Econ 522 Economics of Law

1. Econ 522Economics of Law Dan Quint Spring 2012 Lecture 19

2. Logistics • Midterm 2 is graded, will be returned after lecture • Homework 4 is online • Due May 3 • Longer than others

3. Monday’sexperiment

4. 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.

5. What were we trying to test? Half of you were asked… The other half were asked… • Should the plaintiff in this case be awarded more or less than $10,000? • How much should the plaintiff receive? (Please give a number.) • Are you male or female? • Should the plaintiff in this case be awarded more or less than $10,000,000? • How much should the plaintiff receive? (Please give a number.) • Are you male or female? • The question: how much did the “suggestion” affect answers to question (b)?

6. So, what happened? people given the $10,000 “suggestion” average: 322,125

7. So, what happened? 322,125 4,138,095

8. Another way to see it

9. What about men vs. women? 322,125 4,138,095 368,571 3,990,909

10. What does it mean? • Nobody knows what a leg is worth • “Reference point bias” • “Framing effects”

11. Back to work…

12. What’s a lifeworth?

13. 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

14. 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

15. 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

16. 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

17. What does Viscusi find?

18. 24 studies based on wage differentials Implicitvalueof life

19. 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

20. 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

21. 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

22. Punitivedamages

23. Inconsistency of damages • Damage awards vary greatly across countries, even across individual cases • We saw last week: • As long as damages are correct on average, random inconsistency doesn’t affect incentives (under either strict liability or negligence) • But, if appropriate level of damages isn’t well-established, more incentive to spend more fighting

24. (One problem with inconsistent damages: more incentive to fight hard) • Example: each side can hire cheap lawyer or expensive lawyer • Cheap lawyer costs $10, expensive lawyer costs $45 • If two lawyers are equally good, expected judgment is $100 • If one is better, expected judgment is doubled or halved Defendant Cheap Expensive 90, -110 40, -95 Cheap Lawyer Plaintiff 155, -210 55, -145 Expensive Lawyer

25. Punitive damages • What we’ve discussed so far: compensatory damages • Meant to “make victim whole”/compensate for actual damage done • In addition, courts sometimes award punitive damages • Additional damages meant to punish injurer • Create stronger incentive to avoid initial harm • Punitive damages generally not awarded for innocent mistakes, but may be used when injurer’s behavior was “malicious, oppressive, gross, willful and wanton, or fraudulent”

26. Punitive damages • Calculation of punitive damages even less well-defined than compensatory damages • Level of punitive damages supposed to bear “reasonable relationship” to level of compensatory damages • Not clear exactly what this means • U.S. Supreme Court: punitive damages more than ten times compensatory damages will attract “close scrutiny,” but not explicitly ruled out

27. Example of punitive damages: Liebeck v McDonalds (1994) (“the coffee cup case”) • Stella Liebeck was badly burned when she spilled a cup of McDonalds coffee in her lap • Awarded $160,000 in compensatory damages, plus $2.9 million in punitive damages • Case became “poster child” for excessive damages, but…

28. Liebeck v McDonalds (1994) • Stella Liebeck dumped coffee in her lap while adding cream/sugar • Third degree burns, 8 days in hospital, skin grafts, 2 years treatment • Initially sued for $20,000, mostly for medical costs • McDonalds offered to settle for $800 • McDonalds serves coffee at 180-190 degrees • At 180 degrees, coffee can cause a third-degree burn requiring skin grafts in 12-15 seconds • Lower temperature would increase length of exposure necessary • McDonalds had received 700 prior complaints of burns, and had settled with some of the victims • Quality control manager testified that 700 complaints, given how many cups of coffee McDonalds serves, was not sufficient for McDonalds to reexamine practices

29. Liebeck v McDonalds (1994) • Rule in place was comparative negligence • Jury found both parties negligent, McDonalds 80% responsible • Calculated compensatory damages of $200,000 • times 80% gives $160,000 • Added $2.9 million in punitive damages • Judge reduced punitive damages to 3X compensatory, making total damages $640,000 • During appeal, parties settled out of court for some smaller amount • Jury seemed to be using punitive damages to punish McDonalds for being arrogant and uncaring

