Econ 522
Economics of Law
Dan Quint
Fall 2009
Lecture 18
Results of
Tuesday’s experiment
1
Tuesday’s experiment
You have been asked to serve on a jury on a lawsuit dealing with
personal injury. In the case before you, a 50-year-old construction
worker was injured on the job due to the negligence of his employer.
As a result, this man had his right leg amputated at the knee. Due to
this disability, he cannot return to the construction trade and has few
other skills with which he could pursue alternative employment.
The negligence of the employer has been firmly established, and
health insurance covered all of the related medical expenses.
Therefore, your job is to determine how to compensate this worker for
the loss of his livelihood and the reduction in his quality of life.
2
What did you all say a leg was worth?
25%
20%
15%
10%
5%
0%
less than
100,000
100,000 to
199,999
200,000 to
499,999
500,000 to
999,999
1,000,000 to 2,000,000 to 4,000,000 to
1,999,999
3,999,999
7,999,999
8,000,000
and up
3
What were we actually trying to test?
Half of you were asked…
The other half were asked…
(a) Should the plaintiff in this case be
awarded more or less than
$10,000?
(a) Should the plaintiff in this case be
awarded more or less than
$10,000,000?
(b) How much should the plaintiff
receive? (Please give a number.)
(b) How much should the plaintiff
receive? (Please give a number.)
(c)
(c) Are you male or female?
Are you male or female?
 The question: how much did the “suggestion” affect
answers to question (b)?
4
So, how much did question (a) affect your
answers to question (b)?
35%
asked 10k
asked 10MM
30%
25%
20%
15%
10%
5%
0%
less than
100,000
100,000 to
199,999
200,000 to
499,999
500,000 to
999,999
1,000,000 to 2,000,000 to 4,000,000 to
1,999,999
3,999,999
7,999,999
8,000,000
and up
5
Or to put it another way…
Asked
$10,000
Sample Size
Asked
$10,000,000
Both
Groups
23
25
48
1,002,609
4,644,000
2,899,167
323,118
2,764,049
988,266
10,001
700,000
10,001
25th Percentile
112,500
1,000,000
250,000
Median
250,000
3,000,000
1,000,000
75th Percentile
875,000
5,000,000
3,100,000
10,000,000
20,000,000
20,000,000
Average
Geometric Mean
Smallest
Largest
6
But the picture’s so cool, I’ll show it again
35%
asked 10k
asked 10MM
30%
25%
20%
15%
10%
5%
0%
less than
100,000
100,000 to
199,999
200,000 to
499,999
500,000 to
999,999
1,000,000 to 2,000,000 to 4,000,000 to
1,999,999
3,999,999
7,999,999
8,000,000
and up
7
What does it mean?
 Nobody knows what a leg is worth
 “Reference point bias”
 “Framing effects”
8
Back to work…
9
So far…
 We’ve discussed a bunch of liability rules



No liability
Strict liability
Various versions of a negligence rule
 And the effect of each rule on several incentives:




Injurer precaution
Victim precaution
Injurer activity level
Victim activity level
 And we saw the Hand Rule for determining negligence

“If more precaution would have been efficient, you should have
taken it”
10
Strict liability versus negligence
 Negligence rules lead to efficient precaution by both sides
 But strict liability leads to efficient activity level by injurers
 Over course of 1900s, strict liability rules became more
common
 Why?
11
Strict liability versus negligence: information
 Relatively easy to prove harm and causation
 Harder to prove negligence
 If negligence is hard enough to prove, injurers might avoid
liability altogether…
 …in which case they have no incentive to take precaution
 “Negligence requires me to figure out the efficient level of
care for Coca-Cola; strict liability only requires Coca-Cola
to figure out the efficient level of care”
12
Errors and uncertainty in evaluating damages
 Random mistakes


Damages could be set too high or too low, but on average are
correct
Textbook calls these uncertainty
 Systematic mistakes


Damages are set incorrectly on average – consistently too high, or
consistently too low
Textbook calls these errors
13
Effect of errors and uncertainty under strict
liability
 Strict liability rule: injurer minimizes wx + p(x) D


