The General Gist of Their Conclusion

Econ 522 – Lecture 20 (April 16 2009)

Cooter and Ulen wrap up the chapter on torts with an empirical assessment of the tort system in the U.S.

The general gist of their conclusion:

while critics claim that juries routinely hand out excessive rewards and that the tort system is out of control, it actually functions reasonably well
With the exception of occasional, well-publicized outliers, damage awards are generally not unreasonable
and liability has led to decreases in accidents in a variety of industries.

In the 1990s, tort cases passed contract cases as the most common form of lawsuit
Most tort cases are handled at the state level
in 1994, 41,000 tort cases were resolved in federal courts, while 378,000 were resolved by state courts in the largest 75 counties alone.
Among these cases, most involve a single plaintiff (in contrast with contract cases, where many more involve multiple plaintiffs)

Among the cases within the 75 largest counties in the U.S.,

about 60% had to do with auto accidents
about 17% were “premises liability”, for example, slip and falls in restaurants, businesses or government offices
about 5% were medical malpractice
about 3% were product liability

Punitive damages are historically very rare

between 1965 and 1990, out of all product liability cases, punitive damages were awarded 353 times
the average award was $625,000 (in 1990 dollars), reduced to $135,000 on appeal, with average punitive damages only slightly higher (1.2 times) compensatory damages.

Many states impose a limit on punitive damages, or impose a higher standard of evidence for awarding them

In general, civil suits require a “preponderance of evidence,” which is generally interpreted as anything over 50% certainty
In some states, punitive damages require “clear and convincing” evidence, a higher standard, though still lower than the “beyond a reasonable doubt” standard used in criminal law.)

Cooter and Ulen give a few scary statistics about medical malpractice

a study in New York in the 1980s found 1% of hospital admissions involved serious injury due to negligent care
some estimates suggest that “defensive medicine” – procedures undertaken purely to prevent possible lawsuits – account for 5% of total health care costs
A number of states have considered caps on damages that can be awarded for medical malpractice, although in some cases, these rules have had the opposite effect as intended.

Cooter and Ulen cite a recent product liability survey of CEOs finding that “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.”

The liability standard in many product-related accidents is “strict products liability”, which holds that a manufacturer is liable if the product is determined to have been defective. This can take three forms:

a defect in design – as in cases where the design of a car’s gas tank made it liable to explode
a defect in manufacture – a bolt is left off a lawn mower during assembly, or not tightened all the way; a piece flies off and injures a user
a defect in warning – the manufacturer fails to warn consumers about the dangers the product poses

One might expect precaution to be pretty unilateral – the manufacturer designs and builds the product – and so a strict liability rule might make sense
However, there are elements of bilateral precaution
People get injured turning their lawnmowers sideways to trip hedges.
C&U suggest holding manufacturers strictly liable for defective design, manufacture, or warnings, but not liable when victims misuse the product or “voluntarily assume the risk of injury”
(This is strict liability with a defense of contributory negligence)
(Basically, holding the manufacturer liable in these cases means forcing them to provide insurance for their customers, which is probably inefficient.)

They discuss attempts to reform product liability laws, in response to rising rates for liability insurance; some states put caps on damages. They give some unconvincing numbers, but point out that product-liability insurance costs are on the order of a quarter of a cent for each dollar of purchase price, which doesn’t seem all that problematic.

As I mentioned the other day, if you’re interested, the paper by Schwartz spends some time looking at evidence of the effect of tort law – that is, how actual accident rates have responded to changes in liability rules – in a number of different industries.

vaccines

Recall a silly example from several lectures ago:
I stop a friend to chat in the street, he later gets hit by a falling safe that wouldn’t have hit him if we hadn’t talked
In a sense, I caused his death
but I didn’t raise the ex-ante probability of it happening (I was as likely to cause him to miss the safe as to get hit by it), so I shouldn’t be held liable.

Liability for vaccines is sort of an analogous situation
Many vaccines for diseases are based on a weakened version of the disease itself, causing your body to develop a natural immunity to it.
Thus, while they make you much less likely for you to acquire the disease, there is usually a very slim chance of contracting the disease directly from the vaccine.
For example, the Sabin polio vaccine, which replaced the weaker Salk vaccine and basically wiped out polio, also causes 1 out of every 4,000,000 people who receive the vaccination to contract polio.
A 1974 case established that the maker had to warn its consumers about this risk; since then, vaccines always come with warnings about the risks.
Since then, however, a couple of people have been awarded damages after their children developed polio from the vaccine.

