George Mason University SCHOOL of LAw The economies of tort law: A Precis Giuseppe Dari Mattiacci Francesco parisi 03-49 LAW AND ECONOMICS WORKING PAPER SERIES This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection http://ssrn.com/abstractid=458701
George Mason University SCHOOL of LAW The Economics of Tort Law: A Précis Giuseppe Dari Mattiacci Francesco Parisi 03-49 LAW AND ECONOMICS WORKING PAPER SERIES This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract_id=458701
Giuseppe Dari Mattiacci-Francesco Parisi The economics of tort law a Precis ABSTRACT: Economic analysis has long been employed for the study of tort liability This paper revisits the main contributions to the subject emphasizing the inherent impossibility for tort liability to set perfectly efficient first-best incentives to take outcomes. The paper provides a pathfinder through the literature in various areas of tort law and economics The relatively simple structure of a tort problem provides one of the most fertile areas for the application of economic analysis to law. The positive economic theory of tort law maintains that the common law of torts is best explained as if judges are trying to promote efficient resource allocation, i.e maximize efficiency. The Coase (1960) theorem shows that if parties are allowed to tiate and transaction costs reallocated efficiently. In f tort acciden transaction costs are high. This is easily understood because the parties potentially involved in an accident are not easily identifiable ex ante, and the cost of acquiring the relevant information for bargaining can be high. This renders contractual arrangements a la Coase impracticable. In most tort situations the legal system thus needs to provide rules to give potential injurers and potential victims appropriate incentives to act as if they had to bear the total social cost of their activities. This is an important goal of tort law. Tort law is therefore justified when bargaining is not possible because high transaction costs are present, and banning an activity is undesirable given the social value of the risk-creating activity( Calabresi and Melamed, 1972)
1 Giuseppe Dari Mattiacci – Francesco Parisi The Economics of Tort Law: A Précis ABSTRACT: Economic analysis has long been employed for the study of tort liability. This paper revisits the main contributions to the subject emphasizing the inherent impossibility for tort liability to set perfectly efficient first-best incentives to take precaution for all parties to an accident and the need to choose among second best outcomes. The paper provides a pathfinder through the literature in various areas of tort law and economics. The relatively simple structure of a tort problem provides one of the most fertile areas for the application of economic analysis to law. The positive economic theory of tort law maintains that the common law of torts is best explained as if judges are trying to promote efficient resource allocation, i.e., maximize efficiency. The Coase (1960) theorem shows that if parties are allowed to negotiate and transaction costs are sufficiently low, legal entitlements will be reallocated efficiently. In the case of tort accidents, transaction costs are high. This is easily understood because the parties potentially involved in an accident are not easily identifiable ex ante, and the cost of acquiring the relevant information for bargaining can be high. This renders contractual arrangements à la Coase impracticable. In most tort situations the legal system thus needs to provide rules to give potential injurers and potential victims appropriate incentives to act as if they had to bear the total social cost of their activities. This is an important goal of tort law. Tort law is therefore justified when bargaining is not possible because high transaction costs are present, and banning an activity is undesirable given the social value of the risk-creating activity (Calabresi and Melamed, 1972)
In order to create optimal incentives, liability rules need to induce parties to minimize the total social cost of accidents The relevant variables for this tort problem are the cost of accidents, the cost of accident avoidance(precaution) and the administrative costs of the justice system. Every legal system chooses from various liability rules(e.g, negligence, strict liability, etc. )and safety standards to minimize the overall cost of accidents The goals of tort law A first intuitive end of tort law is to compensate the victims for losses due to accidents. This is indeed an important task of tort adjudication but is not the central issue concerning the design of tort rules. It has been shown that tort law is a very expensive means of compensating harms, because it involves high dministrative cost due to the functioning of the judicial system. Insurance, to the contrary, is a much cheaper and quicker system(Shavell, 1987, at 263 ):if the only goal were to compensate victims, first-party insurance would be preferable over tort liability. Moreover, the cost of insurance can be paid by the potential injurers, shared among potential victims or financed by taxpayers, in order to redistribute the costs(McEwin, 2000) On the contrary, economic analysis suggests that the primary reason fo utilizing the tort system is to allow risk-creating activities to be carried out only if the social value of the activity justifies the risk created. This balancing of costs and benefits is currently endorsed by North American tort doctrine and is clearly summarized by the Restatement( Second)of Torts$ 291:"Where an act is one which a reasonable man would recognize as involving a risk of harm to another, the risk is unreasonable and the act negligent if the risk is of such magnitude as to outweigh what the law regards as the utility of the act or of the