Perfect compensation: D = A
Leads injurer to minimize social cost wx + p(x) A
 Under strict liability, random errors in damages have no
effect on incentives


Injurer only cares about expected level of damages
As long as damages are right on average, injurers still internalize
cost of accidents, set efficient levels of precaution and activity
14
Effect of errors and uncertainty under strict
liability
$
wx + p(x) D
p(x) D
wx + p(x) A
wx
p(x) A
x
x*
Precaution (x)
15
Effect of errors and uncertainty under strict
liability
 Under strict liability:

random errors in setting damages have no effect

systematic errors in setting damages will skew the injurer’s
incentives



if damages are set too low, precaution will be inefficiently low
if damages are set too high, precaution will be inefficiently high
failure to consistently hold injurers liable has the same effect as
systematically setting damages too low

if not all injurers are held liable, precaution will be inefficiently low
16
What about under a negligence rule?
$
wx + p(x) D
wx + p(x) A
p(x) D
wx
p(x) A
xn = x*
x
 Under a negligence rule, small errors in damages have no
effect on injurer precaution
17
What about errors in setting xn?
$
wx + p(x) A
wx
p(x) A
xn
x*
xn
x
 Under a negligence rule, injurer’s precaution responds
exactly to systematic errors in setting the legal standard
18
What about random errors in setting xn?
$
wx + p(x) A
wx
p(x) A
x* x
x
 Under a negligence rule, small random errors in the legal
standard of care lead to increased injurer precaution
19
To sum up the effects of errors and
uncertainty…
 Under strict liability:



random errors in setting damages have no effect
systematic errors in setting damages will skew the injurer’s incentives
in the same direction
failure to consistently hold injurers liable lead to less precaution
 Under negligence:



small errors, random or systematic, in setting damages have no effect
systematic errors in the legal standard of care have a one-to-one
effect on precaution
random errors in the legal standard of care lead to more precaution
 So…



when court can assess damages more accurately than standard of
care, strict liability is better
when court can better assess standards, negligence is better
when standard of care is vague, court should err on side of leniency 20
What about relative administrative costs of
the two systems?
 Negligence rules lead to longer, more expensive trials

Simpler to just prove harm and causation
 But negligence rules lead to fewer trials

Not every victim has a case, since not every injurer was negligent
 Unclear which system will be cheaper overall
21
Does it all
matter?
22
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
 Reviews a wide range of empirical studies
 Finds: tort law does affect peoples’ behavior, in the
direction the theory predicts…
 …but not as strongly as the model suggests
23
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
 Reviews a wide range of empirical studies
 Finds: tort law does affect peoples’ behavior, in the
direction the theory predicts…
 …but not as strongly as the model suggests
 Most academic work either…


took the model literally, or
pointed out reasons why model was wrong and liability rules might
not affect behavior at all
 Schwartz found truth was somewhere in between
24
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
“Much of the modern economic analysis, then, is a worthwhile
endeavor because it provides a stimulating intellectual exercise
rather than because it reveals the impact of liability rules on the
conduct of real-world actors.
Consider, then, those public-policy analysts who, for whatever
reason, do not secure enjoyment from a sophisticated economic
proof – who care about the economic analysis only because it
might show how tort liability rules can actually improve levels of
safety in society.
These analysts would be largely warranted in ignoring those
portions of the law-and-economics literature that aim at finetuning.”
25
Gary Schwartz, Reality in the Economic Analysis
of Tort Law: Does Tort Law Really Deter?
 Worker’s compensation rules in the U.S.


