Econ 522 – Lecture 17 (March 31 2009)
Midterm next Tues: mostly contracts, could have property; no torts
Start by discussing the doctor question from homework
Last Thursday, we introduced an economic model of torts, focusing on precaution –
costly actions that reduce the likelihood of accidents – and the incentive for precaution
that various liability rules create.
We found the following (have on board ahead of time):
Legal Rule
No liability
Strict liability
Simple Negligence
Simple Negligence with a Defense of
Contributory Negligence
Comparative Negligence
Strict Liability with a Defense of
Contributory Negligence
Victim
Precaution
Efficient
Zero
Efficient
Efficient
Injurer
Precaution
Zero
Efficient
Efficient
Efficient
Efficient
Efficient
Efficient
Efficient
The next piece we want to add is activity levels


I can choose to drive carefully or recklessly, and I can also choose to drive more
or less often
You can look both ways before crossing the street, or not; and you can choose
how many streets to cross.
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First, let’s think about what happens under no liability
 Under no liability, I’m never responsible if I hit you
 So I don’t consider the cost of accidents when I decide how carefully to drive, or
how much to drive
o my precaution level will be too low (relative to the efficient level)
o and my activity level will be too high
What about you?
 You bear the costs of all accidents; so you look to maximize the benefit of
walking, minus the cost of precaution (paranoia?), minus the expected cost of
accidents
 Your actions have no externalities (since only you get hurt by accidents, not me);
so your incentives are correct, and you will set the efficient level of precaution
and the efficient activity level
So a rule of no liability leads to too much injurer activity, but the efficient level of
victim activity; just like it leads to too little injurer precaution, but the efficient level
of victim precaution.
The exact opposite will happen under strict liability
 Under strict liability, you know you will be compensated for any accidents, so
you don’t worry about their costs
 Therefore, you take insufficient precautions, and you set too high an activity level
 On the other hand, I know I’m paying for any accidents that happen, so I consider
their costs when I make my decisions
o I take efficient precautions
o and I set an efficient activity level.
What happens under a negligence rule?
 First, consider simple negligence
 I know I won’t be liable as long as I take sufficient care; so under a simple
negligence rule, I’ll take efficient precaution
 But once I’m doing that, I don’t have to worry about the cost of accidents, since
I’m not going to owe any damages
 So I don’t consider the cost of accidents when I choose my activity level, and
therefore I set it too high
 Under a simple negligence rule, I’ll drive carefully, but I’ll still drive too much –
since as long as I’m driving carefully, I no longer internalize the cost of the
accidents I cause


As for you, you know I’ll be driving carefully, so you know that you’ll still be
incurring the costs of any accidents that occur
so you set both your precaution level and your activity level efficiently.
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The same will be true for a rule of simple negligence with a defense of contributory
negligence, or a rule of comparative negligence
 We know that both these rules lead to efficient precaution
 But as long as we’re both taking efficient precaution, I’m still not liable for
damages
 So you still bear the “residual risk” of accidents, and I don’t
 so you set your activity level efficiently, and I set mine too high
 Once again, under any of these rules, I drive carefully
 but since I’m driving carefully, I know I won’t be liable for accidents, so I choose
to drive too much.
Finally, what happens under a strict liability rule with a defense of contributory
negligence?
 Here, I’m liable for damages unless I can show you were negligent
 We know that this will lead you to take efficient precaution; which means I expect
to be held liable for any damages that occur
 Thus, I internalize their cost, and set both my precaution level and my activity
level efficiently
 On the other hand, since you’re being careful, you know that you won’t bear the
cost of accidents
 so you ignore their cost, and set your activity level too high.
Legal Rule
No liability
Strict liability
Simple Neg
Simple Neg,
Contrib Neg
Comparative
Neg
Strict Liab,
Contrib Neg
Victim
Precaution
Efficient
Zero
Efficient
Efficient
Injurer
Precaution
Zero
Efficient
Efficient
Efficient
Victim
Activity
Efficient
Too High
Efficient
Efficient
Injurer
Activity
Too High
Efficient
Too High
Too High
Efficient
Efficient
Efficient
Too High
Efficient
Efficient
Too High
Efficient
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
Which rule is the most efficient, then, depends on the situation

That is, it depends on whose choices have the bigger impact.
o In situations with unilateral precaution – situations where only one party
needs to take steps to avoid accidents – no liability or strict liability work
perfectly well
o In situation with bilateral precaution, negligence rules give appropriate
incentives for precaution on both sides
o However, under any negligence rule, one of the two parties still bears
whatever losses do occur – one party is the residual bearer of the harm of
accidents, and the other party is not
o Any negligence rule yields an efficient activity level by the residual risk
bearer, but an inefficient activity level by the other party
o Thus, the optimal rule depends on whose activity level is most important.
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Friedman has a different take on activity levels

He argues that reducing your activity level is just another type of precaution

But it’s a type of precaution where it’s impossible for the court to determine the
efficient level
o (A court might be able to figure out that it’s efficient for me to drive with
my headlights on at night, but unable to figure out how many miles it’s
optimal for me to drive in a given day
o Therefore, a court might find me negligent if I was driving without
headlights
o But it’s hard for a court to decide whether a particular trip was socially
efficient, and therefore whether I was negligent by being in my car!)