2 In order to create optimal incentives, liability rules need to induce parties to minimize the total social cost of accidents. The relevant variables for this tort problem are the cost of accidents, the cost of accident avoidance (precaution), and the administrative costs of the justice system. Every legal system chooses from various liability rules (e.g., negligence, strict liability, etc.) and safety standards to minimize the overall cost of accidents. 1. The goals of tort law A first intuitive end of tort law is to compensate the victims for losses due to accidents. This is indeed an important task of tort adjudication but is not the central issue concerning the design of tort rules. It has been shown that tort law is a very expensive means of compensating harms, because it involves high administrative cost due to the functioning of the judicial system. Insurance, to the contrary, is a much cheaper and quicker system (Shavell, 1987, at 263): if the only goal were to compensate victims, first-party insurance would be preferable over tort liability. Moreover, the cost of insurance can be paid by the potential injurers, shared among potential victims or financed by taxpayers, in order to redistribute the costs (McEwin, 2000). On the contrary, economic analysis suggests that the primary reason for utilizing the tort system is to allow risk-creating activities to be carried out only if the social value of the activity justifies the risk created. This balancing of costs and benefits is currently endorsed by North American tort doctrine and is clearly summarized by the Restatement (Second) of Torts § 291: “Where an act is one which a reasonable man would recognize as involving a risk of harm to another, the risk is unreasonable and the act negligent if the risk is of such magnitude as to outweigh what the law regards as the utility of the act or of the
particular manner in which it was done(The Restatement(Second)of Torts SS 292 and 293, indicate the criteria for verifying utility of conduct and magnitude of risk.) More specifically, economic analysis suggests that tort law should be designed in such a way as to provide potential injurers and victims with appropriate incentives to avoid the accident by internalizing the externalities created by their activities. In the absence of tort liability, potential tortfeasors would bear the private cost of their precaution without internalizing any of the enefits thereof. The benefits(of precaution) are external with respect to the decision(on how much precaution). This would lead to suboptimal levels of sive accident rates. Through tort liability, a potential tortfeasor internalizes the benefits of his precaution, that is, the re liability. Tort should thus be designed to induce parties to internalize external costs of their activities and to adopt optimal levels of precaution In addition, tort law gives parties incentives to acquire information about the accident. With respect to risk, the tort law system should enhance an optimal allocation of the risk between victim and injurer, but this goal can be reached via insurance. With respect to transaction costs, the goal of the tort law system is to minimize the administrative cost associated with the functioning of the system itself(mainly the costs of courts and lawyers and the indirect costs borne by litigants. Calabresi(1970) presented the first formulation of the ends of liability in those terms, while Brown(1973) formalized an economic model of accidents. We will focus on incentives toward optimal precaution and discuss the other
3 particular manner in which it was done” (The Restatement (Second) of Torts §§ 292 and 293, indicate the criteria for verifying utility of conduct and magnitude of risk.) More specifically, economic analysis suggests that tort law should be designed in such a way as to provide potential injurers and victims with appropriate incentives to avoid the accident by internalizing the externalities created by their activities. In the absence of tort liability, potential tortfeasors would bear the private cost of their precaution without internalizing any of the benefits thereof. The benefits (of precaution) are external with respect to the decision (on how much precaution). This would lead to suboptimal levels of care and excessive accident rates. Through tort liability, a potential tortfeasor internalizes the benefits of his precaution, that is, the reduction in expected liability. Tort rules should thus be designed to induce parties to internalize the external costs of their activities and to adopt optimal levels of precaution. In addition, tort law gives parties incentives to acquire information about the accident. With respect to risk, the tort law system should enhance an optimal allocation of the risk between victim and injurer, but this goal can be reached via insurance. With respect to transaction costs, the goal of the tort law system is to minimize the administrative cost associated with the functioning of the system itself (mainly the costs of courts and lawyers and the indirect costs borne by litigants). Calabresi (1970) presented the first formulation of the ends of liability in those terms, while Brown (1973) formalized an economic model of accidents. We will focus on incentives toward optimal precaution and discuss the other aspects aside
