Econ 522Economics of Law

Dan Quint

Fall 2011

Lecture 18

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“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

Incentives

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We’ve discussed a bunch of liability rules… No liability Strict liability Various versions of a negligence rule

…and the effect of each rule on incentives for: Injurer precaution Victim precaution Injurer activity level Victim activity level

So far…

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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

So far…

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What factors/complications has our simple model been leaving out?

How much money is your life worth?

But first…

Up next…

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Experiment

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Relaxing theassumptionsof our model

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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

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

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

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

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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”

Assumption 1: Rationality

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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

Assumption 2: Injurers pay damages in full

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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

Example of judgment-proofness(from old final exam)

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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

Regulations supply additional incentive to take precaution

Assumption 3: No regulation

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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

Continuing the example of judgment-proofness from before…

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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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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 4: No insurance

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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

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More twistson liability

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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

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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

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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…

Vicarious Liability

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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

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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

Joint and Several Liability

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Negligence with a defense of contributory negligence was 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?

Back to Comparative Negligence

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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

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Comparative negligence and evidentiary uncertainty

x

$

p(x) A

wx

wx + p(x) A

x*

Comparative negligence mitigates effect of evidentiary uncertainty

An

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Sim

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evid

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Com

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, ev

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PerfectCompensation

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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

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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.”

Perfect compensation

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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

One other odd feature of compensatory damages…

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What’s a lifeworth?

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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”

What’s a life worth?

$72,000,000,000Proposed OSHA formaldehyde standard

$ 104,200,000EPA asbestos regulations

$ 89,300,000OSHA asbestos regulations

$ 1,300,000Car side door protection standards

$ 200,000Airplane cabin fire protection

Estimated cost per life savedRegulation

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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

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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

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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

Kip Viscusi, The Value of Risks to Life and Health

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What does Viscusi find?

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24 studies based on wage differentials

0

5,000,000

10,000,000

15,000,000

20,000,000

Kniesn

er &

Lee

th (1

991)

Smith

& G

ilber

t (19

84)

Thaler

& R

osen

(197

6)

Arnou

ld & N

ichols

(198

3)

Dilling

ham

(198

5)

Butler

(198

3)

Brown

(198

0)

Gegax

et.

al. (1

991)

Moo

re &

Visc

usi (

1988

)

Mar

in & P

sach

arsp

oulos

(198

2)

Kniesn

er &

Lee

th (1

991)

Cousin

eau

et a

l (19

88)

Dilling

ham

(198

5)

Viscus

i (19

78, 1

979)

Smith

(197

6)

Olson

(198

1)

Viscus

i (19

81)

Smith

(197

4)

Moo

re &

Visc

usi (

1988

)

Moo

re &

Visc

usi (

1988

)

Kniesn

er &

Lee

th (1

991)

Viscus

i & M

oore

(198

9

Herzo

g & S

chlot

tman

(198

7)

Leigh

& F

olso

m (1

984)

Leigh

& F

olso

m (1

984)

Leigh

(198

7)

Garen

(198

8)

Moo

re &

Visc

usi (

1990

)

Moo

re &

Visc

usi (

1990

)

Implicitvalueof life

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7 studies using other risk-money tradeoffs

4.0Prices of new automobilesAutomobile accident risks, 1986

2.0Purchase price of smoke detector

Fire fatality risks without smoke detectors, 1968-1985

0.7Estimated monetary equivalent of effect of risk info

Cigarette smoking risks, 1980

0.8Property values in Allegheny Co., PA

Mortality effects of air pollution, 1978

0.6Purchase price of smoke detectors

Fire fatality risks without smoke detectors, 1974-1979

1.2Estimated disutility of seat belts

Automobile death risks, 1972

0.07Value of driver time based on wage rates

Highway speed-related accident risk, 1973

Implicit Value of life($ millions)

Component of theMonetary Tradeoff

Nature of Risk,Year

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6 studies based on surveys

1.2Series of contingent valuation questions, New Zealand survey, 1989-1990

Traffic safety

2.7 (median)9.7 (mean)

Interactive computer program with pairwise auto risk-living cost tradeoffs until indifference achieved, 1987

Automobile accident risks

3.8Willingness to pay for risk reduction, U.K. survey, 1982

Motor vehicle accidents

3.4 (pay),8.8 (accept)

Willingness to pay, willingness to accept change in job risk in mail survey, 1984

Job fatality risk

15.6Mail survey willingness to accept increased risk, small (30) U.K. sample, 1975

Airline safety and locational life expectancy risks

0.1Willingness to pay question, door-to-door small (36) Boston sample

Improved ambulance service, post-heart attack lives

Implicit Value of Life ($ millions)

SurveyMethodology

Nature ofRisk

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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

Kip Viscusi, The Value of Risks to Life and Health

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Punitivedamages

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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

Inconsistency of damages

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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”

Punitive damages

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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

Punitive damages

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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…

Example of punitive damages: Liebeck v McDonalds (1994) (“the coffee cup case”)

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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

Liebeck v McDonalds (1994)

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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

Liebeck v McDonalds (1994)

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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

What is the economic purpose of punitive damages?

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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

This suggests…

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

(won’t get to this)

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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

U.S. tort system

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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

U.S. tort system

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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

U.S. tort system

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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

U.S. tort system

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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 Salk 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

Vaccines

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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…

Mass torts

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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

Cooter and Ulen’s overall assessment of U.S. tort system

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“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.”

To wrap up tort law, a funny story from Friedman…