Instead of distinguishing precaution from activity levels, Friedman distinguishes
observable precaution from unobservable precaution

He points out that any negligence rule only causes an efficient level of observable
precaution, since that’s all that can be used to determine whether someone
exercised due care or was negligent

So a negligence rule does not lead to an efficient level of unobservable precaution

Strict liability, on the other hand, leads the injurer to internalize the cost of
accidents, so it leads to efficient levels of both observable and unobservable
precaution – the same result as we already saw, just in different words

Friedman mentions that Posner uses this to explain why highly dangerous
activities – blasting with dynamite, or keeping a lion as a pet – are often governed
by strict liability
o if they’re dangerous enough, the only meaningful type of precaution may
be to not do them at all
o Strict liability leads to efficient levels of both care (if you choose to do
them) and a choice of whether or not to do them in the first place.
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The Shavell paper, “Strict Liability versus Negligence,” is about exactly the incentives
we’ve been discussing
 Shavell refers to the types of cases we’ve been considering so far “accidents
between strangers”
 That is, when a car hits a bicyclist, there is no preexisting relationship between the
two parties
 However, Shavell also looks at cases where the injurer is a business, engaged in
selling some product (either to the victim or to someone else)
 Under the assumption of competitive markets, this changes the story significantly.




Shavell assumes it is only injurer precaution that affects the likelihood of
accidents – that is, he ignores victim precaution
He looks at a number of different cases
Under injurer precaution, a rule of no liability is obviously bad, so he focus on
comparing negligence to strict liability.
And, like we’ve been doing, he assumes there is no insurance.
First, as we’ve already seen, is the case of accidents between strangers


As he puts it, “injurers and victims are strangers, neither are sellers of a product,
and injurers may choose to engage in an activity which puts victims at risk”
He gives a nice explanation of what happens under a simple negligence rule:
“Under the negligence rule, all that an injurer needs to do to avoid the
possibility of liability is to make sure to exercise due care if he engages in his
activity.
Consequently he will not be motivated to consider the effect on accident
losses of his choice of whether to engage in his activity or, more generally, of
the level at which to engage in his activity; he will choose his level of activity
in accordance only with the personal benefits so derived.
But surely any increase in his level of activity will typically raise expected
accident losses. Thus he will be led to choose too high a level of activity.”
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
Under a strict liability rule, on the other hand:
“Because an injurer must pay for losses whenever he is involved in an
accident, he will be induced to consider the effect on accident losses of both
his level of care and his level of activity.
His decisions will therefore be efficient.
Because drivers will be liable for losses sustained by pedestrians, they will
decide not only to exercise due care in driving but also to drive only when the
utility gained from it outweighs expected liability payments to pedestrians.”

We can start our table again, focusing only on injurer precaution and injurer
activity:
ACCIDENTS BETWEEN STRANGERS
Liability Rule
Injurer Precaution
Simple Negligence
Efficient
Strict Liability
Efficient
Injurer Activity
Too High
Efficient
Next, Shavell considers accidents between sellers and strangers




That is, injurers are engaged in some sort of competitive business, but not with
their victims
He gives the example of taxi drivers – taxis provide a service to passengers, but
still run the risk of hitting other pedestrians who aren’t their passengers
Shavell assumes that there is perfect competition – taxis lower their prices to
compete against each other, up till prices equal the costs of “production”; and the
number of passengers who demand rides at those prices determine the level of
sales
Under a strict liability rule, the outcome is still efficient, but for a different reason
o Under strict liability, taxi drivers pay for accidents, so they will take the
efficient level of precaution
o In addition, the expected costs of remaining accidents is borne by the taxi
drivers
o So under competition, it is built into the price of a taxi ride
o (That is, once taxi fares reach the level that just covers costs plus expected
damage payments, taxi drivers stop lowering prices, so that sets the price.)
o This means that taxi passengers face the “socially optimal” price – given
efficient precaution, they now internalize the cost of accidents, so they
take the efficient number of taxi rides
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
Under a negligence rule, the activity level is still inefficiently high, but again, for
a different reason
o Under a negligence rule, taxi drivers take efficient precaution, to avoid
liability for any accidents that occur
o But once they’re taking efficient precaution, they’re no longer liable, so
they do not bear the costs of accidents
o So the cost of accidents is not built into prices
o So passengers face prices that are too low – taxi passengers don’t
internalize the cost of accidents when they decide how often to ride
o So the demand for taxi rides will be inefficiently high – again, we get an
inefficiently high activity level