2. A taxonomy of liability rules There are several ways in which legal systems can apportion liability between parties. Historically, a broad variety of liability rules has been developed by legal systems. Most early legal systems adopted liability rules that did not depend on the fault of the tortfeasor. This feature of early legal systems has been explained as instrumental to promoting appeasement between the parties and to avoiding cumbersome and controversial ascertainment of the subjective elements of a tort(Parisi, 1992 and 2001). Gradually, legal systems began to recognize fault as a viable basis for liability and in modern legal regimes strict liability is seen as an exception to the norm. Liability for accidents should arise only in the case of tortfeasor fault (including both negligent and intentional wrongdoing) We shall proceed with the presentation of some of the most common liability rules, starting from strict liability to simple negligence and more complex legal regimes. In our analysis we shall utilize the conventional terminology by which the injurer is defined as the individual who does not suffer harm in an accident and the victim as the individual who suffers such harm. In this survey, we shall focus on two-party accident There are two fundamental possibilities in a two-party accident The first occurs when both parties have to take precaution in order to avoid the accident (bilateral precaution). The second is given by situations in which either party ident(alternative precaution) In the second case, there is a waste of precaution cost if both parties take precaution, since one party's precaution would have been already enough. A particular and common case of alternative precaution is unilateral precaution As in alternative precaution, one party's precaution is enough to prevent the
4 2. A taxonomy of liability rules. There are several ways in which legal systems can apportion liability between parties. Historically, a broad variety of liability rules has been developed by legal systems. Most early legal systems adopted liability rules that did not depend on the fault of the tortfeasor. This feature of early legal systems has been explained as instrumental to promoting appeasement between the parties and to avoiding cumbersome and controversial ascertainment of the subjective elements of a tort (Parisi, 1992 and 2001). Gradually, legal systems began to recognize fault as a viable basis for liability and in modern legal regimes strict liability is seen as an exception to the norm. Liability for accidents should arise only in the case of tortfeasor fault (including both negligent and intentional wrongdoing). We shall proceed with the presentation of some of the most common liability rules, starting from strict liability to simple negligence and more complex legal regimes. In our analysis we shall utilize the conventional terminology by which the injurer is defined as the individual who does not suffer harm in an accident and the victim as the individual who suffers such harm. In this survey, we shall focus on two-party accidents. There are two fundamental possibilities in a two-party accident. The first occurs when both parties have to take precaution in order to avoid the accident (bilateral precaution). The second is given by situations in which either party can take precaution and successfully avoid an accident (alternative precaution). In the second case, there is a waste of precaution cost if both parties take precaution, since one party’s precaution would have been already enough. A particular and common case of alternative precaution is unilateral precaution. As in alternative precaution, one party’s precaution is enough to prevent the
accident, but only one party has the actual possibility of avoiding the accident We shall consider all such possibilities when referring to the effect of alternative legal rules on the parties' behavion 2. 1 Strict Rules: No Liability and Strict Liability Strict liability can be thought of as the mirror-image of no liability. a party who occasions harm to another will compensate the victim regardless of who is at fault. This rule is the converse of no liability. No liability can in fact be thought of as strict liability on the part of the victim, in that the victim always bears the loss regardless of the parties' fault. No liability and strict liability can thus be considered the limit points in the range of possible liability rules. The choice between strict liability and no liability has obvious distributive effects in that strict liability results in the victim al ways being compensated, while no liability makes the victim bear all accident costs The different allocation of accident costs has clear incentive effects. in a strict liability system, the injurer has to bear both the cost of precaution and the This will lead to the efficient level of precaution. On the contrary, a no-iabiz, expected accident cost and, hence, he will minimize the sum of those costs ule does not achieve an efficient result because the injurer would bear of precaution without internalizing the benefit of such precaution. Absent liability, the injurer would adopt no precaution at all, which is an inefficient result. On the other hand. if we look at the victim's incentives to take precaution, we see that the opposite is true. Strict liability creates no incentives for victim precaution, while no liability would shift the entire residual liability on the victim, inducing optimal victim care. It follows that strict liability and no liability can give incentives to take efficient precaution only to one party
