Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2010 Lecture 15

Logistics • HW3 due Friday (5 p.m.) • Second midterm next Wednesday (November 10) • Covers property and contract law – no torts

Let’s recap ourstory so far…

Our story so far • Efficiency • Maximizing total surplus realized by everyone in society • Scarce resources are owned by whoever values them most • Actions are taken if social benefit exceeds social cost • Design a legal system that leads to efficient outcomes • Once we set up the rules, we don’t expect people to act based on what’s efficient • We expect people to do whatever’s in their own best interest • So the goal is set up the rules such that people acting in their own best interest will naturally lead to efficiency

Our story so far • Coase gives us one way to do that • If property rights are clearly defined and tradable, and there are no transaction costs, people have incentive to trade until each resource is efficiently owned • So initial allocation of rights doesn’t matter for efficiency • But if there are transaction costs, we may not get efficiency this way • Led us to two normative views of the legal system: • 1. Minimize transaction costs (“lubricate” private exchange) • 2. Allocate rights as efficiently as possible • Tradeoff between injunctive relief and damages

Our story so far • Property law works well for simultaneous trade • Contracts allow for non-simultaneous trade • Contract law can… • Enable cooperation • Encourage efficient disclosure of information • Secure optimal commitment to performance • Secure efficient reliance • Supply efficient default rules and regulations • Foster enduring relationships

Our story so far • So far, we’ve been talking about voluntary exchange • Coase is predicated on exchange being voluntary for both parties • Contracts are an extension of voluntary trade • Up next: involuntary trade • You’re bicycling to class, I’m texting while driving and I hit you • You didn’t want to deal with me, I didn’t want to deal with you…

Our story so far • To put it another way… • Property law covers situations where transaction costs are low enough to get agreement ahead of time • Exceptions to property law – private necessity, eminent domain – when this isn’t the case • Contract law covers situations when transaction costs are low enough for us to agree to a contract, high enough that we may not want to renegotiate the contract later • Tort law covers situations where transaction costs are too high to agree to anything in advance

Tort law

Tort law • Tort, noun. from French word meaning injury • Contract law: situations where someone harms you by breaking a promise they had made • Tort law: situations where someone harms you without having made any promises • “If someone shoots you, you call a cop. If he runs his car into yours, you call a lawyer.”

As always, we’ll be focused on achieving efficiency • I hit you with my car, do $1,000 worth of damage • You’re $1,000 worse off • (No damage to me or my car) • Should I have to pay you damages? I owe nothing I owe $1,000 I owe $50,000 Your payoff –1,000 0 49,000 My payoff 0 –1,000 –50,000 Combined payoffs –1,000 –1,000 –1,000

Something to remember distributionbut notefficiency efficiency

Tort law • Question: how to structure the law to get people to behave in a way that leads to efficient outcomes? • Deliberate harms: make punishment severe (criminal law) • Accidental harms: trickier • Goal isn’t “no accidents”; goal is “efficient number of accidents”

Tort law • Question: how to structure the law to get people to behave in a way that leads to efficient outcomes? • Deliberate harms: make punishment severe (criminal law) • Accidental harms: trickier • Goal isn’t “no accidents”; goal is “efficient number of accidents” • Unlike nuisance law, injunctive relief is not an option • Unlike contract law, no agreement ahead of time • Cooter and Ulen: essence of tort law is “the attempt to make injurers internalize the externalities they cause, in situations where transaction costs are too high to do this through property or contract rights”

Cast of characters • Plaintiff – person who brings a lawsuit • Defendant – person who is being sued • In a nuisance case, the defendant caused a nuisance, plaintiff was bothered by it, might be asking for injunction or damages • In a contract case, defendant breached a contract or violated its terms • In a tort case, defendant caused some harm to plaintiff, plaintiff is asking for damages • Plaintiff is the victim (person who was harmed) • Defendant is the injurer (person who caused the harm)

“Classic” legal theory of torts • Harm • Causation • Breach of Duty

Element 1: Harm • For a tort to exist, the plaintiff needs to have been harmed • “Without harm, there is no tort” • Gas company sold gas with a defective additive • Dangerous for cars with turbocharged carburetors • You have a car with normal carburetors • You might be angry; but you weren’t harmed, so you can’t sue • Similarly, no compensation for exposure to risk • Manufacturer exposed workers to some chemical • Exposure will cause 15% of them to develop cancer later in life • Can’t sue now – have to wait, see who gets cancer, then they can sue