Employer is liable – whether or not he was negligent – for economic
costs of on-the-job accidents
Victim still bears non-economic costs (pain and suffering, etc.)
“…Worker’s 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.”
26
Relaxing the
assumptions
of our model
27
Our model thus far has assumed…
 So far, our model has assumed:

People are rational

There are no regulations in place other than the liability rule

There is no insurance

Injurers pay damages in full


They don’t run out of money and go bankrupt
Litigation costs are zero
 We can relax each assumption and see what happens
28
Assumption 1: Rationality
 Behavioral economics: people systematically misjudge
value of probabilistic events
 Daniel Kahneman and Amos Tversky, “Prospect Theory: An
Analysis of Decision under Risk”







45% chance of $6,000 versus 90% chance of $3,000
Most people (86%) chose the second
0.1% chance of $6,000 versus 0.2% chance of $3,000
Most people (73%) chose the first
But under expected utility, either u(6000) > 2 u(3000), or it’s not
So people don’t actually seem to be maximizing expected utility
And the “errors” have to do with how people evaluate probabilities
29
Assumption 1: Rationality
 People seem to overestimate chance of unlikely events with
well-publicized, catastrophic events
 Freakonomics: people fixate on exotic, unlikely risks, rather
than more commonplace ones that are more dangerous
30
Assumption 1: Rationality
 People seem to overestimate chance of unlikely events with
well-publicized, catastrophic events
 Freakonomics: people fixate on exotic, unlikely risks, rather
than more commonplace ones that are more dangerous
 How to apply this: accidents with power tools





Could be designed safer, could be used more cautiously
Suppose consumers underestimate risk of an accident
Negligence with defense of contributory negligence: would lead to
tools which are very safe when used correctly
But would lead to too many accidents when consumers are irrational
Strict liability would lead to products which were less likely to cause
31
accidents even when used recklessly
Assumption 1: Rationality
 Another type of irrationality: unintended lapses
 “Many accidents result from tangled feet, quavering hands,
distracted eyes, slips of the tongue, wandering minds,
weak wills, emotional outbursts, misjudged distances, or
miscalculated consequences”
32
Assumption 2: Injurers pay damages in full
 Strict liability: injurer internalizes expected harm done,
leading to efficient precaution
 But what if…






Harm done is $1,000,000
Injurer only has $100,000
So injurer can only pay $100,000
But if he anticipates this, he knows D << A…
…so he doesn’t internalize full cost of harm…
…so he takes inefficiently little precaution
 Injurer whose liability is limited by bankruptcy is called
judgment-proof

One solution: regulation
33
Assumption 3: No regulation
 What stops me from speeding?


If I cause an accident, I’ll have to pay for it
Even if I don’t cause an accident, I might get a speeding ticket
 Similarly, fire regulations might require a store to have a
working fire extinguisher
 When regulations exist, court could use these standards as
legal standard of care for avoiding negligence

Or court might decide on a separate standard
34
Assumption 3: No regulation
 When liability > injurer’s wealth, liability does not create
enough incentive for efficient precaution
 Regulations which require efficient precaution solve the
problem
 Regulations also work better than liability when accidents
impose small harm on large group of people
35
Assumption 4: No insurance
 We assumed injurer or victim actually bears cost of
accident
 When injurer or victim has insurance, they no longer have
incentive to take precaution
 But, insurance tends not to be complete
36
Assumption 4: No insurance
 If both victims and injurers had complete insurance…





Neither side would bear cost of accidents
If insurance markets were competitive, premiums would exactly
balance expected payouts (plus administrative costs)
We said earlier, goal of tort law was to minimize sum of accidental
harm, cost of preventing accidents, and administrative costs
In a world with universal insurance and competitive insurance
markets, goal of tort law can be described as minimizing cost of
insurance to policyholders
Under strict liability, only injurers need insurance; under no liability,
only victims need insurance
37
Assumption 4: No insurance
 Insurance reduces incentive to take precaution

Moral hazard
 Insurance companies have ways to reduce moral hazard



Deductibles, copayments
Increasing premiums after accidents
Insurers may impose safety standards that policyholders must meet
38
Assumption 5: Litigation costs nothing
 If litigation is costly, this affects incentives in both directions




If lawsuits are costly for victims, they may bring fewer suits
Some accidents “unpunished”  less incentive for precaution
But if being sued is costly for injurers, they internalize more than the
cost of the accident
So more incentive for precaution
 A clever (unrealistic) way to reduce litigation costs





At the start of every lawsuit, flip a coin
Heads: lawsuit proceeds, damages are doubled
Tails: lawsuit immediately dismissed
Expected damages are the same  same incentives for precaution
But half as many lawsuits to deal with!
39