indifference curve I started out on
Just like in the hairy hand case, we can work out perfect damages in this way.
So that’s the theory – the notion of “perfect compensation”
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In reality, courts have traditionally been very willing to compensate victims for
tangible losses
o medical costs
o lost income
o damaged property
Historically, courts have been less willing to compensate for intangible losses or
losses that are difficult to measure
o emotional harm
o pain and suffering
o loss of companionship
Over the years, however, American courts in particular have expanded the list of
compensable harms to include many of these intangibles
One area where there is a huge disparity between tangible harm and actual harm is
in the death of a child
If a drunk driver kills a child, there is no loss of income to the child’s family; if
anything, they avoid the expense of raising the child.
This used to be a difficult problem for courts, as they could not find a tangible,
measurable harm on which to base compensation.
Allowing compensation for emotional distress and loss of companionship
solves this problem
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There are pros and cons to trying to compensate for intangible harms
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As we’ll see soon, the closer we come to setting liability equal to the actual harm
done, the better we’ll set incentives for efficient harm avoidance
o That is, we will want injurers to internalize the harm they do, so we want
liability as close as possible to the actual harm
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On the other hand, intangible harms are extremely difficult to calculate.
o Reasonable people might disagree dramatically about the emotional harm
of losing a leg, much less a child
o In addition, some people are horrified at the very idea of putting a dollar
value on someone’s life
o And clearly, there is no amount of money that would make most parents
indifferent to losing a child
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So while compensation for intangible harms is an appealing idea, it leads to a
great deal of disparity in awards, across different courts, or even within the same
court, for similar injuries.
That covers the first element of a tort under the traditional view – harm
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The second element that must be present is causation – that is, the defendant must have
caused the plaintiff’s harm.
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Here, things can get pretty tricky
Suppose the factory where I work exposes me to some chemical that increases my
risk of some disease from 1% to 1.2%
I come down with the disease
Did the chemical cause it?
The law distinguishes between two types of causes
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The first is “cause-in-fact”
o The test for cause-in-fact is generally the “but-for test”
o That is, “but for the defendant’s actions, would the harm have occurred?”
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There’s an example in the Friedman book that shows how tricky even this simple
rule can be
o Three friends go out hunting, one of them scares up a pheasant, the other
two turn and shoot and both, mistakenly, at the same exact time, shoot the
first one, one through the head, one through the heart.
o Each one is very apologetic to the man’s widow, but say, “If I hadn’t shot
him, he’d still be dead.”
o Did either of them cause his death? But for either one’s actions, he’d still
have died.
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Another problem with the “but-for” test is that it doesn’t distinguish between
recent actions and more distant actions.
o I punch a guy in the face in a bar
o Clearly, but for my punching him, his nose wouldn’t have been broken.
o Also, but for him getting a job in Madison and moving here three years
ago, he wouldn’t have been in my bar to get punched in the face, and the
harm wouldn’t have occurred
o So is his employer liable?
o Also, but for his parents having conceived him, he wouldn’t have been
alive to be punched in the face, and the harm wouldn’t have occurred
o So are his parents liable?
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For this reason, for a tort to exist, the defendant’s act must not only be the cause-in-fact
of the harm, it must also be the proximate cause
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Proximate just means close – that is, the immediate cause
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There’s no rigid definition for how close the cause must be.
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There’s a famous case, Palsgraf v Long Island Railway (1928), that addressed this
problem:
Plaintiff [Mrs. Palsgraf] was standing on a platform of defendant’s railroad after
buying a ticket to go to Rockaway Beach. A train stopped at the station, bound
for another place. Two men ran forward to catch it.
One of the men reached the platform of the car without mishap, thought he train
was already moving. The other man, carrying a package, jumped aboard the car,
but seemed unsteady as if about to fall.
A guard on the car, who had held the door open, reached forward to help him in,
and another guard on the platform pushed him from behind. In this act, the
package was dislodged, and fell upon the rails.
It was a package of small size, about fifteen inches long, and was covered by a
newspaper. In fact it contained fireworks, but there was nothing in its appearance
to give notice of its contents. The fireworks when they fell exploded.
The shock of the explosion threw down some scales at the other end of the
platform many feet away. The scales struck the plaintiff, causing injuries for
which she sues.
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The Long Island Railroad guard’s actions in pushing the passenger did indeed
cause Mrs. Palsgraf’s injuries
o he pushed a passenger who dropped a package of fireworks which went
off and caused the scales to fall on her
But the court ruled his actions were too remote to be considered the proximate
cause
As I said, though, there’s no precise legal definition for how close the action must
be to the harm
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Another example from the Friedman book:
I run into a friend on the street, and we stop to talk for a minute. We say
goodbye, go our separate ways, and twenty seconds later, he’s crushed by a
falling safe. Clearly, but for talking to me, he would still be alive – he would
have passed that spot well before the safe fell. Did I cause his death? Am I
liable?
Friedman claims this hypothetical is based on a real case:
“A tree fell on a moving trolly, injuring passengers. One of them sued. He
succeeded in demonstrating that in order for the trolly to be where it was when the
tree fell on it the driver had to have driven faster than the speed limit at some
point during the trip. Breaking the law is per se negligence, so the driver was
legally negligent whether or not his driving was actually unsafe. If he had not
driven over the speed limit, the trolly would not have been under the tree when it
fell, so, the plaintiff argued, the driver’s negligence caused the injury.”
