Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Fall 2013 Lecture 21
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Announcements

• This evening Jason Furman, head of Pres. Obamas
  Council of Economic Advisors, Fiscal Policy
  Achievements, Opportunities and Challenges
• Tonight, 530-630
• DeLuca Forum Room at Wisc Institute for Discovery
• Includes QA
• Second midterm Wednesday, in Education L196

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Whats left this semester

• Today wrapping up tort law
• Wednesday second midterm
• Next week no lectures, happy Thanksgiving!
• December 2 and 4 two classes on criminal law
• December 9 and 11 one class on behavioral law
  and econ, one revisiting efficiency and wrapping
  up
• Saturday December 21 final exam

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Last Wednesdays Experiment

• You have been asked to serve on a jury on a
  lawsuit dealing with personal injury. In the
  case before you, a 50-year-old construction
  worker was injured on the job due to the
  negligence of his employer. As a result, this
  man had his right leg amputated at the knee. Due
  to this disability, he cannot return to the
  construction trade and has few other skills with
  which he could pursue alternative employment.
• The negligence of the employer has been firmly
  established, and health insurance covered all of
  the related medical expenses. Therefore, your
  job is to determine how to compensate this worker
  for the loss of his livelihood and the reduction
  in his quality of life.

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What were we trying to test?
The other half were asked
Half of you were asked

1. Should the plaintiff in this case be awarded more
   or less than 10,000?
2. How much should the plaintiff receive? (Please
   give a number.)
3. Are you male or female?

1. Should the plaintiff in this case be awarded more
   or less than 10,000,000?
2. How much should the plaintiff receive? (Please
   give a number.)
3. Are you male or female?

• Testing how much did the suggestion in question
  (a) affect the answers to question (b)?

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So, did the first question make a difference?
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Distribution of answers to question 2
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Distribution of answers to question 2
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Distribution of answers to question 2

• The only statistical test one ever needs is the
  IOTT, or inter-ocular trauma test. The result
  just hits one between the eyes.
• - David H. Krantz

Asked 10,000,000
Asked 10,000
0
20,000
Minimum
50,000,000
1,000,000
Maximum
7,342,105
390,000
Average
5,000,000
450,000
Median
84
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at least one million
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One other way to see it
asked 10,000,000
asked 10,000
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less than1,000,000
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less than 100,000
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exactly1,000,000
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exactly 100,000
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more than 1 MMbut less than 5 MM
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more than 100kbut less than 500k
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exactly5,000,000
25
exactly 500,000
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more than5,000,000
25
more than 500,000
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What do we learn?

• Nobody knows exactly what a leg is worth
• Even among people asked exactly the same
  question
• answers varied from 20,000 to 1,000,000, or
  from 0 to 50,000,000
• So theres an incentive to fight!
• Since no one knows the right answer,
  suggestions matter
• Higher suggestion raised average from 400,000 to
  7 MM!
• Reference point bias
• Framing effects

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A couple variationson liability
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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 torts of employee if
  employee was acting within the scope of his
  employment

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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

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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

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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

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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

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Punitivedamages
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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 doesnt affect incentives (under
  either strict liability or negligence)
• But, if appropriate level of damages isnt
  well-established, more incentive to spend more
  fighting

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One problem with inconsistent damages more
incentive to fight hard

• Example each side can hire cheap lawyer or
  expensive lawyer
• Cheap lawyer costs 10, expensive lawyer costs
  45
• If two lawyers are equally good, expected
  judgment is 100
• If one is better, expected judgment is doubled or
  halved

Defendant
Cheap
Expensive
90, -110
40, -95
Cheap Lawyer
Plaintiff
155, -210
55, -145
Expensive Lawyer
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Punitive damages

• What weve 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 injurers
  behavior was
• malicious, oppressive, gross, willful and
  wanton, or fraudulent

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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

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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

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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

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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

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What is the economic purpose of punitive damages?

• Weve 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 wont, 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

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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 injurers actions
  were deliberately fraudulent, since may have been
  based on cost-benefit analysis of chance of being
  caught

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How should we think about the legal process
itself?
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Over the last three months, we have

• Developed theories of property/nuisance law,
  contract law, and tort law
• Looked at how rules of legal liability create
  incentives
• Thought about how these rules can be chosen to
  try to achieve efficient outcomes

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Weve been thinking of normative goal of
minimizing social costs

• Property law
• Goal was to allocate resources/entitlements
  efficiently
• or, to minimize inefficiencies due to
  misallocation
• Contract law
• Goal was to further facilitate trade
• or, to decrease inefficiencies due to unrealized
  Kaldor-Hicks improvements
• Tort law
• Goal was explicitly to minimize social costs
• which consist of cost of accidents plus cost of
  precaution

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Implicitly, weve generally been assuming two
things so far

• The legal system works flawlessly
• Whatever theoretical goal we set, we can
  implement correctly
• (In tort law, weve considered effect of errors)
• The legal system costs nothing
• Gave us nice theoretical results for achieving
  efficiency
• Example injunctions when TC low, damages when TC
  high
• Example strict liability when injurer activity
  matters a lot negligence when both sides
  precaution matters a lot
• Next what additional concerns are there when
  trying to put a legal structure in place to
  enforce these ideas?

