Part D-III The Economics of Tort Law

1. Part D-III The Economics of Tort Law Tort_G

2. Objectives Relaxing Core Assumptions • Rationality • No regulations to deal with the external costs of risk • No insurance • No bankruptcy • No litigation costs Additional concepts • Vicarious Liability • Joint and Several Liability With and Without Contribution Tort_G

3. Objectives Relaxing Core Assumptions What happens if relax some of the fairly restrictive assumptions under which we modelled the tort system. What happens in the ‘real world’? Does the Tort system work well? Is it outdated? does it require wholesale reform or replacement? (product liability/ medical malpractice) Tort_G

4. Rationality As for most economic analysis we have assumed that economic agents were rational decision makers (maximizing utility, profits or something else). - stable, well-ordered preferences - able to calculate the costs and benefits of alternatives that they face - choose alternatives that yield the greatest net benefit Tort_G

5. The economic efficiency of the tort system depends on its ability to ‘send signals’ to economic agents. Signals that cause economic agents to fully internalize the cost of risk where appropriate. Rational agents that ‘receive’ such signals will then make rational self-interested choices and if the tort system has structured the signals correctly, this will lead to ‘socially efficient’ private choices. All of this depends crucially on rational behaviour of individual agents (as does most economic analysis). Tort_G

6. Rationality BUT findings of Kahneman and Tversky (1981) 1. Most individuals cannot accurately estimate (the effect) of low probability events. They respond by assuming that ‘low probability’ implies that the event ‘will not occur’ (probability = zero). 2. Most individuals over-estimate the probability of well-publicized, potentially catastrophic events (nuclear accidents, nuclear war, terrorists attacks, airplane accidents, visitors from outer space ... ). This occurs even when they possess objective information concerning the true probability. WHY? Who knows? Maybe evolutionary roots for such behaviour Tort_G

7. What are the implication of errors in the estimation of the probability of an accident Recall almost all of our results rely on the potential injurer’s or potential victim’s desire to minimize the expected cost of accidents. Expected cost of accidents = wv xv + p(xv, xi)A (potential victim) and = wi xi + p(xv, xi)A (potential injurer) Tort_G

8. Rationality – low probability events Recall many (most?) accidents are low probability events. Perhaps very costly if they happen, but not very likely to happen (car accidents, building fires, etc.). Systematically under-estimating p(xv, xi) for ‘low probability’ events is a serious problem. Any efficiency claims for the tort system based on rationality are brought into question. Even when the correct ‘liability/negligence’ signals are sent, if agents underestimate the risk, then too little precaution will be taken. Tort_G

9. Rationality – potentially catastrophic events Potentially catastrophic means a very large A (harm if the accident does occur) – nuclear power plants, airline accidents, terrorist attacks, nuclear war Systematically over-estimating p(xv, xi) for ‘catastrophic’ events is also a serious problem. Again efficiency claims for the tort system based on rationality are brought into question. Even when the correct ‘liability/negligence’ signals are sent, if agents overestimate the risk, then too much precaution will be taken. Tort_G

10. Note that if individuals are truly behaving irrationally then providing ‘warnings’ or ‘alarming information’ in the case of low probability events or ‘calming information’ in the case of potentially catastrophic events, does little good. The problem is that individuals tend to discount such information or simply ignore it. Tort_G

11. Possible solution (in some cases): What under ‘rationality’ would be a bilateral precaution situation might best be treated as a unilateral precaution situation under ‘irrationality’ (power tool example from text). If potential victims cannot accurately assess the risk (in particular if they systematically underestimate the true risk) then we might want the potential injurer to assume all of the liability (strict liability instead of a negligence rule). For catastrophic events we might need ‘public’ precaution Does the political process feed on this phenomenon? Tort_G

12. Regulations We spoke about the role of ‘regulations’ in setting standards of care. But regulations are often more ‘forceful’: setting specific standards and if the agent fails to meet these standards they can be fined whether or not an accident occurs (fire codes, health and safety standards). At other times, even though the agent meets the regulated standards, they might still be found ‘negligent’ if an accident occurs. Tort_G

13. Regulations – redundancy? Potential injurers/victims often face both regulation and liability. Even if they meet the regulatory standards (fire code, safety code, professional code of conduct, etc.) and someone is injured, they still face liability. Why have both liability and regulation? If liability is adequate, the potential injurer will do what is appropriate and regulation is redundant. (an efficient regulation should set the standard at the efficient level, presumably the level that defines negligence/non-negligence under tort liability rules.) If the regulation is adequate, then what is the point of finding the potential injurer negligent even though they met the safety code. Is this a case of tort law going too far? Tort_G