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Thankfully, the court was not stupid, and the plaintiff lost
The court held that the driver’s negligence “had not caused the accident in the
legally relevant sense.”
I’m not really sure what that means, but it seems pretty clear that innocent actions
which led to an accident by chance, but did not increase its likelihood, should not
be punished
In this case, the driver’s speeding was just as likely to prevent the accident (by
passing that point before the tree fell) as to cause it
If we think about tort law as an attempt to set the right incentives, there is no
reason to discourage the driver’s actions
(SKIP: This could still be accomplished in two ways:
o One, we could make him liable for the accident, but make him reverseliable (have him receive a large reward) if his speeding caused him to miss
a falling tree
o Of course, it might be very hard to prove when he’s avoided an accident;
really much simpler just to not make him liable in either case.)
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That’s two elements of a tort under the traditional theory
The third element is breach of duty, and is sometimes necessary and sometimes not.
When just harm and causation are sufficient for a tort to exist, the rule is referred to as
“strict liability”
 Under the common law, strict liability tends to be the rule for unusually
dangerous activities
 The book gives the example of a construction company blasting with dynamite –
the company is liable for any harm caused by the blasting.
In most situations, however, there is a third element that must be demonstrated in
addition to harm and causation.
 It must be shown that the defendant breached a duty he owed to the defendant,
and that this breach led to the harm
 If I punch someone in a bar, I breach a duty not to punch them
 When an injurer breaches a legal duty, he is “at fault,” or “negligent.”
A liability rule requiring all three elements – harm, causation, and fault – is referred to as
a “negligence” rule.
 Under a negligence rule, a defendant can argue that an accident occurred despite
his best efforts to prevent it.
 That is, under a negligence rule, even if I caused you harm, I’m not liable if I
satisfied the applicable standard of care and the accident happened anyway
o For accidents, the “duty” owed to the victim is the duty of care
o When that duty is breached, that is, when I am careless or negligent, I am
liable
o When I meet that duty, even if you get hurt, I’m not liable
Of course, this leaves the question of who determines the applicable standard of care –
that is, how careful you have to be to not be considered negligent.
 In some cases, there may be a clear yes/no test – a swimming pool had a lifeguard
on duty or it didn’t.
 In many cases, there isn’t. Is driving a car 50 MPH on a particular road
negligent? What about 51? 52?
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How is this standard of care determined in practice?
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In some cases, the government imposes safety regulations that set the standard
o speed limits for highway driving
o the requirement that bicycles have brakes
o workplace regulations
o and so on
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Some standards are left vague
o the definition of “reckless driving” may depend on the road, the time of
day, the weather
o in these situations, the common law tends to focus on the duty of
reasonable care
o like foreseeable reliance, this is the level of care that a reasonable person
would have taken under the circumstances
o If you took less care than a reasonable person would have, you are liable
o If you took more care, you are not.
o (The civil law tends to rely less on standards of “reasonableness”, and tries
to be more specific in what duties are owed and what level of care is
required.)
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Under a rule of strict liability, proof of negligence is unnecessary; proving harm
and causation is enough to establish liability
Under a rule of negligence, you must prove harm, causation, and negligence
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Interestingly, the movement between these two rules has not always gone in the same
direction.
 Strict liability was the usual rule in much of Europe before the 1800s.
 By the beginning of the 1900s, negligence became the usual rule
 but in the second half of the 1900s, strict liability experienced a rebirth, especially
for manufacturer liability in American consumer products.
 Manufacturers in the U.S. are now held liable for harms caused by defective
products, whether or not they were at fault – we’ll see examples of this shortly
o The Friedman book spends a surprising amount of time on the problem of
who should be responsible when a bottle of Coke explodes, which I guess
used to be a pretty big problem before they switched away from glass
bottles
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On Thursday, we’ll begin our economic analysis of tort law
However, there’s one thing I want to emphasize
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In this class, we’re generally using efficiency to evaluate whether a law makes
sense
Suppose you’re out bicycling one day and I hit you with my car
Once I’ve hit you, the damage is already done
o Your bike is bent
o Maybe your arm is broken
Whether I have to pay you a big settlement, or even replace your bike, has no
impact on efficiency
That is, no new wealth is created or destroyed by me writing you a check
It might seem fair if I at least pay for the damage I did
But from an economic point of view, once the accident has happened, who
bears the cost is completely uninteresting
So then why do we care about how tort law is designed?
As we’ll see on Thursday, because it impacts how we behaved leading up to the
accident
If I know that drivers who hit bicyclists owe huge settlement payments, I might
drive more slowly – or take a cab if I’m planning to drink – or I might have
chosen not to drive at all that day
If you know that bicyclists who get hit by cars don’t owe anything, you might
bicycle less, or only on bike paths, or you might be more likely to wear a helmet
And these choices affect whether or not the accident occurs – which means, they
have a big impact on efficiency
Obviously, tort cases only come up once the accident has occurred
But our analysis will focus on what behaviors they lead to, since that’s the only
part that matters for efficiency
See you Thursday.
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