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What is the goal of the legal system itself
i.e., how we implement the rules we chose?

• Start with the best possible benchmark
• Theoretically perfect rules, implemented
  flawlessly and costlessly
• Thats obviously the best we can hope to do
• How does reality differ?
• 1. Rules actually implemented wont be the
  perfect ones
• Imperfect rules will lead to imperfect
  incentives, leading to less-than-perfectly-effici
  ent actions and outcomes
• Think of any loss of efficiency due to
  imperfections in legal system as error costs
• 2. Actual system wont be costless
  administrative costs
• Goal of legal system minimize sum of these two
  costs

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Administrative costs and error costs

• Administrative costs
• Hiring judges, building courthouse, paying
  jurors
• More complex process ? higher cost
• Error costs
• Any legal process is imperfect
• Errors are any judgments that differ from
  theoretically perfect ones
• An error in computing damages after the fact only
  affects distribution, not efficiency
• But anticipated errors affect incentives, which
  may lead to actions which arent efficient
• Error costs are costs of distortions in actions
  people take (precaution, activity levels, etc.)
  due to flaws in legal system

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The goal of the legal process

• So theoretically, the efficient legal process is
  the one that minimizes the sum of
• The direct costs of administering the system, and
• The economic effects of errors due to process not
  being perfect
• Weve already seen the tradeoff between these two
  types of costs
• Tradeoff between simpler versus more complex
  rules
• Weve seen this several times

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Weve already seen tradeoff between
administrative and error costs

• Whaling law fast fish/loose fish vs.
  iron-holds-the-whale
• FF/LF lower administrative costs (fewer
  disputes)
• IHTW lower error costs (better incentives for
  whaling)
• Pierson v. Post (fox hunt case)
• Majority first to catch, otherwise fertile
  source of quarrels
• Dissent first to chase, hunting foxes is
  meritorious
• Privatizing ownership of land
• Expanding property rights adds admin costs
  (boundary maintenance)
• But lowers error costs (better incentives for
  efficient use of resource)
• Demsetz privatize when gains outweigh costs
• Same as pick system with the lower sum of admin
  error costs

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Another application how costly should it be to
sue somebody?

• Worth it for victim to sue if

Expected value of legal claim
Cost toinitiatelawsuit
gt

• Probability of winning at trial, times expected
  judgment
• Or likelihood of a settlement, times expected
  amount
• Minus costs expected to be incurred

• Filing fees

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Filing fees

• Expected value of claims should vary widely

Probability
Filing Fee
SUE
DONTSUE
Expected value of claims
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So what level of filing fees is efficient?

• The efficient legal system minimizes the sum of
  administrative costs and error costs
• Higher filing fees ? fewer lawsuits ? lower
  administrative costs
• But, higher filing fees ? more injuries go
  unpunished
• ? greater distortion in incentives ? higher
  error costs
• Filing fee is set optimally when these balance on
  the margin
• Marginal cost of reducing fee marginal benefit
• Administrative cost of an additional lawsuit
  error cost of providing no remedy in the marginal
  case

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How high should filing fees be?

• Error costs
• If were only concerned with efficiency, we dont
  care about distributional effects
• That is, we dont care if a particular victim is
  or isnt compensated
• So the size of error costs depends on how much
  peoples behavior responds to the incentives
  caused by liability
• The social value of reducing errors depends on
  whether the errors affect production or merely
  distribution
• When errors have large incentive effects, filing
  fees should be low
• When errors have small incentive effects,
  efficiency requires higher filing fees

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Class Action Lawsuits
Probability
Cost to initiate lawsuit
SUE
DONTSUE
Expected value of claims

• As long as there is any cost to litigation, some
  harms will be too low to justify a lawsuit
• When harm is small to each individual but large
  overall, one solution is a class action lawsuit

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Class Action Lawsuits

• One or more plaintiffs bring lawsuit on behalf of
  a large group of people harmed in a similar way
• Example California lawsuit over 6 bounced-check
  fee
• Court must certify (approve) the class
• Participating in a class-action suit eliminates
  victims right to sue on his own later
• If suit succeeds, court must then approve
  plaintiffs proposal for dividing up the award
  among members of the class
• Class-action suits are desirable when individual
  harms are small but aggregate harms are large
• Especially when avoidance of liability has strong
  incentive effect
• But theres also a danger

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Some empirical observations about tort system in
the U.S.(might not get to)
Skip
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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

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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

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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

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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

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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 cant be avoided, built into cost of
  the drug
• And discourages companies from developing vaccines

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To wrap up tort law, a funny story from Friedman
A tort plaintiff succeeded in collecting a
large damage judgment. The defendants
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.