SPRING 2012 IV. TORT LAW PPS231S.01 Law, Economics, and Organization

SPRING 2012

IV. TORT LAW

PPS231S.01Law, Economics, and

Organization

Tort Law

The Economics of Accidents and the Learned Hand Formula for Liability for Negligence

Everybody takes precautions against accidents. But how extensive are those precautions?

Ex.: You own a collection of rare South American lizards (Posner, 2007). Assume risk neutrality. There is a probability P you incur a loss L, but you can take precaution against this loss at cost B.

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If the person taking precautions and the person who may be injured if such precautions are not taken are one and the same, the optimal precaution is achieved without legal intervention.

In other words, efficiency is attained, since both the costs and benefits are internalized by the individual.

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But suppose the person who bears PL is not the same as the person who bears B.

Ex.: The hazard is the loss of your little finger in a car accident, and the cheapest way to avoid this loss is for some other driver to drive more slowly. P = 0.001, L = $10,000, and B = $8.

Efficiency requires that the other person drive more slowly. But TCs with potential victims (i.e., you) are so high that the other drive will not do so unless the legal system steps in. For example, they could be held liable in damages ($10,000) should an accident occur.

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Then, the other person has an expected legal judgment cost of $10 (since PL = $10), which will induce him to invest $8 in a precaution that will drive his expected judgment cost to zero by preventing the accident.

This example illustrates the Law of Negligence, as summarized in the negligence formula of Judge Learned Hand. For Learned Hand, a potential injurer is negligent iff B < PL.

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There is an ambiguity, however. Suppose the PL of $10 would be reduced to $0 if the other driver reduced his speed by 25 MPH at a cost of $8, it could be reduced to $1 by reducing his speed by 5 MPH at a cost of $2.

This means that, to reduce PL down from $1 to $0, it would cost him $6, for a net social loss of $5. Clearly, we would want him to reduce his speed by just 5 MPH, which yields a net social gain of $3 (his cost of $2 plus the new PL of $1.)

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This shows that PL and B must be compared at the margin by measuring costs and benefits of small increments in safety and stopping investing more in safety at the point where another dollar spent would yield a dollar or less in added safety.

The Common Law method facilitates such an approach, since it will usually be difficult for courts to get information on anything but small changes in the safety precautions taken by the injurer. Which leads us to…

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Units of Care

$

PL

B

c*

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The intersection of the supply of and demand for precaution, c*, represents due care.

At any point left of c*, the injurer is negligent (B < PL). At any point right of c*, the injurer is not negligent. This is where accidents are unavoidable (in an economic sense.)

Possible objection: this assumes risk-neutrality. This can be justified on the basis that there are well-functioning insurance markets (not so for contract law, where risk-aversion was very important.) Consequently, the tort system need not play an insurance function.

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Although the Learned Hand Formula is relatively recent, its philosophy and the method it presents has been used for a long time. See Blyth v. Birmingham Water Works (1856); Adams v. Bullock (1919); and Hendricks v. Peabody Coal Co. (1969).

The application of the Learned Hand Formula depends on the interaction between B, P, and L – not on any individual component.

“[I]t does not follow that (…) it is justifiable to neglect a risk of such a small magnitude.” In other words, it is not because P is incredibly low that one can be negligent.

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The Reasonable Person Standard

It seems as though if the Learned Hand Formula really created the proper incentives to avoid negligence, there would be no negligence cases.

Of course, there are several such cases. One explanation is that in deciding whether an accident could have been avoided at a cost less than PL, courts do not measure actual costs to the parties involved.

Rather, they estimate the accident-avoidance cost of the average (“reasonable”) person in each party’s situation. This is justified by the high transactions costs of individualized measurement.

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The Reasonable Person Standard

Of course, when differences in capacity to avoid accidents are ascertainable at low cost, the courts do recognize exceptions to the reasonable person rule.

Ex.: Blind people are not held to as high a standard of care as sighted ones, although a uniform standard of care is imposed upon all blind people.

The advantage of the reasonable-person rule is that it reduces the cost of litigation to the tort plaintiff, since she doesn’t have to determine the actual capacity of the defendant to avoid the accident.

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Custom as Defense

Should a defendant’s compliance with the safety standard of his or her industry be recognized as a defense to a negligence suit?

