Econ 522 – Lecture 18 (April 2, 2009)
Over the last three lectures…
 we introduced the notion of torts, and several possible rules for when an injurer will be 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 liability

At the end of last lecture, we introduced the rule put forward by Judge Learned
Hand

Referred to as the Hand Rule

The Hand Rule says, to determine whether someone who did not take a particular precaution was negligent… o Let P be the probability of the accident occurring, L the harm, and B the cost of precaution o If P x L > B , then not taking this precaution constitutes negligence o If P x L < B , then not taking this precaution does not constitute negligence

This basically says, efficient precaution is required to avoid negligence ; inefficient precaution is not

There are a few complications… o P really should be the amount that precaution reduces the probability o That is, if precaution makes accidents less likely, but does not eliminate them entirely, P should be the reduction in probability, not the whole probability o L should be the total harm done by the accident (to both injurer and victim), but courts tend to only count harm to victim o P may be hard to estimate after the fact, due to hindsight bias
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Next, a little bit of history.
 We’ve shown that a negligence rule creates efficient incentives for precaution by both the victim and the injurer, while a strict liability rule only creates efficient incentives for the injurer

However, over the course of the 1900s, the incidence of strict liability rules increased

Why?
The answer may have to do with information
 It’s relatively easy to prove harm and causation o A coke bottle explodes and takes out my left eye o Clearly, I got hurt; and clearly, the bottle did it.
 But it’s very hard to prove that Coca-Cola was negligent in their bottling process o I’d have to understand their whole manufacturing process o understand the likelihood of accidents o how the likelihood of accidents responds to precautionary measures they could have taken o how much those actions would have cost o and so on.

Under a negligence rule, it might be too hard to prove negligence

And so under a negligence rule, the manufacturer might not have to take precautions, because they know they can avoid liability anyway.
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On the other hand, under strict liability, the company bears the cost of accidents

So it faces the incentive to reduce accidents directly, not just avoid having appeared negligent

To put it another way, negligence requires me to figure out the efficient level of care Coca-Cola should have taken; strict liability only requires Coca-Cola to figure out the efficient level of care

If Coca-Cola has better knowledge of their manufacturing process than I do, this might be better.
This leads us to the topic of errors and uncertainty in evaluating damages
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For now, let’s put aside the question of whether or not someone is liable, and think only about the problem of calculating the amount of damages owed

There are two types of mistakes a court can make: systematic mistakes , and random mistakes

Random mistakes mean that, if an accident caused $10,000 in harm, the court may end up setting damages either higher or lower than $10,000, but on average will get it right
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Systematic mistakes are when damages, on average, are set incorrectly – that is, they’re either biased to be consistently too high, or consistently too low

C and U refer to systematic mistakes as errors , and to random mistakes as uncertainty
First, let’s look at the effects of errors under a strict liability rule

Under a strict liability rule, the injurer minimizes the sum of two things: cost of precaution, plus expected damage payments (or, wx + p(x) D)

(With perfect compensation, damage payments = cost of accidents, and so the injurer minimizes the total social cost of accidents.)

Random errors in damages awarded have no effect on injurer incentives under a strict liability rule o This is because the injurer is only concerned with the expected level of damages he will have to pay o As long as damages are right on average, he will still internalize the expected cost of accidents, and still take the same level of precaution
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On the other hand, systematic errors in calculating damages will skew the injurer’s incentives o If damages are consistently set too low, then the injurer will internalize less than the entire social cost of accidents; so precaution will be set too low. (DRAW IT.) o If damages are consistently set too high, the injurer will internalize more than 100% of the social cost of accidents, so precaution will be set too high
So under strict liability,
 systematic errors in setting damages will cause the injurer’s precaution level to respond in the same direction as the error
 random errors in setting damages will have no effect
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Another way the court could err is to fail to find the injurer liable when it should

If the probability of being found liable is less than 100%, this has the same effect as lowering the expected level of damages that the injurer has to pay o The injurer is indifferent between paying $10,000 in damages half the time, or paying $5,000 in damages for sure.

So a failure to consistently hold injurers liable has the same effect as a systematic error in setting damages too low
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Under strict liability, systematic failures to hold all injurers liable leads to less injurer precaution
Next, we can look at the same incentives under a negligence rule. (DRAW IT.)

Here, the result is very different

Small errors in setting damages will change how the injurer perceives the p(x)A curve

However, because of the discontinuity, small errors will not cause the injurer to change his behavior – it will still be optimal to take a precaution level of x~
 So “modest” errors – either systematic or random – in setting damages will have no effect on precaution under a negligence rule
Under a negligence rule, modest errors in setting damages will not affect injurer precaution.

Similarly, occasional failures to hold negligent injurers liable will also not affect injurer precaution, as long as they are occasional
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If you have a 90% chance of being held liable when negligent, it’s the same as being charged 90% of the proper level of damages; it may not be enough to change your behavior under a negligence rule.