30. What is the economic purpose of punitive damages? • We’ve said all along: with perfect compensation, incentives for injurer are set correctly. So why punitive damages? • Example… • Suppose manufacturer can eliminate 10 accidents a year, each causing $1,000 in damages, for $9,000 • Clearly efficient • If every accident victim would sue and win, company has incentive to take this precaution • But if some won’t, then not enough incentive • Suppose only half the victims will bring successful lawsuits • Compensatory damages would be $5,000; company is better off paying that then taking efficient precaution • One way to fix this: award higher damages in the cases that are brought

31. This suggests… • Punitive damages should be related to compensatory damages, but higher the more likely injurer is to “get away with it” • If 50% of accidents will lead to successful lawsuits, total damages should be 2 X harm • Which requires punitive damages = compensatory damages • If 10% of accidents lead to awards, damages should be 10 X harm • So punitive damages should be 9 X compensatory damages • Seems most appropriate when injurer’s actions were deliberately fraudulent, since may have been based on cost-benefit analysis of chance of being caught

32. Some empirical observations about tort system in the U.S.

33. U.S. tort system • In 1990s, tort cases passed contract cases as most common form of lawsuit • Most handled at state level: in 1994, 41,000 tort cases resolved in federal courts, 378,000 in state courts in largest 75 counties • Most involve a single plaintiff (many contract cases involve multiple plaintiffs) • Among tort cases in 75 largest U.S. counties… • 60% were auto accidents • 17% were “premises liability” (slip-and-fall in restaurants, businesses, government offices, etc.) • 5% were medical malpractice • 3% were product liability

34. U.S. tort system • Punitive damages historically very rare • 1965-1990, punitive damages in product liability cases were awarded 353 times • Average damage award was $625,000, reduced to $135,000 on appeal • Average punitive damages only slightly higher than compensatory • In many states, punitive damages limited, or require higher standard of evidence • Civil suits generally require “preponderance of evidence” • In many states, punitive damages require “clear and convincing” evidence

35. U.S. tort system • Medical malpractice • New York study in 1980s: 1% of hospital admissions involved serious injury due to negligent care • Some estimates: 5% of total health care costs are “defensive medicine” – procedures undertaken purely to prevent lawsuits • Some states have considered caps on damages for medical malpractice

36. U.S. tort system • Product liability • Recent survey of CEOs: “liability concerns caused 47% of those surveyed to drop one or more product lines, 25% to stop some research and development, and 39% to cancel plans for a new product.” • Liability standard for product-related accidents is “strict products liability” • Manufacturer is liable if product determined to be defective • Defect in design • Defect in manufacture • Defect in warning

37. Vaccines • Most vaccines are weakened version of disease itself • Make you much less likely to acquire the disease • But often come with very small chance of contracting disease directly from vaccine • Sabin polio vaccine wiped out polio, but caused 1 in 4,000,000 people vaccinated to contract polio • 1974 case established maker had to warn about risk • Since then, some people were awarded damages after their children developed polio from vaccine • If liability can’t be avoided, built into cost of the drug • And discourages companies from developing vaccines

38. Mass torts • Since health risks of asbestos understood, over 600,000 people have brought lawsuits against 6,000 defendants • DES (drug administered to pregnant women in 1950s) • Impossible to establish which firm produced dose given to a particular woman • California Supreme Court introduced “market share liability” • Class action lawsuit • Small, dispersed harms – no plaintiff might find it worthwhile to sue • Class action suits allow large lawsuits with lots of plaintiffs • Give more incentive for precaution against diffuse harms • But…

39. Cooter and Ulen’s overall assessment of U.S. tort system • Critics claim juries routinely hand out excessive awards and tort system is out of control… • …but actually it functions reasonably well • Outside of occasional, well-publicized outliers, damage awards are generally reasonable… • …and liability has led to decreases in accidents in many industries

40. To wrap up tort law, a funny story from Friedman… “A tort plaintiff succeeded in collecting a large damage judgment. The defendant’s attorney, confident that the claimed injury was bogus, went over to the plaintiff after the trial and warned him that if he was ever seen out of his wheelchair he would be back in court on a charge of fraud. The plaintiff replied that to save the lawyer the cost of having him followed, he would be happy to describe his travel plans. He reached into his pocket and drew out an airline ticket – to Lourdes, the site of a Catholic shrine famous for miracles.”