14. Regulation vs Tort System Answer: In some situations ‘tort liability’ is the more efficient (least cost) way to ensure efficient precaution – In some situations ‘regulation’ is the most efficient tool and sometimes both are required. Regulation is ‘ex ante’, regulators have the power to order potential injurers to correct a hazard (decrease a risk) before an accident occurs. Liability is ‘ex post’, giving courts the power to force injurers to compensate victims. Even though both can lead to the same level of precaution, this basic difference explains the advantages and disadvantages of regulation and liability Tort_G

15. At times bureaucrats can more efficiently acquire information concerning specialized products/industries/hazards. They have the technical knowledge and resources (time) to better understand the risk. Courts are of ‘general’ jurisdiction, often with very little information regarding highly specialized hazards/risks and the appropriate precautions. In such situations courts often defer to regulatory rules and potential injurers can avoid ‘ex ante’ fines and ‘ex post’ liability by simply following the safety regulations. Tort_G

16. ‘Good’ regulations are made when regulators develop information on the nature of the risks, cost of harm and methods and costs of precaution and then apply standard efficiency rules (do a cost-benefit analysis) in order to arrive at the socially optimal rule. ‘Good’ law should be made the same way. Courts assess the ‘ex ante’ risks, harm and methods and costs of precaution and decide on negligence (legal standard of care – reasonable person) and then assign liability. Hopefully they apply the same efficiency criteria. Tort_G

17. So why both regulators and courts? 1. • At times courts can develop more information during the course of a trial than can bureaucrats. (Particularly with respect to the cost of precaution and/or the value of harm.) Injurers and victims might have to reveal facts to courts that they do not have to reveal to regulators. Tort_G

18. 2. - At times courts might believe that bureaucrats are politically motivated in setting safety or other standards. protecting large corporations or other ‘special interests’ (set standard too low) or they have ‘given in’ inappropriately to public interest groups (set standard too high). Note that if liability law imposes a higher standard of care than regulation, then potential injurers will meet the tort standard in order to avoid liability. if regulation imposes a higher standard of care than does tort law, then potential injurers will meet the regulation in order to avoid fines. Tort_G

19. 3. - ‘Safety’ or other regulations might really be trade restrictions in disguise –domestic or foreign trade high cost/low cost (EU and ozone protection), leading courts to set aside the regulated ‘standard of care’. 4. - Regulations and bribes. The stronger the regulation the higher the cost of bribes, leading courts to set aside the regulated ‘standard of care’. Tort_G

20. 5. • We will see that some agents (individuals and firms) take on risks that exceed their financial resources - bankruptcy. If an accident occurs, then they cannot cover the cost of harm irrespective of the liability rule. Pit bulls in backyards - asbestos manufacturing ‘ex post’ liability will not have much effect on behaviour. We require ‘ex ante’ regulation/fines. Tort_G

21. 6. • large number of victims each suffering a small amount of harm (many forms of pollution/industrial accidents). The trial costs for any one victim will likely exceed the harm suffered by that one victim. Is this case, the tort system is an inefficient way to deal with this risk. It might be more efficient simply to impose regulation on the potential injurer. (Note class action suits?) Tort_G

22. Insurance The ‘no liability’ rule causes potential victims to buy insurance (house fires, health care, life insurance, etc) if they are risk adverse. The rule of ‘strict liability’ causes potential injurers to buy insurance (product liability, much commercial insurance) if they are risk adverse. Insurance represents a transfer of risk from the insured to the insurer (the risk is said to be externalized) Tort_G

23. Effect of insurance on the efficiency of tort/liability rules If victims receive compensation from their own insurer, then potential injurers might not take efficient precaution. BUT ‘subrogation clauses’ assign the right to sue (cause of action) to the insurer if you become a victim (OHIP generally gets a piece of most personal injury law suits.) The insurance company pays the victim and then sues the injurer. Tort_G

24. More important effect of insurance If potential victims, or injurers, have insurance they might not take efficient precaution (moral hazard). BUT most insurance contracts provide for co-insurance (a share of the total loss) and/or deductibles (the first $?? of loss), or the rates are ‘experience rated’. ALSO to the extant that the insurer assumes the risk, from either the potential victim or the potential injurer, they have an incentive to ‘manage the risk’ (private safety codes, private negligence standards, private regulation) Tort_G