If so, only firms that lag behind the average firm in their industry would be held liable. This is fine if the average firm is expected to all cost-justified precautions without the coercion of the law.

But a firm will have no incentive to take precautions against accidents dangerous only to people with whom the firm does not and cannot (due to high TCs) deal. In this case, these people will not pay the firm to take precautions, nor will the firm’s customers. In this case, the law rejects compliance to a custom as defense.

Tort Law

Custom as Defense

In one area of tort law – medical malpractice – the courts have traditionally allowed a defense of custom. A doctor’s duty of care toward his patient requires him only to comply with the customary standards of the profession in the area and specialty in which the doctor is practicing.

So the doctor implicitly promises to treat the patient with the care customary among doctors in the area. If he does not, he is guilty of malpractice (a tort), but he has also violated his contract with the patient.

Tort Law

Victim Fault: Contributory and Comparative Negligence, Assumption of Risk, and Duties to Trespassers

The B < PL if precaution is not taken is a necessary rather than sufficient condition for the precaution to be efficient: a precaution that would do the trick at lower cost would be more efficient.

Since many accidents can be prevented at lower cost by victims than by injurers, the law must be careful not to impair the incentives of potential victims to take efficient precautions.

Ex.: A PL of $1000 can be avoided by defendant at cost of $100 but by plaintiff at cost of $50. The efficient solution is to make the plaintiff “liable” by refusing to allow her to recover damages from the defendant.

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Victim Fault: Contributory and Comparative Negligence, Assumption of Risk, and Duties to Trespassers

Tort damages are not always fully compensatory. To the extent they fall short, potential victims will have an incentive to take precautions even if their failure to do so would not cut down their entitlement.

Traditional Common Law approach (i.e., “contributory negligence”) has been to (i) ask whether the defendant has been negligent; and (ii) if he has been, ask whether the plaintiff has been negligent. If “yes”, the plaintiff loses.

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Strict Liability

“Strict tort liability” means that someone who causes an accident is liable for the victim’s damages even if the injurer could not have avoided inflicting the injury by exercise of due care.

This has the same effects on safety as negligence liability, provided there is a defense of contributory negligence. If B < PL, the strictly liable defendant will take precautions to avoid the accident (just as under a negligence system) in order to reduce his net costs.

Less obviously, if B > PL, the strictly liable defendant will not take precautions, just as under negligence. So even though he will have to pay the victim’s damages, the expected damages are less than the cost of avoidance, so avoidance does not pay.

Tort Law

Strict Liability

There are significant economic differences, however. One way to avoid a car accident is to drive more carefully, another is to drive less. Rarely will courts try to determine the optimal level of an accident-causing activity.

So when a driver is in an accident, the court will not inquire as to whether the benefit of this one trip was equal to or greater than the costs including PL, or whether driving was truly cheaper than walking. This is just too difficult for a court to determine.

Only if the benefits to the activity are obviously very slight will the court take note.

Tort Law

Strict Liability

The courts’ inability to determine optimal levels of activity (except in simple cases) is potentially a serious shortcoming of a negligence system.

In contrast, potential injurers under strict liability will automatically take into account possible changes in activity level, as well as possible changes in expenditures on care in deciding whether to prevent accidents.

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Strict Liability

MCs

MCp

D

q0q*

ps

p0

Industry demand

Industry’s private MC

Industry’s social MC (includes cost ofaccidents.)

Industry Output

$

1. Under strict liability, MCp moves here

2. So under strict liability, industry output is reduced

3. And under strict liability, we eliminate all these socially wasteful accident costs (think of the Coase Theorem.)

Tort Law

Strict Liability

The problem, however, is that changes in activity levels by victims are also a means of accident avoidance, i.e., one encourage by negligence liability, but completely discouraged by strict liability.

So only when a class of activities can be identified in which activity-level changes by potential injurers are the most efficient method of accident prevention is there a good argument for strict liability.

Conversely, in a class of activities in which activity-level changes by potential victims are the most efficient method of accident prevention, there is a strong argument for a rule of no liability (e.g., dangerous sports.)

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Products Liability

Most controversial area of strict liability: personal injuries caused by defective or unreasonably dangerous products.

