Part D-II The Economics of Tort Law

1. Part D-II The Economics of Tort Law Tort_C2

2. Objectives • Liability rules – strict liability rule • Perfect Damages • Efficient tort law under unilateral precaution Tort_C2

3. Strict Liability Rule and Perfect Damages Incentives for Precaution under Strict Liability with Perfect Damages Assume that the law provides for perfect damages (D) for the victim paid by the injurer Recall, perfect damages implies that the victim is paid damages such that he is returned exactly to his pre-accident level of utility (D=A) The potential victim is indifferent to having suffered the accident and receiving the damages and to not having suffered the accident. Tort_C2

4. Strict Liability Rule – potential victim D is the dollar amount of perfect damages Recall the potential victim will initially suffer the harm A (by definition) But under strict liability with perfect damages the potential victim is assured that he will be fully compensated for the harm if it occurs D = A What will the cost of accidents be to the potential victim? Tort_C2

5. Strict Liability Rule – potential victim The total costs to the potential victim under a rule of strict liability and perfect damages is: wv xv + p(xv, xi)A - p(xv, xi)D = wv xv since A is exactly equal to D Now in order to minimize the cost of accidents, the potential victim sets xv equal to zero Tort_C2

6. From the potential victim’s perspective Strict Liability– potential victim The costs of accidents to the potential victim is wvxv because with strict liability and perfect damages A = D so that there is no cost of harm to the potential victim $ Under the rule of strict liability the cost minimizing potential victim will chooses xv = 0 wv xv x= xv xv =0 x* Precaution Tort_C2

7. Strict Liability Rule – potential victim The victim completely internalizes the costs of precaution but completely externalizes the benefits of precaution (the decreases in the cost of harm) Conclusion: under a rule of strict liability with perfect damages the potential victim has no incentive to internalize the benefits of precaution and chooses to take no precaution. Why pay something for nothing? Tort_C2

8. Strict Liability Rule – potential injurer Incentives for Precaution under Strict Liability/Perfect Compensation The law provides for perfect compensation for the victim by the injurer (D exactly equals A). The potential victim will have no incentive to take precaution since he faces no possibility of loss as a result of a ‘bad event’. Therefore, xv will equal zero, and the potential injurer will know this. Tort_C2

9. Strict Liability Rule – potential injurer D is the dollar amount of perfect damages so that the costs to the potential injurer is: wi xi + p(xi, xv=0)D The cost minimizing potential injuruer (rational, optimizing individual) will setxiequal to xi* Why? Tort_C2

10. Strict Liability Rule – potential injurer In order to minimize the cost of accidents, the potential injurer ‘buys’ precaution until the marginal costs of precaution exactly equals the marginal benefit of precaution, or wi = - Δp(xi*)/ΔxiD Potential injurer’s = potential injurer’s marginal cost marginal benefit of precaution from precaution Tort_C2

11. From the potential injurer’s perspective Strict Liability Rule – potential injurer The costs of accidents to the potential injurer can be written as wixi + p(xi, xv=0)A because with strict liability/perfect compensation liability xv = 0 and D=A Recall D=A ‘perfect damages’ $ wixi + p(xi, xv=0)D wi xi p(xi, xv=0)D x= xi 0 xi=xi* Precaution Tort_C2

12. Strict Liability Rule – potential injurer But since D = A under perfect compensation damages, wi = -p’(xi*)D = -p’(xi*)A Potential injurer’s = potential injurer’s marginal cost marginal benefit of precaution from precaution = potential victim’s marginal benefit from precaution Tort_C2

13. Strict Liability Rule – potential injurer Conclusion: under a rule of strict liability with perfect compensatory damages the potential injurer has an incentive to internalize both the costs and benefits of precaution. Note the importance of perfect damages (D = A) What would happen if D = .5A or D = 2A? Tort_C2

14. Who can control the level of risk? A risk situation is one of unilateral precaution if only the potential victim or only the potential injurer can take precaution but not both. A risk situation is one of bilateral precaution if both the potential victim and the potential injurer can take precaution. Tort_C2

15. Unilateral Precaution Examples: Transporting hazardous materials in unmarked vehicles – potential injurer Using a properly manufactured hammer or knife in you home – potential victim Aircraft engine maintenance – potential injurer Proper storage of medicine in your home – potential victim Tort_C2

16. What liability rule should apply to a risk characterized by unilateral precaution? What rule will be efficient? Tort_C2

17. The following chart shows who will internalize what costs under alternative liability rules: Which costs will be internalized? Potential VictimPotential Injurer Legal Rule no liabilityprecaution and harmprecaution strict liability with perfect precaution precaution and harm damages Tort_C2

18. The following chart shows who will take what level of precaution: Who can take the unilateral precaution: Potential VictimPotential Injurer Legal Rule no liability efficient levelzero strict liability with perfect zero efficient level damages Tort_C2

19. Note You should be able to explain each of the four entries in the previous two charts Tort_C2

20. Unilateral Precaution How to ensure the socially optimum amount of precaution? Efficient tort rule for risks characterized by unilateral precaution - if only the potential victim can take precaution, then the tort rule should be no liability - if only the potential injurer can take precaution, then the tort rule should be strict liability with perfect damages Tort_C2

21. Unilateral Precaution The idea is that if only one agent has control over the risk, then the tort rule should be such that the agent with control over the risk will internalize both the cost of precaution and the cost of harm. This is accomplished by assigning the of cost harm ‘if an accident does occur’ to the agent who controls the risk Tort_C2

22. Unilateral Precaution This happens automatically if the potential victim has control over the risk. The potential victim will suffer the harm if an accident happens, so noliabilityis the efficient rule. If the potential injurer controls the risk, the cost of harm must be shifted from the victim, who initially suffers the harm, to the injurer so that the potential injurer will ‘internalize’ the cost of harm in his decision making. Strict liability withperfect damages accomplishes this. Tort_C2

23. Unilateral Precaution Question Why is it that in most cases in which someone gets hurt, (broken leg, broken arm, a cut, a bruise – most visits to the emergency room) or something gets broken (a window, a DVD player, a computer, etc.) the cost of harm does not get shifted? Most accidents actually do happen in the home. The victim had control over the risk – therefore no liability! Tort_C2