So the table looks the same as before:
Liability Rule
Seller Precaution
Seller Activity
ACCIDENTS BETWEEN STRANGERS
Simple Negligence
Efficient
Too High
Strict Liability
Efficient
Efficient
ACCIDENTS BETWEEN SELLERS AND STRANGERS
Simple Negligence
Efficient
Too High
Strict Liability
Efficient
Efficient
The third case that Shavell considers is that of accidents between sellers and their
customers




Here, he uses the example of restaurants taking precautions to reduce the risk of
food poisoning
(He also points out that accidents between sellers and their employees are very
similar)
In this case, it ends up vitally important how accurately customers perceive risks
He looks at three separate cases:
o customers can accurately perceive the risk of each restaurant
o customers can accurately perceive the average level of risk, but not
differences between different restaurants
o customers are just generally ignorant of the risks
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Under strict liability, customer perception of risk ends up not mattering after all



Under strict liability, the seller bears the cost of accidents, so he takes efficient
precaution to prevent them
And since he still bears the remaining risk of accidents, their expected cost is built
into the price of meals
o That is, menu prices include a premium for expected damage payments
when food poisoning does occur
Which means that regardless of whether they perceive risk, customers make
efficient choices about how often to eat out, because they explicitly see the cost of
risk through prices
o That is, if I like seafood, I don’t have to know that if I eat raw shellfish, I
have a 1-in-100 chance of an unpleasant experience that costs me $500
o I don’t need to know this because the cost of a raw shellfish meal is $5
more than it would be otherwise, since the restaurant needs to charge this
just to break even since if I ever do get sick, he knows I’ll sue
o So the prices I face include the expected cost of food poisoning; so even if
I don’t realize that, I choose efficiently.
Under negligence, however, this doesn’t work





Under negligence, restaurants will still take efficient precaution, to avoid liability
(they’ll keep the kitchen clean, wash hands after using the bathroom, etc.)
But since they then won’t be liable when accidents do occur, prices won’t reflect
these risks
If customers correctly perceive risks, this won’t matter – customers will consider
the money cost of the meal, plus the expected cost due to food poisoning, and will
choose efficiently
But if customers underestimate the risk of food poisoning, they’ll order an
inefficiently large number of risky meals – the level of activity will be too high
We can start a new table, just for the case of sellers and their customers:
Liability Rule
Risk Perception
Strict Liability
Yes
No
Yes
No
Negligence
Seller
Precaution
Efficient
Efficient
Efficient
Efficient
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Buyer Activity
Efficient
Efficient
Efficient
Too High
We can also look at what will happen under a rule of no liability

If customers correctly judge the risk, then sellers will still take efficient
precaution – it gives them a way to attract customers
o If the restaurant can spend $3 to make a meal $5 cheaper in expected
costs, they could charge $4 more for the meal and still get more customers
o Competition means that this will happen

So if risk is judged accurately, sellers will take efficient precautions, and buyers,
judging risk correctly, will buy the efficient number of meals

Next, suppose customers can accurately judge the average level of risk across all
restaurants, but can’t differentiate between restaurants

In this case, restaurants have no reason to take precaution – since they won’t be
rewarded with higher sales, and they won’t be liable if there are accidents – so
precaution will be zero

But, at least customers will know that precaution is low and the product is risky,
so they’ll eat the efficient number of meals
o Under no liability in a city without any health inspectors, maybe people
don’t eat much sushi

Finally, consider the case where customers are just completely oblivious to the
risk of the product

Like the last case, there is no reason for sellers to take any precaution

And since there is no liability, risk will not be built into prices

And since customers can’t perceive risk, not only is precaution too low, but
activity is too high – customers don’t consider the risks when deciding how often
to eat out
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So for the case of accidents between sellers and their customers, we can sum up Shavell’s
results like this:
ACCIDENTS BETWEEN SELLERS AND THEIR CUSTOMERS
Liability Rule
Risk Perception Seller
Buyer Activity
Precaution
Strict Liability
Yes
Efficient
Efficient
No
Efficient
Efficient
Negligence
Yes
Efficient
Efficient
No
Efficient
Too High
No Liability
Yes
Efficient
Efficient
Average
None
Efficient
No
None
Too High
(They also argue accidents between businesses and their employees work the same way.)
It’s a really nice paper. I know we went through all this pretty quickly – if you’re still
confused, I highly recommend reading at least the introduction of the paper.
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Next topic: due care.