“Strict liability” is a bit of a misnomer: in determining whether a product is defective or unreasonably dangerous in design or manufacture, the courts generally use the Learned Hand Formula in balancing PL against the B implied by making a product safer.

So if a car is destroyed in an accident, the manufacturer is not held liable because the car was not built like a tank. The manufacturer is liable only if the vehicle was defective.

Tort Law

Joint Torts, Contribution, Indemnity; Herein of Respondeat Superior and Sexual Harassment

Some torts are committed by two or more persons. Ex.: where an employee is negligent and injures someone, the employer is liable, too, because most employees lack the resources to pay a a judgment if they injure someone seriously (limited liability again!)

But then, employees are not very responsive to the threat of tort liability (because of limited liability), so the employer must induce them to be careful. This liability is strict and may cause activity-level changes by the employer.

Tort Law

Joint Torts, Contribution, Indemnity; Herein of Respondeat Superior and Sexual Harassment

Sexual harassment in the workplace is now widely recognized as a tort: if employee A harasses employee B, their employer will be liable to B. But under the prevailing view of this tort, the employer will be liable only if A is B’s supervisor (why?), or if the employer had reason to know that sexual harassment was a problem in its workplace and did not do anything about it.

So in the case of coworker (not superior) harassment, the employer is liable only if negligent: respondeat superior (“Let the master answer”) is not applied.

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Rescue: Liability and Restitution

Suppose you walk down the street and see a flowerpot fall out a window, about to hit a pedestrian on the head. You can save her simply by shouting a warning. So PL is high, and B is practically zero.

If you don’t shout out a warning, then you are not liable. Causation defines the pool of potential defendants: those who in some sense caused the plaintiff’s injury. But the universe of those who could have prevented the injury is not easily defined.

With liability, good swimmers would avoid crowded beaches. In practice, altruism and being seen as a hero is perceived as motivation.

Restitution. Ex.: If one sacrifices something in order to prevent a bigger loss, one does not have to bear the cost of that thing, but neither does one receive the benefits of preventing the loss.

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The Function of Tort Damages

A defendant found liable must pay damages at least as great as L in the Learned Hand Formula. But should she pay the victim or the state?

She should pay the victim. Otherwise, the victim has no incentive to sue, an incentive that is essential to the maintenance of the tort system as a credible deterrent to negligence. Alternatively, the victim may take too much precaution.

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Damages for Loss of Earning Capacity

When an accident disables the victim, the court may order the defendant to pay the victim a lump sum calculated so as to equal the present value of the victim’s expected (lost) future earnings.

Paying a lump sum now minimizes administrative costs as well as the disincentive effect of tying continuous receipt of money to continued disability.

In other words, having received the lump sum, the victim has no further interest in remaining disabled. A system of periodic payments would be equivalent to a 100 percent tax on earned income.

Tort Law

Damages for Loss of Earning Capacity

A potential offset is that with a lump sum payment, the victim has every incentive to exaggerate his or her injury.

Ex.: Lucky, on King of the Hill -- Luanne's dimwitted, itinerant, but benign redneck husband. He lives on the remainder of the $53,000 "settlement monies" he received after "slipping in a puddle of pee-pee at the Costco.“ (Wikipedia)

How to compensate plaintiff housewives? It has to do with opportunity cost -- and how one estimates streams of future earnings.

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Damages for Pain and Suffering, the Problem of Valuing Human Life, and the Risk of Overcompensation

Damages awards for pain and suffering, even when apparently generous, may well undercompensate victims crippled by accidents – after all, the loss of vision or a limb reduces the amount of utility derived from a sum of money.

Conversely, proper award of damages for death cannot be infinite. This implies that the optimum rate of fatal accidents is zero, and society is unwilling to incur the costs necessary to attain such a low rate.

Tort Law

Damages for Pain and Suffering, the Problem of Valuing Human Life, and the Risk of Overcompensation

Courts have resolved this problem largely by ignoring it. Damages are usually limited to the pecuniary (not economic) loss to survivors (victim’s lost earnings minus living expenses), plus medical expenses and any pain and suffering experienced by the victim before death.

Current value of an American life: $7 million (see Viscusi and Adley on value of statistical life, 2003.)

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SPRING 2012 IV. TORT LAW PPS231S.01 Law, Economics, and Organization