41. Second Midterm • Scores lower than the first one • Average 82, median 83 • Again, not actually assigning letter grades till after final… • …but I’d still think of 80-90 being roughly the B range, 65-75 roughly the C range A-H I-P Q-Z

42. The legalprocess (won’t get to this)

43. Over the last 2 ½ months, we have… • Developed theories of property/nuisance law, contract law, and tort law • Looked at how rules of legal liability create incentives • Thought about how these rules can be chosen to try to achieve efficient outcomes

44. Over the last 2 ½ months, we have… • To achieve efficiency, we’ve generally tried to set a party’s liability equal to the harm he caused someone else • Damages in nuisance law • Expectation damages in contract law • Compensatory damages in tort law • That way, he internalizes the externality he imposes, leading to efficient decisions • In doing this, we’ve been making two big assumptions: • The legal system works flawlessly • The legal system costs nothing

45. An example from Polinsky, “An Introduction to Law and Economics” • I hit you with my car and did $10,000 worth of damage • We both know I was negligent • But courts aren’t perfect • If we go to trial, 80% chance I’ll be found liable, 20% I won’t • If I’m held liable, damages are correctly set at $10,000 • So on average, if we go to trial, you expect to recover $8,000 • But if we go to trial, we both have to hire lawyers • Suppose this costs us each $3,000 • Now your expected gain from going to trial is $8,000 – 3,000 = 5,000 • And my expected cost is $8,000 + 3,000 = 11,000

46. An example from Polinsky, “An Introduction to Law and Economics” • So… • Going to trial gains you $5,000 (in expectation) • Going to trial costs me $11,000 (in expectation) • Maybe we can settle out of court • If we avoid going to court and I pay you any settlement between $5,000 and $11,000, we’re both better off • So maybe this happens • But…

47. An example from Polinsky, “An Introduction to Law and Economics” • Suppose I’m more pessimistic about my chances than you • You think I’m 80% likely to be found liable • I think I’m 90% likely to be found liable • You think your expected gain is $8,000 – 3,000 = $5,000 • I think my expected cost is $9,000 + 3,000 = $12,000 • Now the range of possible settlements is even wider • Any settlement between $5,000 and $12,000 is a Pareto-improvement over going to trial • So settling is more likely

48. An example from Polinsky, “An Introduction to Law and Economics” • Now instead, suppose I’m more optimistic about my chances than you • You think I’m 80% likely to be found liable • I think I’m only 10% likely to be found liable • You think your expected gain is $8,000 – 3,000 = $5,000 • I think my expected cost is $1,000 + 3,000 = $4,000 • Now an out-of-court settlement is impossible • There are no settlements that you and I would both agree to

49. An example from Polinsky, “An Introduction to Law and Economics” • And, even if our beliefs are compatible and there are settlements that we would both prefer to trial… • …private information might lead to failure to reach a settlement • Remember from before: if our threat points are private information, we might fail to reach an agreement because each of us is holding out for too big a share • So even if we had the same beliefs about what will happen at trial, private information could prevent settlement

50. An example from Polinsky, “An Introduction to Law and Economics” • So when litigation is costly… • If the two parties agree on the likely outcome of a trial, there are gains from settling out of court, and a range of settlements they would both prefer to going to trial • If the two parties are relatively pessimistic, settlement is even more likely • If the two parties are relatively optimistic, settlement may be impossible • Even if the two have the same beliefs or are relatively pessimistic, private information may lead to failures in bargaining