Element 1: Harm Money Health • Perfect compensation • restores victim to original level of well-being • generally done through money damages

Perfect Compensation Tangible harms Intangible harms • Medical costs • Lost income • Damaged property • Emotional harm • Pain and suffering • Loss of companionship • In theory, perfect compensation should cover all losses • Historically, courts have been less willing to compensate for intangible or hard-to-measure losses • Over time, U.S. courts have started compensating for more intangible harms • Pro: the closer liability is to actual harm done, the better the incentive to avoid these harms • Con: disparity in award sizes, unpredictability

Element 2: Causation • For a tort to exist, the defendant needs to have caused the harm to the plaintiff • Cause-in-fact • “But for the defendant’s actions, would the harm have occurred?”

Element 2: Causation • For a tort to exist, the defendant needs to have caused the harm to the plaintiff • Cause-in-fact • “But for the defendant’s actions, would the harm have occurred?” • Proximate cause • Immediate cause – defendant’s action can’t be too distant from the harm • Palsgraf v Long Island Railway (NY Ct Appeals, 1928): • Guard pushed a passenger to help him onto train, passenger dropped fireworks he was carrying, they went off, explosion knocked down scales at the other end of the platform, which fell on Mrs. Palsgraf • Guard’s actions were not the proximate cause

Element 2: Causation “A tree fell on a moving trolly, injuring passengers. One of them sued. He succeeded in demonstrating that in order for the trolly to be where it was when the tree fell on it the driver had to have driven faster than the speed limit at some point during the trip. Breaking the law is per se negligence, so the driver was legally negligent whether or not his driving was actually unsafe. If he had not driven over the speed limit, the trolly would not have been under the tree when it fell, so, the plaintiff argued, the driver’s negligence caused the injury.” • Court ruled driver’s negligence “had not caused the accident in the legally relevant sense”

(Sometimes required, sometimes not) Element 3: Breach of Duty Strict Liability Negligence • Harm • Causation • Harm • Causation • Breach of duty (fault) • When someone breaches a duty he owes to the defendant, and this leads to the harm, the injurer is at fault, or negligent • Injurers owe victims the duty of due care • Negligence rule: I’m only liable if I failed to take the required standard of care – not if I was careful and the accident happened anyway

Hence the language in the trolly example “A tree fell on a moving trolly, injuring passengers. One of them sued. He succeeded in demonstrating that in order for the trolly to be where it was when the tree fell on it the driver had to have driven faster than the speed limit at some point during the trip. Breaking the law is per se negligence, so the driver was legally negligent whether or not his driving was actually unsafe. If he had not driven over the speed limit, the trolly would not have been under the tree when it fell, so, the plaintiff argued,the driver’s negligence caused the injury.”

So under a negligence rule… • If I breach my duty of due care and injure you, I am liable • If I exercise the appropriate level of care but still injure you, I’m not liable • How is the standard of care determined? • That is, how careful do I have to be to avoid liability, and who decides? • Is it negligent to drive 40 MPH on a particular road at a particular time of day? What about 41 MPH? 42?

How is the standard of care determined? • Some settings: government imposes safety regulations that set standard for negligence • Speed limits for highway driving • Requirement that bicycles have brakes • Workplace regulations • Some standards are left vague • “Reckless driving” may depend on road, time of day, weather… • Common law focuses on duty of reasonable care • Level of care a reasonable person would have taken • (Civil law relies less on “reasonableness” tests, tries to spell out what level of care is required)

Strict liability versus negligence • Strict liability rule: plaintiff must prove harmand causation • Negligence rule: must prove harm, causation, and negligence • A little history • Early Europe: strict liability was usual rule • By early 1900s, negligence became usual rule • Second half of 1900s, strict liability became more common again, especially for manufacturer liability in American consumer products • U.S. manufacturers now held liable for harms caused by defective products, whether or not they were at fault

Economicmodel

Precaution • The more carefully I drive, the less likely I am to hit you • But, driving more carefully is also more costly to me • Must be some efficient level of care • Similarly… • Construction company can reduce accidents with better safety equipment, better training, working shorter days, all of which cost money • Manufacturer can reduce accidents by designing/inspecting products more carefully – again, more expensive

Lots of things both victims and injurers can do to reduce number (or harm) of accidents Accident Injurer’s Precaution Victim’s Precaution faulty electrical wiring causes house fire manufacture wiring more carefully fireproof house moving car hits parked car drive more safely park car in safer space car hits pedestrian drive more safely walk more safely software fails better design of software back up data at risk exploding coke bottle improve quality control by bottler handle bottles carefully medicine causes side effects improve warning on medicine study warning on medicine Cooter and Ulen, p. 338

We will call all these things precaution • Precaution: anything either injurer or victim could do to reduce likelihood of an accident (or damage done) • The next two questions should be obvious… • How much precaution do we want? • What is efficient level of precaution? • How do we design the law to get it?