Of course, large enough errors in either measure could cause the p(x) D curve to dip below the level of w x*, in which case they would have an effect.

(C and U also point out that these errors can be thought of as court errors in setting appropriate damages, or as injurer errors in predicting the level of damages. Again, neither one leads to a change in precaution level under a negligence rule, so long as the errors are not too large.)
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Under a negligence rule, in addition to calculating damages, the court also has to rule on whether the legal standard of care was met
 that is, the court has to compare the care the injurer took, x, to the legal standard, x~, which we hope is set equal to the efficient level, x*

Systematic errors in the standard of care have a very direct effect on injurer precaution
 In general, under a negligence rule, the injurer’s level of precaution responds exactly to systematic court errors in setting the legal standard

(DRAW IT)

What about random errors?

Here, the result is a little bit harder to see

(DRAW IT)

Ssmall amounts of uncertainty about the legal standard will lead to firms taking higher precaution

That is, in general, under a negligence rule, small random errors in the legal standard of care cause the injurer to increase precaution.
Given these results,
 when courts are able to assess damages more accurately than standards of care , a strict liability rule is better
 when a court can assess standards more accurately than damages, a negligence rule is better
 also, when the standard of care is vague – that is, when there is uncertainty about what does and does not constitute negligence – the court should err on the side of leniency, so as not to further aggravate the problem of excessive precaution.
(The book does a little aside on “bright-line” rules, like speed limits, versus vague standards, like “don’t drive recklessly”. In certain settings, laws won’t be enforced if they’re overly vague. Off-topic a bit, but California helmet law.)
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We can think quickly about the relative costs of administering the different liability rules
 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
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(More time spent, more witnesses, etc.)
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On the other hand, under a negligence rule, many victims will know they have no case, and therefore not bring a lawsuit at all
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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
 So it’s not clear which will be cheaper

(Obviously, a rule of no liability leads to lower administrative costs than either, since there’s no work to be done)

There is also a 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
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Next: does it all matter?
That is, given all the time that we’ve just spent developing a formal economic model and examining its implications, it’s fair to step back a bit and ask the question: does the model work?

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?
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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 o implicitly assuming that people behaved exactly as in the model; or o 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 o 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.
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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 lawand-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 non-economic 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.”
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
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.
Decision-makers are rational
2.
There are no regulations in place beyond the liability rule
3.
There is no insurance
4.
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 will have.
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
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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.
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
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 to lots of regulations about flame-retardant childrens’ pajamas
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But they ignore 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 o (People assume that any product on the market must be very safe, so they exercise no caution whatsoever.)

A negligence rule with a defense of contributory negligence is common for product liability

This would lead chainsaw companies to design chainsaws that are perfectly safe
(or at least, efficiently safe) as long as they are not used negligently

Under perfect rationality, this would lead consumers to take efficient care in using them, and all would be well

But if irrational consumers underestimate chainsaw risk, this would lead to too many accidents
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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.
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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”
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All of which they summarize as “lapses”
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The idea: 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)
 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 o Proving intent is even harder than proving negligence, which was already harder than proving harm and causation

Such a rule 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.
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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: o dump recklessly o earn short-term profits o pay them out to shareholders o remain undercapitalized o and expect to go bankrupt the first time an accident happens

An injurer whose liability is limited by bankruptcy is referred to as being judgment-proof

That is, they are immune to judgments beyond a certain level o If I have $100,000 in the bank and I cause an accident causing $1,000,000 in harm, I expect to only pay $100,000 o So my incentive to take precautions is much lower

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
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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, if I speed and cause a car accident, I may be liable

But if I get caught speeding, I’ll get a ticket, even if I didn’t cause an accident

Similarly, fire regulations may require a store to have a working fire extinguisher, and fines may be issued to stores that fail safety inspections

But on top of the regulations, if a fire in the store injured a customer, the store would still be liable
When there is both liability and safety regulation, courts could adopt the safety standards as the required standard of care

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, C&U also offer arguments why a court might fear industry regulators would 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.
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
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

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. insurance
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.
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In reality, the victim might buy insurance for harm caused by accidents, and the injurer might buy insurance to cover his liability.

However, insurance tends not to 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 o neither the injurer nor the victim would bear the cost of accidents o the injurer’s liability would be covered by insurance o the victim would recover the full amount of his losses o and the two insurance companies would fight it out between them for who bears the costs

Insurance companies take in revenues, in the form of premiums; and they pay out claims and administrative costs

If insurance markets are perfectly competitive, then profits will be 0; premiums will exactly balance (on average) claims plus other costs

Earlier, we described the goal of tort law as minimizing the sum of the cost of accidental harm, the cost of preventing accidents, and the costs of administration.
Translated into a world with insurance, this becomes…
In a system of universal insurance and competitive insurance markets, the goal of tort law can be described as minimizing the total cost of insurance to policyholders.
(The costs of precaution seem to have vanished from this formulation, but with perfect insurance, neither side has any incentive to take precautions.)
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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
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.)
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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.
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