25. Consider a world in which there is perfect insurance Perfect insurance means perfect compensation for any loss – the insured is indifferent between suffering an accident and not suffering an accident. Perfectly insured individuals do not care about accidents but they do care about insurances rates As insurance markets become more complete and approach perfect insurance, the focus shifts to insurance cost. Tort_G

26. Insurance – Private Liability Law Costs of accident allocated through private contracts Private system of regulation that imposes safety standards. Insurance markets privatize liability and regulate precaution – Private Liability Law. If insurance premiums are experience rated then potential injurers will have an incentive to take precaution. Insurance companies will monitor the behaviour of potential injurers (firms, doctors, etc.) and this will lead to the appropriate precaution. Tort_G

27. Insurance and Tort Law Recall: a ‘no liability’ rule causes potential victims to buy insurance, a ‘strict liability’ rule transfers the risk to the potential injurers causing them to buy insurance. Tort law determines who will bear the risk and therefore who will buy the insurance. Who can buy the insurance most cheaply? Tort_G

28. Question: Does tort law provided ‘too much’ compensation? Consider that the victim of accident (car, fire, etc.) covered by his/her own insurance is generally paid out-of-pocket losses (property, earnings, medical). When no liability applies individuals do not insure against pain and suffering. BUT the victim of an accident in which injurer is liable under tort law is generally paid out-of-pocket losses (property, earnings, medical) plus pain and suffering. Tort law forces potential injurers to insure against pain and suffering of victims. Conclusion: Tort law forces potential injurers to buy more insurance for potential victims than they would buy themselves. (Canada capped at $320,000.) Tort_G

29. Mandatory Insurance – adverse selection Individuals buy insurance - they turn uncertain outcomes into certain outcomes. Insurance companies sell insurance because they can take advantage of the ‘law of large numbers’ and ‘risk pooling’ What is not predictable for any individual is predictable for the larger group. Note, they never know if your particular house will burn but they know ‘on average’ how many houses will burn. Such information on population probabilities allows insurance companies to predict the total number of claims and therefore set insurance premiums. Tort_G

30. Consider two groups of individuals: ‘high risk’ group and ‘low risk’ group Insurance companies cannot identify which individual belongs to which group Insurance premiums are set consistent with the ‘average risk’ and insurance is offered for sale ‘High risk’ group – good deal – buy’s insurance ‘Low risk’ group – bad deal – do not buy insurance Insurance company goes bankrupt - victim of adverse selection Tort_G

31. As a result of the above insurance markets can never really be complete. Some types of insurance will never be offered in the private market. Flood insurance, disaster insurance, unemployment insurance, AIDS insurance (insurance against specific diseases) - also we have the problem of moral hazard Tort_G

32. Why does it cost your employer $3,500 to provide you with extended health benefits BUT you would have to pay $5,000 if you bought it directly? Why are EI, WSIB public schemes? Why is some insurance mandatory (EI, WSIB, Auto)? Note also: adverse selection and the spiraling collapse of insurance schemes Tort_G

33. Bankruptcy The following will be discussed in terms of potential injurers who are firms but the essentials of the analysis hold for private, non-business injurers also. Rule of strict liability causes potential injurers to internalize the cost of harm and choose the optimal level of precaution. Why? Because they face the full social costs of accidents: SC = wi xi + p(xv, xi)A , where A = D (compensation under a liability rule ) But what if the firm’s net worth is less than A (=D) Tort_G

34. If the firm’s net worth is less than A (=D) and an accident occurs, the firm is bankrupt. The firm knows this, so its optimal strategy would be to minimize cost of accidents = wixi+ p(xv, xi)NW, where NW is the net worth of the firm. BUT the firm can control its own net worth. So, in fact it can minimize the costs of accident by minimizing its net worth. Tort_G

35. Recall that the concept of a limited liability corporation implies that the liability of firm owners is limited to their initial investment. What is the value of their initial investment? The net worth of the firm. The firm’s NW (capitalization) is given by: Total Assets (incl. ret. earn.) – Total liabilities Tort_G

36. How does a profitable firm minimize NW? - pay out all earnings to the owners of the firm - borrow against the firm’s assets (real and imagined). Secured creditors get their money first - securitize future revenue Such a firm will become ‘undercapitalized’ Total Assets will be very small as compared to total liabilities (perhaps smaller than) Tort_G

