Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 17.

Econ 522Economics of Law

Dan Quint

Fall 2010

Lecture 17

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Midterm on Wednesday, in 272 Bascom

HW3 (and solutions) returned today

Logistics

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The story so far

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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

The story so far…

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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…

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Accidents between strangers

EfficientToo HighEfficientEfficientNegligence with a Defense of Contributory Negligence

Too HighEfficientEfficientEfficientStrict Liability with Defense of Contributory Negligence

EfficientToo HighEfficientEfficientComparative Negligence

EfficientToo HighEfficientEfficientSimple Negligence

Too HighEfficientZeroEfficientStrict Liability

EfficientToo HighEfficientZeroNo Liability

Victim Activity

Injurer Activity

Victim Precaution

Injurer Precaution

take precaution only to AVOID liability

precaution is efficient, butactivity level is too high

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Accidents between strangers

EfficientToo HighEfficientEfficientNegligence with a Defense of Contributory Negligence

Too HighEfficientEfficientEfficientStrict Liability with Defense of Contributory Negligence

EfficientToo HighEfficientEfficientComparative Negligence

EfficientToo HighEfficientEfficientSimple Negligence

Too HighEfficientZeroEfficientStrict Liability

EfficientToo HighEfficientZeroNo Liability

Victim Activity

Injurer Activity

Victim Precaution

Injurer Precaution

to reduce accidents, since he bears their cost

precaution and activity levelare both efficient

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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…

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When injurer is a business and victim is not customer

EfficientEfficientStrict Liability

Too HighEfficientSimple Negligence

InjurerActivity

InjurerPrecaution

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When injurer is a business and victim is its customer

Too HighNoneNo

EfficientNoneAverage

EfficientEfficientYesNo Liability

Too HighEfficientNo

EfficientEfficientYesNegligence

EfficientEfficientNo

EfficientEfficientYesStrict Liability

BuyerActivity

SellerPrecaution

RiskPerception?

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Due Care andthe Hand Rule

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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?

Setting the legal standard of care

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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”

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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.”

“The Hand Rule”

cost of precaution cost of accident probability of accident

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Hand rule: precaution is required to avoid negligence ifCost 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

“The Hand Rule”

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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

So how is legal standard for negligence established?

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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

Two difficulties in establishing legal standards for negligence

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Effect of Errors

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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

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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”

Strict liability versus negligence: information

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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

Errors and uncertainty in evaluating damages

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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

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Precaution (x)

$

p(x) A

wx

wx + p(x) A

x*

p(x) D

wx + p(x) D

x

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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


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What about under a negligence rule?

x

$

p(x) A

wx

wx + p(x) A

xn = x*

p(x) D

wx + p(x) D

Under a negligence rule, small errors in damages have no effect on injurer precaution

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What about errors in setting xn?

x

$

p(x) A

wx

wx + p(x) A

x*

Under a negligence rule, injurer’s precaution responds exactly to systematic errors in setting the legal standard

xn xn

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What about random errors in setting xn?

x

$

p(x) A

wx

wx + p(x) A

x*

Under a negligence rule, random errors in the legal standard of care lead to increased injurer precaution

x

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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

To sum up the effects of errors and uncertainty…

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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

What about relative administrative costs of the two systems?

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Does it allmatter?

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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?

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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


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“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.”


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“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.”


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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.”


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Relaxing theassumptionsof our model

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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

Our model thus far has assumed…

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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

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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


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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


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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”


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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 2: Injurers pay damages in full

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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

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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 3: No regulation

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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

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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


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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


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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!

Assumption 5: Litigation costs nothing

Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 17.

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Transcript of Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 17.