Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2010 Lecture 17

Logistics • Midterm on Wednesday, in 272 Bascom • HW3 (and solutions) returned today

The story so far

The story so far… • Precaution – costly actions that reduce the likelihood of an accident • Activity – how much a “dangerous” activity is done • Effects of different liability rules on precaution and activity levels

Accidents between strangers… • Strict liability… • Injurer internalizes cost of accidents he causes • Efficient precaution and efficient activity by injurers • Victim is “fully insured” – too little precaution, too much activity • Simple negligence… • Injurer takes required level of care to avoid liability – efficient injurer precaution • Injurer is then “safe” – too much activity • Victim bears residual risk of accidents – efficient precaution, efficient activity • Other negligence rules – similar to simple negligence

Accidents between strangers take precaution only to AVOID liability precaution is efficient, butactivity level is too high Injurer Precaution Victim Precaution Injurer Activity Victim Activity No Liability Zero Efficient Too High Efficient Strict Liability Efficient Zero Efficient Too High Simple Negligence Efficient Efficient Too High Efficient Negligence with a Defense of Contributory Negligence Efficient Efficient Too High Efficient Comparative Negligence Efficient Efficient Too High Efficient Strict Liability with Defense of Contributory Negligence Efficient Efficient Efficient Too High

Accidents between strangers precaution and activity levelare both efficient to reduce accidents, since he bears their cost Injurer Precaution Victim Precaution Injurer Activity Victim Activity No Liability Zero Efficient Too High Efficient Strict Liability Efficient Zero Efficient Too High Simple Negligence Efficient Efficient Too High Efficient Negligence with a Defense of Contributory Negligence Efficient Efficient Too High Efficient Comparative Negligence Efficient Efficient Too High Efficient Strict Liability with Defense of Contributory Negligence Efficient Efficient Efficient Too High

When injurer is a business… • Strict liability… • Injurer takes efficient precaution to minimize costs • Perfect competition  “residual risk” built into price of good/service • Customers internalize risk through price, demand efficient amount of good/service – whether or not they’re the ones at risk, whether or not they understand risk • Simple negligence… • Injurer takes efficient precaution to avoid liability • “Residual risk” not built into price • Customers demand too much of good/service if they’re not the one at risk, or if they don’t perceive risks

When injurer is a business and victim is not customer InjurerPrecaution InjurerActivity Simple Negligence Efficient Too High Strict Liability Efficient Efficient

When injurer is a business and victim is its customer RiskPerception? SellerPrecaution BuyerActivity 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

Due Care andthe Hand Rule

Setting the legal standard of care • We’ve been assuming xn = x* • court could set legal standard for avoiding negligence equal to efficient level of precaution • In some cases, this is what court actually tries to do • U.S. v Carroll Towing (1947, U.S. Court of Appeals) • Several barges secured together to piers • Defendant’s tugboat was hired to tow one out to harbor • Crew readjusted mooring lines to free barge, adjustment done incorrectly, one barge broke loose, collided with ship, sank • Barge owner sued tug owner, saying his employees were negligent • Tug owner claimed barge owner was also negligent for not having an agent on board to help • Question: was it negligent to not have a “bargee” on board?

“The Hand Rule” • Judge Learned Hand, in Carroll Towing decision: “It appears… that there is no general rule… 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… 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. Perhaps 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.”

“The Hand Rule” • Failure to take a precaution constitutes negligence if B < L x P • So a particular precaution is required to avoid liability if it is cost-justified – its cost is less than its benefit • Or, a precaution is required to avoid liability if taking it would have been efficient • Hand Rule: “If a precaution is efficient, then you’re negligent if you didn’t take it.” cost of precaution cost of accident probability of accident

“The Hand Rule” • Hand rule: precaution is required to avoid negligence if Cost of precaution < reduction in accidents X size of accident • Having/not having a bargee is discontinuous (yes/no) • But if precaution were a continuous variable, we could think of these as marginal costs/benefits… • Cost is w (marginal cost of precaution) • Reduction in accidents is –p’(x) • Size of accidents is A • Hand Rule says, if w < –p’(x) A, you were negligent, because more precaution would have been efficient

So how is legal standard for negligence established? • One way: successive application of Hand Rule • Another: laws and regulations can specify legal standard • Third: law can enforce social norms or industry best-practices

Two difficulties in establishing legal standards for negligence • American courts have misapplied Hand Rule • To calculate efficient level of precaution, reduction in harm should be based on total social cost of an accident • Should include harm to victim (“risk to others”) and to injurer himself (“risk to self”) • Courts have tended to only count “risk to others” when calculating benefit of precaution • Hindsight bias • After something happens, we assume it was likely to occur • Hard to get unbiased estimate of probability after something happens – likely to overestimate

Effect of Errors

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?

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”

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

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

Effect of errors and uncertainty under strict liability $ wx + p(x) D p(x) D wx + p(x) A wx p(x) A Precaution (x) x x*

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

What about under a negligence rule? $ wx + p(x) D wx + p(x) A p(x) D wx p(x) A x xn = x* • Under a negligence rule, small errors in damages have no effect on injurer precaution

What about errors in setting xn? $ wx + p(x) A wx p(x) A x xn x* xn • Under a negligence rule, injurer’s precaution responds exactly to systematic errors in setting the legal standard

What about random errors in setting xn? $ wx + p(x) A wx p(x) A x x x* • Under a negligence rule, random errors in the legal standard of care lead to increased injurer precaution

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

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

Does it allmatter?

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

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: the truth is somewhere in between

Gary Schwartz, Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter? “Yet between the economists’ strong claim that tort law systematically deters and the critics’ response that tort law rarely if ever deters lies an intermediate position: tort law, while not as effective as economic models suggest, may still be somewhat successful in achieving its stated deterrence goals. …The information [in various studies] suggests that the strong form of the deterrence argument is in error. Yet it provides support for that argument in its moderate form: sector-by-sector, tort law provides something significant by way of deterrence.”

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 fine-tuning.”

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.”

Relaxing theassumptionsof our model

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 think about what would happen when each of these assumptions is violated

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

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

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 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”

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

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

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

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

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

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

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!

Econ 522 Economics of Law