37. Bankruptcy –Risky Business Consider a firm involved in a very risky business (hazardous waste, a bar, etc) FIRM’S COST OF PROBABILITY COST OF EXPECTED FULL COST PRODUCTION OF ACCIDENT HARM TO COST OF PER UNIT Victim ACCIDENTS per unit $1.00 0.0001 $10,000 $1.00 $2.00 for a million units $1 mil. 0.0001 $10,000 x 1 mil. $1 mil. $2 million Tort_G

38. Bankruptcy –Risky Business Now what if the firm sets net worth to zero FIRM’S COST OF PROBABILITY COST OF EXPECTED FULL COST PRODUCTION OF ACCIDENT HARM TO COST OF Victim ACCIDENTS for a million units net worth > or = $1 million $1 mil. 0.0001 $10,000 x 1 mil. $1 mil. $2 million for a million units net worth = 0 $1 mil. 0.0001 $10,000 x 1 mil. $0 $1 million Since there is no chance of having to pay damages the expected cost of accidents is zero. Will this firm take any precaution? What if one firm in this industry plays this game, what will happen to the other firms? Tort_G

39. This is called ‘judgment proofing’ There is another strategy that is more common for ‘respectable’ firms. If reputation matters then you can play the bankruptcy game only once. But what if your production/sales chain has 10 links and only one of these links is very risky? Why put all of your assets at risk? Why not ‘spin off’ the risky part of your business as a small stand alone firm (owned and operated by former employees – preferably in Latin America or Asia) Tort_G

40. What can be done about the impact of insolvency on our ‘efficient’ tort outcomes? - compulsory insurance - posting bonds - ‘ex ante’ regulation - negligence rule as opposed to strict liability (if cost of precaution is small relative to expected cost of harm) Tort_G

41. Think about private individuals owning dangerous pets (pit bulls) or participating in dangerous activities – private individuals can easily create risk which have an expected cost of harm beyond their financial resources. It might appear harsh to ban pit bulls but … Again - compulsory insurance - ‘ex ante’ regulation Tort_G

42. Litigation Costs Litigation can be very costly. Cost of litigation causes victims to enforce their rights less frequently, hence allowing potential injurers to take less precaution) Cost of litigation causes potential injurers to take more precaution in order to avoid costly litigation. We cannot reach a general conclusion as to whether or not costly litigation leads to too much or too little precaution (or the right amount). This issue is studied as part of Legal Process Tort_G

43. Vicarious Liability One person (or firm) is responsible for a tort committed by another person. The third person (or party) is said to be vicariously liable from agent to principle from child to parent (increasingly popular) from employee to employer (most common) An employer can be held liable for the actions of his/her employee acting ‘within the scope of his or her employment’ You sue the city if a policeman misbehaves, the hospital if a nurse makes a mistake, etc. Tort_G

44. What is the logic of this rule? An employer is best able to monitor the actions of the employee (can monitor most efficiently) - competence, responsibility, equipment The employer should then internalizes the cost associated with accidents caused by the employee. Parent - child Tort_G

45. Joint and Several Liability With and WithoutContribution Consider the situation in which several parties have caused harm to a victim. Injurers are jointly liable if the victim can sue the injuring parties simultaneously (same trial), recovering the total cost of harm from the injuring parties jointly. Injurers are severally liable if the victim can sue the injuring parties separately (separate trials) Tort_G

46. Injurers are jointly and severally liable if each injurer is liable for all of the victim’s losses not just a portion of the total loss. Then the victim can decide which injurer to sue (the hospital or the nurse - the hospital of course - deeper pockets). If the two injurers are jointly and severally liable and one is sued but can claim contribution from the other, the rule is said to be joint and several liability with contribution. Tort_G

47. Example: Dr. A, with the assistance of staff at Hospital B completes a medical procedure on Mr. C. Something goes wrong and Mr. C suffers $100 worth of harm. Under a rule of joint liability, C can sue both A and B and recovering a total of $100. Under a rule of several liability, C can sue A and B separately and recover $100 from each of them ($200 in total) - several liability with no contribution and ensures that all potential injurers internalize the total cost of harm. Under a rule of joint and several liability, C can sue A and/or B and recover $100 in total. C can pick his defendant. The victim need not prove who caused the harm among the joint and severally liable defendants. The victim can select the plaintiff with the ‘deepest pockets’, thereby assuring full recovery. Tort_G

48. In practice, it is often the case that in medical malpractice the victim initially sues everyone but then lets off the least negligent party in exchange for information useful against the remaining injurers. The point is that when you enter the operating room for your heart bypass, you would want all health care professionals and the hospital jointly and severally liable with no contribution. You want everyone to internalize the full costs of an accident. Tort_G