5 accident, but only one party has the actual possibility of avoiding the accident. We shall consider all such possibilities when referring to the effect of alternative legal rules on the parties’ behavior. 2.1 Strict Rules: No Liability and Strict Liability Strict liability can be thought of as the mirror-image of no liability. A party who occasions harm to another will compensate the victim regardless of who is at fault. This rule is the converse of no liability. No liability can in fact be thought of as strict liability on the part of the victim, in that the victim always bears the loss regardless of the parties’ fault. No liability and strict liability can thus be considered the limit points in the range of possible liability rules. The choice between strict liability and no liability has obvious distributive effects, in that strict liability results in the victim always being compensated, while no liability makes the victim bear all accident costs. The different allocation of accident costs has clear incentive effects. In a strict liability system, the injurer has to bear both the cost of precaution and the expected accident cost and, hence, he will minimize the sum of those costs. This will lead to the efficient level of precaution. On the contrary, a no-liability rule does not achieve an efficient result because the injurer would bear the cost of precaution without internalizing the benefit of such precaution. Absent liability, the injurer would adopt no precaution at all, which is an inefficient result. On the other hand, if we look at the victim’s incentives to take precaution, we see that the opposite is true. Strict liability creates no incentives for victim precaution, while no liability would shift the entire residual liability on the victim, inducing optimal victim care. It follows that strict liability and no liability can give incentives to take efficient precaution only to one party
espectively either the injurer or the victim. Strict liability will fail to produce an efficient outcome when the avoider is the victim, and no liability will fail when the avoider is the injurer With respect to alternative precaution, the result is slightly different. In the case of unilateral precaution, if the tort law system fails to target the avoider, he will take no precaution at all, while in the case of alternative precaution, either party can take precaution; therefore, imposing liability on the party who is not the least cost avoider will result in suboptimal precaution levels and excessive precaution costs. Strict liability and no liability can thus yield efficient results only in the case of unilateral or alternative precaution, provided that liability is allocated on the least cost avoider In the case of bilateral precaution, both strict liability and no liability fail to generate optimal incentives, because neither rule can simultaneously threaten both parties with liability in a Nash equilibrium. In bilateral-precaution situations a different rule is therefore needed to induce both parties to adopt the necessary precautions 2. 2 Negligence rules in Genero Fault can be seen as a way of creating optimal incentives on both tortfeasors and victims and also of achieving efficiency in the case of bilateral precaution. Negligence rules draw a line between liability and no liability by identifying a level of due care and verifying if the relevant party adopted that level of due care. American case law in a sense anticipated the economic definition of negligence, adopting the simple and formal logic of cost-benef analysis to adjudicate tort cases. Already in 1947, Judge Learned Hand, in the celebrated decision of United States v. Carroll Towing Co(159 F 2d 169(2d
6 respectively either the injurer or the victim. Strict liability will fail to produce an efficient outcome when the avoider is the victim, and no liability will fail when the avoider is the injurer. With respect to alternative precaution, the result is slightly different. In the case of unilateral precaution, if the tort law system fails to target the avoider, he will take no precaution at all, while in the case of alternative precaution, either party can take precaution; therefore, imposing liability on the party who is not the least cost avoider will result in suboptimal precaution levels and excessive precaution costs. Strict liability and no liability can thus yield efficient results only in the case of unilateral or alternative precaution, provided that liability is allocated on the least cost avoider. In the case of bilateral precaution, both strict liability and no liability fail to generate optimal incentives, because neither rule can simultaneously threaten both parties with liability in a Nash equilibrium. In bilateral-precaution situations a different rule is therefore needed to induce both parties to adopt the necessary precautions. 2.2 Negligence rules in General Fault can be seen as a way of creating optimal incentives on both tortfeasors and victims and also of achieving efficiency in the case of bilateral precaution. Negligence rules draw a line between liability and no liability by identifying a level of due care and verifying if the relevant party adopted that level of due care. American case law in a sense anticipated the economic definition of negligence, adopting the simple and formal logic of cost-benefit analysis to adjudicate tort cases. Already in 1947, Judge Learned Hand, in the celebrated decision of United States v. Carroll Towing Co. (159 F.2d 169 (2d
Cir. 1947)), clarified the tradeoffs between the costs and benefits of risk and prevention activities using a mathematical formula. This rule became a milestone in the law of torts and it is now known as the hand formula of negligence. The formula defines negligence as a function of three variables: a) the probability of a harmful event occurring(magnitude of risk); b)the seriousness of the damage that may result from this event(gravity of harm) and c)the cost of preventing the occurrence of the harmful event(burden of prevention). In the original formula,(P) indicates the magnitude of risk; (L) indicates the gravity of the loss; and (B)indicates the burden of prevention (i.e the cost of adequate precautions ). According to the Hand formula, conduct is negligent if the cost of adequate precautions is less than the cost of the injury multiplied by the probability of its