All our talk about negligence rules, and especially about efficiency, has assumed
that courts are able to set a legal standard of care equal to the efficient level

That is, a negligence rule leads to an actual level of precaution equal to the legal
standard x~
o Efficiency requires this to match the level that minimizes the total social
cost of accidents, x*
o So negligence rules are only efficient if x~ = x*.

In some cases, this is exactly what the courts try to do

This is based on a 1947 case, United States v Carroll Towing Company, in which
Judge Learned Hand formulated a rule for deciding on negligence

The case (as described in Cooter and Ulen) was this:
A number of barges [in New York Harbor] were secured by a single mooring line
to several piers.
The defendant’s tug was hired to take one of the barges out to the harbor.
In order to release the barge, the crew of the defendant’s tug, finding no one
aboard in any of the barges, readjusted the mooring lines.
The adjustment was not done properly, with the result that one of the barges later
broke loose, collided with another ship, and sank with the cargo.
The owner of the sunken barge sued the owner of the tug, claiming that the tug
owner’s employees were negligent in readjusting the mooring lines.
The tug owner replied that the barge owner was also negligent because his agent,
called a “bargee,” was not on the barge when the tug’s crew sought to adjust the
mooring lines.
The bargee could have assured that the mooring lines were adjusted correctly.
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Judge Learned Hand, in his decision, wrote the following:
It appears from the foregoing review that there is no general rule to determine
when the absence of a bargee or other attendant will make the owner of a barge
liable for injuries to other vessels if she breaks away from her moorings…
Since there are occasions when every vessel will break away from her moorings,
and since, if she does, she becomes a menace to those around her; the owner’s
duty, as in other similar situations, to provide against resulting injuries is a
function of three variables:
(1) the probability that she will break away; (2) the gravity of the resulting injury,
if she does; (3) the burden of adequate precautions.
Possibly it serves to bring this notion into relief to state it in algebraic terms:
if the probability be called P; the injury, L; and the burden, B; liability depends
upon whether B is less than L multiplied by P.

Thus, Judge Hand argued that if precaution (in this case, having a bargee on board
your barge) cost less than its expected benefit, then it was negligent not to do it

So the legal standard for what constituted negligence was exactly whether the
precaution was efficient (“cost-justified”)

Since having an agent on board the barge is a yes-no decision, not a continuous
variable, these were stated as absolutes
But if we reinterpret them as marginal terms, we get back to our old rule for
efficiency
If w, the marginal cost of precaution, is less than –p’A, the marginal benefit, the
injurer is negligent
Implicitly, this is the same as setting the legal standard for care, x~, equal to the
efficient level, x*.



Cooter and Ulen argue that successive application of the Hand rule over time will lead to
people figuring out what the legal standard for precaution is.
 I’m careless, I cause an accident, I get sued.
 The court rules that a little more precaution would have been justified, so I’m held
liable
 The next guy is a little more careful
 Eventually, an accident happens, he gets sued, he’s found negligent
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


The next guy is a little more careful
Eventually, we reach a level of care where a little bit more would not have been
cost-justified
That guy is found not to be negligent, and not held liable, and then we all know
what level of care is required.
So that’s one way for the legal standard of care to be worked out





Another alternative, of course, is for laws and regulations to specify a legal
standard
Highway officials could compute the efficient speed for a particular road –
accounting for the value of getting somewhere sooner, and the effect of speed on
the likelihood of accidents – and set the speed limit to the be efficient speed.
And of course, a third alternative is for the law to enforce social norms or bestpractices of an industry when it comes to standards of care
That is, if a community or an industry has been facing this problem for a long
time, and evolved its own norms or practices for what level of care is required,
it’s plausible that this level is efficient, and the court may just choose to enforce it
The book gives the example of a residential community setting rules concerning
the maintenance of steps leading up to houses, or the accounting industry having
standards regarding auditing.
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Cooter and Ulen point out that American courts have consistently made a mistake in the
way they’ve applied the Hand rule




In terms of calculating the efficient level of precaution, marginal cost should be
balanced against the total social benefit of reducing accidents, which includes
both the reduction in risk to the plaintiff (“risk to others”) and the risk to the
injurer himself (“risk to self”)
For example, when I drive recklessly, I risk hitting a pedestrian, and I also risk
destroying my own car
The reduction in both these risks constitutes the social benefit of driving more
carefully
However, courts have tended to only consider the reduction in “risk to others”
when assessing the benefits of precaution.
Cooter and Ulen also point out the idea of “hindsight bias”
 Once something happens, we tend to assume it was likely to happen
 That is, if something is extremely low-probability, but then occurs, we may
change our mind about how unlikely it initially was to happen
 This would lead to an overestimate after the fact of the probability of an accident
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