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Econ 522 Economics of Law. Dan Quint Fall 2011 Lecture 18. Incentives. “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. So far….

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econ 522 economics of law

Econ 522Economics of Law

Dan Quint

Fall 2011

Lecture 18


“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.”


so far
So far…
  • 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 far1
So far…
  • 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
up next
Up next…
  • What factors/complications has our simple model been leaving out?
  • How much money is your life worth?
  • But first…
our model thus far has assumed
Our model thus far has assumed…
  • 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
assumption 1 rationality
Assumption 1: Rationality
  • 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 rationality1
Assumption 1: Rationality
  • 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 rationality2
Assumption 1: Rationality
  • 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 rationality3
Assumption 1: Rationality
  • 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 2 injurers pay damages in full
Assumption 2: Injurers pay damages in full
  • 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
example of judgment proofness from old final exam
Example of judgment-proofness(from old final exam)
  • 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
assumption 3 no regulation
Assumption 3: No regulation
  • 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
continuing the example of judgment proofness from before
Continuing the example of judgment-proofness from before…
  • 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
assumption 3 no regulation1
Assumption 3: No regulation
  • 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 4 no insurance
Assumption 4: No insurance
  • 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 insurance1
Assumption 4: No insurance
  • 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 5 litigation costs nothing
Assumption 5: Litigation costs nothing
  • 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!
vicarious liability
Vicarious Liability
  • 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 liability1
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 liability2
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
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 liability1
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
back to comparative negligence
Back to 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
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 uncertainty1
Comparative negligence and evidentiary uncertainty


Comparative negligence, evidentiary uncertainty

Simple negligence, evidentiary uncertainty

Any negligence rule

wx + p(x) A


p(x) A



  • Comparative negligence mitigates effect of evidentiary uncertainty
perfect compensation
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 compensation1
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
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 life worth
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”


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


kip viscusi the value of risks to life and health
Kip Viscusi, The Value of Risks to Life and Health
  • 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 health1
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 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 health2
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 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
7 studies using other risk money tradeoffs
7 studies using other risk-money tradeoffs

Nature of Risk,Year

Component of theMonetary Tradeoff

Implicit Value of life($ millions)

Highway speed-related accident risk, 1973

Value of driver time based on wage rates


Automobile death risks, 1972

Estimated disutility of seat belts


Fire fatality risks without smoke detectors, 1974-1979

Purchase price of smoke detectors


Mortality effects of air pollution, 1978

Property values in Allegheny Co., PA


Cigarette smoking risks, 1980

Estimated monetary equivalent of effect of risk info


Fire fatality risks without smoke detectors, 1968-1985

Purchase price of smoke detector


Automobile accident risks, 1986

Prices of new automobiles


6 studies based on surveys
6 studies based on surveys

Nature ofRisk


Implicit Value of Life ($ millions)

Improved ambulance service, post-heart attack lives

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


Airline safety and locational life expectancy risks

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


Job fatality risk

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

3.4 (pay),8.8 (accept)

Motor vehicle accidents

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


Automobile accident risks

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

2.7 (median)9.7 (mean)

Traffic safety

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


kip viscusi the value of risks to life and health3
Kip Viscusi, The Value of Risks to Life and Health
  • 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
inconsistency of damages
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
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 damages1
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
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
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 19941
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
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
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
u s tort system
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 system1
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 system2
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 system3
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
  • 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
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
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
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.”