Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2012 Lecture 18

Incentives “I hear in some places, you need one form of ID to buy a gun, but two to pay for it by check. It’s interesting who has what incentives to care about what mistakes.” - XKCD

Jumping back into tort law • Coase Theorem relied on voluntary negotiations to allocate goods, and rights, efficiently • Certain interactions, ex-ante negotiations not feasible • I can’t negotiate with everyone in Madison over how carefully I should drive • Best we can do: design rules that make “good” behavior in my own private interest • Several ways we could discourage adverse behavior • “Punish the behavior” – criminal law, speed limits, safety regulation • “Punish the outcome” – strict liability rule • “Punish the combination of behavior and outcome” – negligence rule

Jumping back into tort law • We’ve focused on a few particular incentives: • Injurer precaution • Victim precaution • Injurer activity level • Victim activity level • …and considered the effect on each of these of… • No liability • Strict liability • Various versions of a negligence rule • Both in interactions between private individuals… • …and between businesses and individuals

Jumping back into tort law • Also examined how legal standard for negligence is set • Hand Rule: efficient precautions are required • Other ways: safety standards, industry norms • …and the effect of errors in implementing each rule • Strict liability rule: random errors in calculating damages have no effect, systematic errors do • Negligence rule: small errors in damages have no effect; errors in standard for negligence have strong effect; uncertainty in legal standard leads to overprecaution

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.”

Up next… • What factors/complications has our simple model been leaving out? • How much money is your life worth? • But first…

Experiment

Relaxing theassumptionsof our model

Our model thus far has assumed… • So far, our model has assumed: • People are rational • Injurers pay damages in full • They don’t run out of money and go bankrupt • There are no regulations in place other than the liability rule • There is no insurance • Litigation is costless • 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

Example of judgment-proofness(from old final exam) • Owner of an oil tanker • Any accident would be an environmental catastrophe, doing $50,000,000 of harm • Upgraded navigation system would cost $225,000, and reduce likelihood of an accident from 1/100 to 1/500 • Precaution reduces expected harm from $500,000 to $100,000, costs $225,000, so efficient to take precaution • If company would be forced to pay $50,000,000 after an accident, then under strict liability, would choose to buy new nav system • Suppose the business is only worth $5,000,000 • If there’s an accident, pay the $5,000,000 and go out of business • Now nav system reduces expected damages from $50,000 to $10,000 – not worth the cost • So judgment-proof business would take too little precaution

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 • Regulations supply additional incentive to take precaution

Continuing the example of judgment-proofness from before… • We saw, if business is only worth $5,000,000, liability does not create enough incentive to upgrade nav system • Now suppose government passes regulation requiring modern navigation systems on all oil tankers • If business doesn’t upgrade, 1 in 5 chance of being caught by safety inspector and having to pay a $1,000,000 fine • Now, combining liability with regulation… • Upgrade: cost of new nav system is $225,000, expected damages are $10,000  private cost is $235,000 • Don’t upgrade: expected damages are $50,000, expected government fine is $200,000  private cost is $250,000 • Liability + regulation gives enough incentive to take precaution, even though either one alone would not be enough

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 • 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!

More twistson liability

Vicarious Liability • Vicarious liability is when one person is held liablefor harm caused by another • Parents may be liable for harm caused by their child • Employer may be liable for harm caused by employee • Respondeat superior – “let the master answer” • Employer is liable for unintentional torts of employeeif employee was acting within the scope of his employment

Vicarious Liability • Gives employers incentive to... • be more careful who they hire • be more careful what they assign employees to do • supervise employees more carefully • Employers may be better able to make these decisions than employees… • …and employees may be judgment-proof

Vicarious Liability • Vicarious liability can be implemented through… • Strict liability rule: employer liable for any harm caused by employee (as long as employee was acting within scope of employment) • Negligence rule: employer is only liable if he was negligent in supervising employee • Which is better? It depends. • If proving negligent supervision is too hard, strict vicarious liability might work better • But an example favoring negligent vicarious liability…