If liability cannot be avoided through due care and warnings, it ends up being built into the cost of the drug.
Worse, it discourages companies from developing beneficial vaccines.
The book gives a couple of examples – a 1976 outbreak of swine flu, and a more recent shortage of a vaccine against whooping cough – where a company refused to market a vaccine because it could not get liability insurance.
In the first case, the government stepped in, basically ordering the company to produce the vaccine and assuming liability for itself.

Cooter and Ulen wrap up with a brief discussion of mass torts – situations where many people have been harmed in the same way, by the same plaintiff.

Since the health risks of asbestos became widely known, over 600,000 people have come forward with lawsuits against 6000 different defendants
Many of the claimants do not yet have, and may never get, an asbestos-related disease.
Complicating things is that every state has a statute of limitations, a time by which actions must be started.
One estimate is that asbestos litigation has already cost $50 billion, with less than half of that actually going to the victims; estimates are that future litigation will be even more costly.

They don’t give much content about mass torts, other than to point out that courts have shown a willingness to use some creativity in handling the situations
One example: the case of DES, a drug administered to pregnant women in the 1950s to prevent miscarriages, which was later found to lead to cervical cancer and other problems
It was impossible to establish which firm had produced the dose that was given to a particular woman
The California Supreme Court introduced the concept of “market share liability” – all manufacturers of DES were held liable for the harm, in proportion to their market share at the time.

In this case, as in many others, victims did not all sue individually; large groups of plaintiffs were handled together.
This is the idea of a class action lawsuit – a simultaneous lawsuit brought by lots of plaintiffs who were all harmed in the same way
We’ll come back to this
On the one hand, this gets around the problem of small, dispersed harms
Remember our example from earlier: if a firm’s actions do $100 of damage to each of 10,000 people, it won’t be worth anyone’s time to sue
But if someone can sue at once on behalf of all 10,000, the lawsuit will get brought, which means there is an incentive to take efficient precaution
On the other hand…

the legal system

Over the last two months or so, we’ve
developed theories of property and nuisance law, contract law, and tort law
we’ve looked at how rules of legal liability create incentives
and thought about how these rules can be chosen to achieve efficient, or close to efficient, results

In general, we tried to set one party’s liability for damages equal to the harm he caused to the other party
damages in nuisance law
expectation damages in contract law
compensatory damages in tort law

That way, he would internalize the externality he was causing, and therefore make efficient decisions

Implicitly, we were making two big assumptions:
the legal system works flawlessly
the legal system costs nothing

The first assumption we made explicitly – by assuming we could set damages precisely in relationship to actual harm
In tort law, we even examined the effect on incentives when it is violated

The second assumption we made implicitly
By ignoring the costs of the legal system in figuring efficiency
And also by ignoring the private costs of litigation when considering the parties’ incentives.

Today and next Tuesday, we will relax these assumptions, and explicitly consider the details of the legal system and the incentives it creates.

We begin with an example from a book by Mitch Polinsky, “An Introduction to Law and Economics”
I hit you with my car and did $10,000 worth of damage. (Sorry.)
You and I both know that I was negligent
But we also both know that courts aren’t perfect
If we go to trial, there’s an 80% chance I’ll be held liable, and a 20% chance I won’t
If I am held liable, damages will be correctly set at $10,000
So if we go to trial, you expect to recover (on average) 80% X $10,000 = $8,000.

However, if we go to trial, we’ll both have to hire lawyers, and lawyers are expensive
Suppose going to trial will cost each of us $3,000

So now your expected net gain from going to trial is $8,000 – $3,000 = $5,000
Similarly, my expected cost if we go to trial is $8,000 + $3,000 = $11,000

Of course, since a trial will (in expectation) cost me $11,000 and earn you $5,000, it’s possible we can agree to settle without going to court.
Any settlement between $5,000 and $11,000 makes both of us better off.
So perhaps this will happen.

However, it’s also possible we disagree about the likely outcome of a trial
You probably have some private information about the degree of your injuries
I probably have some private information about how recklessly I was driving

First, suppose I’m more pessimistic about my chances at trial than you
That is, you think I’m 80% likely to be found liable, but I think it’s more like 90%
So you perceive your expected gain from trial to be $5,000
But I perceive my expected cost to be 90% X $10,000 + $3,000 = $12,000

This makes the range of possible settlements we’d both agree to even wider, and makes settling more likely.

On the other hand, suppose I’m more optimistic about my chances
You still think I’m 80% likely to be held liable, but I think it’s more like 10%
Your expected gain from trial is still $5,000
But now my expected cost, given my beliefs, is 10% x $10,000 + $3,000 = $4,000
So now we’re very unlikely to settle.