To answer these questions, we’ll introduce a very simple model of accidents • Car hits a bicycle • In real life: driver probably has insurance • In real life: some damage to bicycle, some damage to driver’s car • In real life: driver and bicyclist may not even know what the law is • We’ll simplify things a lot, by assuming… • Only one party is harmed • Parties know the law, don’t have insurance (for now) • We’ll focus on one party’s precaution at a time

x level of precautionw marginal cost of precautionp(x) probability of an accidentA cost of an accident Model of unilateral harm • Unilateral harm – just one victim • Precaution – costly actions that make accident less likely • Could be taken by either victim or injurer • We’ll focus on one at a time • Notation • x – the amount of precaution that is taken • w – the cost of each “unit” of precaution • so total cost of precaution is wx • p(x) – probability of an accident, given precaution x • p is decreasing in x • A – cost of accident (to victim) • so expected cost of accidents is p(x) A

x level of precautionw marginal cost of precautionp(x) probability of an accidentA cost of an accident Model of unilateral harm $ wx + p(x) A(Total Social Cost) wx (Cost of Precaution) p(x) A (Cost of Accidents) Precaution (x) x* (Efficient Level of Precaution)

x level of precautionw marginal cost of precautionp(x) probability of an accidentA cost of an accident Model of unilateral harm efficient precaution: minx { wx + p(x) A } w + p’(x) A = 0 w = – p’(x) A • Under reasonable assumptions (p(x) convex)… • x < x*  w < – p’(x) A MSC < MSB  more precaution efficient • x > x*  w > – p’(x) A MSC > MSB  less precaution efficient • x = x*  MSC = MSB marginal social cost of precaution marginal social benefit of precaution

x level of precautionw marginal cost of precautionp(x) probability of an accidentA cost of an accident Model of unilateral harm $ wx + p(x) A wx p(x) A x x < x* x* x > x*

Model of unilateral harm • We haven’t yet said who is taking precaution • Some situations, only injurer can reduce accidents • Some situations, victim can too • Bilateral precaution is a little bit tricky, but if we look at the two parties one at a time, everything works fine • Wednesday: consider effect of different liability rules on precaution

Effect of Liability Ruleson Precaution

Effect of liability rules on precaution • Three rules we’ll consider: • No liability • Strict liability • Negligence

Rule 1: No Liability • In a world with no liability… • Victim bears the cost of any accidents, plus the cost of any precaution he takes • Injurer bears cost of any precaution he takes, does not have to pay for accidents

Rule 1: No LiabilityInjurer precaution $ Private cost to injurer wx + p(x) A wx p(x) A x x* • Injurer’s private cost is just wx • Injurer minimizes private cost by setting x = 0

Rule 1: No LiabilityVictim precaution $ Private cost to victim wx + p(x) A wx p(x) A x x* • Victim’s private cost is wx + p(x) A • To minimize this, victim takes efficient level of precaution

Rule 1: No Liability • So in a world with no liability… • Injurer takes inefficiently low level of precaution • (zero, or minimal amount) • Victim takes efficient amount of precaution

Rule 2: Strict Liability • Perfect compensation: damages D = A • Under strict liability… • Injurer pays damages for any accidents he causes • So injurer bears cost of accidents, plus his own precaution • Victim pays only for his precaution

Rule 2: Strict LiabilityInjurer precaution $ Private cost to injurer wx + p(x) A wx p(x) A x x* • Injurer’s private cost is wx + p(x) A • Injurer minimizes this by taking efficient level of precaution

Rule 2: Strict LiabilityVictim precaution $ Private cost to victim wx + p(x) A wx p(x) A x x* • Victim’s private cost is wx • No incentive to take any precaution, victim sets x = 0

Effect of liability rules on precaution Victimprecaution Injurerprecaution No Liability Efficient Zero Strict Liability Zero Efficient

Econ 522 Economics of Law