Joint and Several Liability • Suppose you were harmed by accident caused by two injurers • Joint liability: you can sue them both together • Several liability: you can sue each one separately • Several liability with contribution: each is only liable for his share of damage • Joint and several liability: you can sue either one for the full amount of the harm • Joint and several liability with contribution: the one you sued could then sue his friend to get back half his money

Joint and Several Liability • Joint and several liability holds under common law when… • Defendants acted together to cause the harm, or… • Harm was indivisible (impossible to tell who was at fault) • Good for the victim, because… • No need to prove exactly who caused harm • Greater chance of collecting full level of damages • Instead of suing person most responsible, could sue person most likely to be able to pay

Back to Comparative Negligence • Negligence with a defense of contributory negligencewas dominant liability rule in common law countries • Negligent injurer is liable, unless victim was also negligent • Example: a car going 60 mph hits a car going 35 in a 30-mph zone • Since victim was also negligent, injurer is not liable • Last 40 years, most U.S. states have adopted a comparative negligence rule • Usually through legislation, sometimes through judicial decision • Appealing from fairness point of view • But any negligence rule leads to efficient precaution • So how do we explain the move?

Comparative Negligence and Evidentiary Uncertainty • Evidentiary uncertainty • Given a legal standard for negligence, xn… • …and an actual level of precaution taken, x… • still uncertainty in whether the court will find negligence • Evidentiary uncertainty, like random errors in setting xn, leads to over-precaution… • …but comparative negligence partly mitigates this

Comparative negligence and evidentiary uncertainty $ Comparative negligence, evidentiary uncertainty Simple negligence, evidentiary uncertainty Any negligence rule wx + p(x) A wx p(x) A x x* • Comparative negligence mitigates effect of evidentiary uncertainty

PerfectCompensation

Perfect compensation • Perfect compensatory damages (D = A) • Returns victim to original level of well-being • (Works like insurance) • And sets correct incentive for injurers • But in some cases, hard to determine level • Might be no price at which you’d be willing to give up a leg • Certainly no price at which a parent would be indifferent toward losing a child

Perfect compensation • Recommended jury instructions, Massachusetts: • “Recovery for wrongful death represents damages to the survivors for the loss of value of decedent’s life. There is no special formula under the law to assess the plaintiff’s damages… • It is your obligation to assess what is fair, adequate, and just. • You must use your wisdom and judgment and your sense of basic justice to translate into dollars and cents the amount which will fully, fairly, and reasonably compensate the next of kin for the death of the decedent. • You must be guided by your common sense and your conscience on the evidence of the case…” • And from California: • “…You should award reasonable compensation for the loss of love, companionship, comfort, affection, society, solace or moral support.”

One other odd feature of compensatory damages… • Most people would rather be horribly injured than killed • Which means killing someone does more damage than injuring someone • But compensatory damages tend to be lower for a fatal accident than an accident which crippled someone • When someone is badly injured, may require huge amount of money to compensate them • In wrongful-death case, damages compensate victim’s loved ones, but no attempt to compensate victim • So these damages tend to be smaller

What’s a lifeworth?

What’s a life worth? • Assessing damages in a wrongful death lawsuit requires some notion of what a life is worth • Safety regulators also need some notion of what a life is worth • Kip Viscusi, The Value of Risks to Life and Health • Regulators need to decide “where to draw the line” Regulation Estimated cost per life saved Airplane cabin fire protection $ 200,000 Car side door protection standards $ 1,300,000 OSHA asbestos regulations $ 89,300,000 EPA asbestos regulations $ 104,200,000 Proposed OSHA formaldehyde standard $72,000,000,000