Finally, even if our beliefs are compatible, that is, even if there is a range of settlements which would make us both better off than going to trial, the private information we both have might lead to a failure to settle.
Recall from before, that if each of our threat points are private information, we might fail to reach an agreement because one of us tries to hold out for too big a share.
So even if we both had the same beliefs about the likely outcome of a trial, private information could lead us to fail to settle.

This leads us to a few quick observations:

When there are litigation costs, if we agree on the likely outcome of a trial, there will always be gains from settling out of court, and a range of settlements we would both prefer to trial
If the two sides are relatively pessimistic – the injurer perceives his expected liability to be higher than the victim – settlement is even more likely
If the two sides are relatively optimistic – the injurer perceives his expected liability to be lower than the victim – settlement may be impossible
Even if the two sides have the same beliefs or are relatively pessimistic, private information may lead to failures in bargaining

Recall that under a strict liability rule, the injurer bore the cost of accidents, and therefore internalized these costs and took efficient precaution

But this assumed the cost of being sued was equal to the damage done
With unpredictable courts and litigation costs, the private cost of being sued for damages can be either greater or less than the actual cost of the accident
So this could lead to either too much or too little precaution.

But it’s trickier than that as well

Suppose we believe that settlement talks are likely to break down, and most cases will end up going to trial
Then the total social cost of an accident includes the resources expended during a trial
That is, rather than $10,000, the cost of an accident might really be $16,000 – the harm done, plus the cost of a trial
If accidents do more harm, this means more precaution is cost-justified – the optimal level of precaution is higher than before!

We’ve already spent a lot of time looking at how incentives respond to the private cost of accidents, so we’ll put that question aside for now.
However, in the next couple of lectures, we’ll go into greater detail about the legal process itself – how these costs are incurred, and the effects this has.

Cooter and Ulen point out that the legal process has a large number of steps: Once an injury has occurred….

The victim can decide to sue or decide not to
The victim and injurer can immediately settle out of court, or else begin the process of preparing for trial
In the U.S., one of the first steps in preparing for a trial involves exchanging information relevant to the case – more on this shortly
Once information has been exchanged, the two sides still have an opportunity to bargain again over an out-of-court settlement, and can either settle or go to trial
At trial, the victim (now the plaintiff) might win or lose
The losing side at the original trial can choose to appeal or not

Over the next lecture and a half, we’ll look more closely at each of these steps.

But first, it will help to have in mind what the theoretical goal of the legal process should be.

Recall that the economic essence of tort law was to minimize the total social cost of accidents
counting both the cost of the accidents themselves, and the costly actions that were taken to prevent them

Similarly, in economic terms, the goal of the legal process is to minimize its total social costs.

These costs come in two varieties: direct (administrative) costs, and error costs.

Administrative costs are obvious.

If a legal process is going to require judges, you have to hire judges.
If it’s going to require courtrooms, you have to build a courthouse.
If it’s going to require jurors, you’ll have to pay the jurors.
The more complex the process is, the more it is likely to cost.

Error costs are less obvious.

Any legal process will be imperfect
some defendants will not be found liable when they should be
damages will sometimes be set incorrectly
and so on.

We can think of an error as any judgment that differs from the theoretically perfect judgment
That is, any result that is different the judgment a court would impose if it were infinitely wise and had perfect information

An error incomputing damages after the factwill affect distribution but not efficiency
That is, after the fact, me paying you very high damages, or not being found liable when I should be, will matter to us
But since the damage is already done, it won’t affect efficiency

But anticipated errors also affect the costs that each side perceives as stemming from their actions

And therefore change incentives, and may lead to actions which are not efficient.

Error costs are the costs of any distortions in actions (precaution, activity levels, etc.) due to imperfect incentives caused by flaws in the legal system
An example we already saw: if courts make errors in sometimes not finding injurers liable, this may lead to lower precaution, which is inefficient
This inefficiency – however much the results differ from what would happen if damages were always set correctly – is an error cost

Theoretically, then, we can see the goal of a legal process as minimizing the sum of these two costs

the direct costs of administering a legal process
plus the economic effects of errors due to that process.

Next, we look more closely at each of the different stages we already mentioned:

the decision to pursue a legal claim or not
the decision to settle immediately or exchange information
the decision to settle then or go to trial
the trial itself
the appeals process

We begin with the question of whether or not to sue

In a rational world, this comes down to calculating the amount you expect to gain from suing, and comparing it to the cost
Looking at the problem from the victim’s point of view, we can turn all the questions above into a decision tree
Then assign values and probabilities to the different outcomes
And then calculate the overall expected value of a legal claim.