Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 18

Econ 522Economics of Law

Dan Quint

Fall 2009

Lecture 18

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Results ofTuesday’s experiment

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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.

Tuesday’s experiment

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What did you all say a leg was worth?

0%

5%

10%

15%

20%

25%

less than100,000

100,000 to199,999

200,000 to499,999

500,000 to999,999

1,000,000 to1,999,999

2,000,000 to3,999,999

4,000,000 to7,999,999

8,000,000and up

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What were we actually trying to test?

(a) Should the plaintiff in this case be awarded more or less than $10,000?

(b) How much should the plaintiff receive? (Please give a number.)

(c) Are you male or female?

The other half were asked…Half of you were asked…

(a) Should the plaintiff in this case be awarded more or less than $10,000,000?

(b) How much should the plaintiff receive? (Please give a number.)

(c) Are you male or female?

The question: how much did the “suggestion” affect answers to question (b)?

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So, how much did question (a) affect your answers to question (b)?

0%

5%

10%

15%

20%

25%

30%

35%

less than100,000

100,000 to199,999

200,000 to499,999

500,000 to999,999

1,000,000 to1,999,999

2,000,000 to3,999,999

4,000,000 to7,999,999

8,000,000and up

asked 10kasked 10MM

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Or to put it another way…

10,001700,00010,001Smallest

20,000,00020,000,00010,000,000Largest

3,100,0005,000,000875,00075th Percentile

1,000,0003,000,000250,000Median

250,0001,000,000112,50025th Percentile

988,2662,764,049323,118Geometric Mean

2,899,1674,644,0001,002,609Average

482523Sample Size

BothGroups

Asked $10,000,000

Asked$10,000

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But the picture’s so cool, I’ll show it again

0%

5%

10%

15%

20%

25%

30%

35%

less than100,000

100,000 to199,999

200,000 to499,999

500,000 to999,999

1,000,000 to1,999,999

2,000,000 to3,999,999

4,000,000 to7,999,999

8,000,000and up

asked 10kasked 10MM

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Nobody knows what a leg is worth

“Reference point bias”

“Framing effects”

What does it mean?

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Back to work…

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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 several incentives: Injurer precaution Victim precaution Injurer activity level Victim activity level

And we saw the Hand Rule for determining negligence “If more precaution would have been efficient, you should have taken it”

So far…

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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, small 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 found truth was somewhere in between


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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 relax each assumption and see what happens

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

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Econ 522 Economics of Law Dan Quint Fall 2009 Lecture 18