Kip Viscusi, The Value of Risks to Life and Health • Let w be starting wealth, D death, p probability • There might be some amount of money M such that p u(D) + (1 – p) u(w + M) = u(w) • When p = 1, this breaks down not because you can’t equate death with compensation, but because the second term vanishes • So how do we find M? • Ask a bunch of people how much money they would need to take a 1/1000 chance of death? • Can’t do a lab experiment where you actually expose people to a risk of death! • Clever trick: impute how much compensation people require from the real-life choices they make

Kip Viscusi, The Value of Risks to Life and Health • Lots of day-to-day choices increase or decrease our risk of death • Choose between Volvo and sports car with fiberglass body • Take a job washing skyscraper windows, or office job that pays less • Buy smoke detectors and fire extinguishers, or don’t • “Hand Rule Damages” • Hand Rule: precaution is cost-justified if cost of precaution < reduction in accidents X cost of accident • Suppose side-curtain airbags reduce risk of fatal accident by 1/1000 • If someone pays $1,000 extra for a car with side-curtain airbags, it must mean that $1,000 < 1/1000 * value of their life • or, they value their life more than $1,000,000

Kip Viscusi, The Value of Risks to Life and Health • Viscusi surveys lots of existing studies which impute value of life from peoples’ decisions • Many use wage differentials • How much higher are wages for risky jobs compared to safe jobs? • Others look at… • Decisions to speed, wear seatbelts, buy smoke detectors, smoke cigarettes • Decision to live in very polluted areas (comparing property values) • Prices of newer, safer cars versus older, more dangerous ones • Some used surveys to ask how people would make tradeoffs between money and safety • Each paper reaches some estimate for implicit value people attach to their lives

What does Viscusi find?

24 studies based on wage differentials Implicitvalueof life

7 studies using other risk-money tradeoffs Nature of Risk,Year Component of theMonetary Tradeoff Implicit Value of life($ millions) Highway speed-related accident risk, 1973 Value of driver time based on wage rates 0.07 Automobile death risks, 1972 Estimated disutility of seat belts 1.2 Fire fatality risks without smoke detectors, 1974-1979 Purchase price of smoke detectors 0.6 Mortality effects of air pollution, 1978 Property values in Allegheny Co., PA 0.8 Cigarette smoking risks, 1980 Estimated monetary equivalent of effect of risk info 0.7 Fire fatality risks without smoke detectors, 1968-1985 Purchase price of smoke detector 2.0 Automobile accident risks, 1986 Prices of new automobiles 4.0

6 studies based on surveys Nature ofRisk SurveyMethodology Implicit Value of Life ($ millions) Improved ambulance service, post-heart attack lives Willingness to pay question, door-to-door small (36) Boston sample 0.1 Airline safety and locational life expectancy risks Mail survey willingness to accept increased risk, small (30) U.K. sample, 1975 15.6 Job fatality risk Willingness to pay, willingness to accept change in job risk in mail survey, 1984 3.4 (pay),8.8 (accept) Motor vehicle accidents Willingness to pay for risk reduction, U.K. survey, 1982 3.8 Automobile accident risks Interactive computer program with pairwise auto risk-living cost tradeoffs until indifference achieved, 1987 2.7 (median)9.7 (mean) Traffic safety Series of contingent valuation questions, New Zealand survey, 1989-1990 1.2

Kip Viscusi, The Value of Risks to Life and Health • Wide range of results • Most suggest value of life between $1,000,000 and $10,000,000 • Many clustered between $3,000,000 and $7,000,000 • Even with wide range, he argues this is very useful: • “In practice, value-of-life debates seldom focus on whether the appropriate value of life should be $3 or $4 million… • However, the estimates do provide guidance as to whether risk reduction efforts that cost $50,000 per life saved or $50 million per life saved are warranted.” • “The threshold for the Office of Management and Budget to be successful in rejecting proposed risk regulations has been in excess of $100 million.” • C&U: NHTSA uses $2.5 million for value of traffic fatality • Current: EPA $9.1 MM, FDA $7.9 MM, Transpo Dept $6 MM

Econ 522 Economics of Law