Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 19

Midterm 2Question 3a“Explain why expectation damages lead to efficient breach”

In this class, we generally ask two distinct questions What actionswould be efficient? What do we expectpeople to actually do? SocialCost vs. SocialBenefit PrivateCost vs. PrivateBenefit Example: promisor’s decision to perform on contract vs. vs. Promisor’scost of performing Promisee’s benefit from performance Promisor’scost of performing Promisor’s liability from breach • Expectation damages: set promisor’s liability = promisee’s benefit • Or, make private benefit from performance = social benefit • Promisor “internalizes the externality” caused by breach • This way, promisor’s action matches the efficient one

In this class, we generally ask two distinct questions What actionswould be efficient? What do we expectpeople to actually do? SocialCost vs. SocialBenefit PrivateCost vs. PrivateBenefit Another example: injurer precaution under strict liability vs. vs. Cost of injurerprecaution Reduction in expected harm Cost of injurer precaution Reduction in expected liability • Strict liability + perfect compensation: injurer’s liability = actual harm • Again, private benefit from precaution = social benefit • Injurer internalizes the externality caused by accidents he causes • And so injurer’s level of precaution matches the efficient one

Back to work:more twists on liability

Vicarious Liability • Vicarious liability is when one person is held liable for 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 employee if employee was acting within the scope of his employment

Vicarious Liability • 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 • 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…

Joint and Several Liability • 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 • 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

Comparative Negligence • Negligence with a defense of contributory negligencewas 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?

Comparative Negligence and Evidentiary Uncertainty • 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 $ Comparative negligence, evidentiary uncertainty Simple negligence, evidentiary uncertainty Any negligence rule wx + p(x) A wx p(x) A x x* • Comparative negligence mitigates effect of evidentiary uncertainty

PerfectCompensation

Perfect compensation • 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 • 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.”

One other odd feature of compensatory damages… • 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

What’s a lifeworth?

What’s a life worth? • 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” Regulation Estimated cost per life saved Airplane cabin fire protection $ 200,000 Car side door protection standards $ 1,300,000 OSHA asbestos regulations $ 89,300,000 EPA asbestos regulations $ 104,200,000 Proposed OSHA formaldehyde standard $72,000,000,000

Kip Viscusi, The Value of Risks to Life and Health • If w is starting wealth, D is death, p is 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 • Lots of day-to-day choices increase or decrease our risk of death • Choose between a sports car with fiberglass body and a Volvo • 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 • Viscusi surveys lots of existing studies which impute value of life from peoples’ decisions • Many use wage differentials: how much higher wages are required for risky jobs compared to safe jobs? • Some papers look at other decisions • 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 people who they would make hypothetical money-safety tradeoffs • Each paper reaches some estimate for implicit value people attach to their lives

Kip Viscusi, The Value of Risks to Life and Health • What does Viscusi find? • 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: National Highway Traffic Safety Administration uses $2.5 million for value of traffic fatality in cost-benefit analysis

Viscusi’s findings: papers using wage differentials

Viscusi’s results: papers using other tradeoffs

Viscusi’s results: papers using survey data

Back toother topics

Inconsistency of damages • 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

Punitive damages • 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 • 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

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

Liebeck v McDonalds (1994) • 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) • 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

What is the economic purpose of punitive damages? • 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

This suggests… • 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

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

U.S. tort system • 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 • 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 • 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 • 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

Vaccines • 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

Mass torts • 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…

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

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

Econ 522 Economics of Law