occurrence, i.e., if(B)<(PL) Although the Hand formula does not directly consider the social value of sk-creating behavior, it produces the proper incentives for the evaluation of such behavior. By imposing a balance between risk and prevention, the result in Carroll Towing encourages individuals to weigh the cost of prevention against the utility of the behaviour. When deciding whether to engage in an activity, the reasonable person will consider whether the utility derived from the activity justifies the risk of liability and/or the cost of prevention( this is, indeed, the question of the Restatement(Second) of Torts 8 291, comment a, which asks whether the game is worth the candle). According to this logic, individuals will respond to liability rules by undertaking the socially optimal level of precaution. A vast region of law and economics literature has explored the wisdom of this tort doctrine. often with the use of formal economic model bringing to light the importance of using marginal(rather than total) values in the assessment of liability. Along similar lines, after establishing a positive economic model of tort law, Landes and Posner(1982)conclude that the Hand
7 Cir. 1947)), clarified the tradeoffs between the costs and benefits of risk and prevention activities using a mathematical formula. This rule became a milestone in the law of torts, and it is now known as the Hand formula of negligence. The formula defines negligence as a function of three variables: a) the probability of a harmful event occurring (magnitude of risk); b) the seriousness of the damage that may result from this event (gravity of harm); and c) the cost of preventing the occurrence of the harmful event (burden of prevention). In the original formula, (P) indicates the magnitude of risk; (L) indicates the gravity of the loss; and (B) indicates the burden of prevention (i.e., the cost of adequate precautions). According to the Hand formula, conduct is negligent if the cost of adequate precautions is less than the cost of the injury multiplied by the probability of its occurrence, i.e., if (B) < (PL). Although the Hand formula does not directly consider the social value of risk-creating behavior, it produces the proper incentives for the evaluation of such behavior. By imposing a balance between risk and prevention, the result in Carroll Towing encourages individuals to weigh the cost of prevention against the utility of the behaviour. When deciding whether to engage in an activity, the reasonable person will consider whether the utility derived from the activity justifies the risk of liability and/or the cost of prevention (this is, indeed, the question of the Restatement (Second) of Torts § 291, comment a, which asks whether “the game is worth the candle”). According to this logic, individuals will respond to liability rules by undertaking the socially optimal level of precaution. A vast region of law and economics literature has explored the wisdom of this tort doctrine, often with the use of formal economic models, bringing to light the importance of using marginal (rather than total) values in the assessment of liability. Along similar lines, after establishing a positive economic model of tort law, Landes and Posner (1982) conclude that the Hand
formula of negligence, as applied, coincides with the economic model of due care Introducing fault means setting a due level of precaution, defined by the legislator or by the judge. The due level of precaution should be set to be equal to the efficient level of precaution. Under any negligence rule the judge has to perform such a test by confronting the level of precaution actually taken by the parties with the due level of precaution. This increases the administrative cost of adjudication compared to strict liability rules and generates some Among such complexities is the fact that, while some forms of precaution to assess and to compare with the legal standard of precaution. In the presence of non-observable precautions, it is clear that individuals would rationally limit their investment to observable precaution to avoid negligence and refrain from investing in non-observable precautions, since they could not draw much benefit from such investment In the law and economics literature the case of non-observable precautions is generally treated under the discussion of care levels versus activity level The most common example of activity level is the repetition of a dangerous action, as driving. Although courts may occasionally take into account the frequency of an activity in their assessment of negligence, often no threshold of optimal frequency" can be easily utilized by legal rules as a liability allocation mechanism, given the difficulty of pinpointing a critical value to efficient from excessive activity. Since courts cannot be asked to unascertainable costs and benefits and cannot be asked to evaluate non- observable precaution levels, it is clear that the types of precautions that are evaluated for the finding of negligence are generally confined to care levels, not
8 formula of negligence, as applied, coincides with the economic model of due care. Introducing fault means setting a due level of precaution, defined by the legislator or by the judge. The due level of precaution should be set to be equal to the efficient level of precaution. Under any negligence rule the judge has to perform such a test by confronting the level of precaution actually taken by the parties with the due level of precaution. This increases the administrative cost of adjudication compared to strict liability rules and generates some complexities. Among such complexities is the fact that, while some forms of precaution are easily observable ex post, some others are very difficult, or even impossible to assess and to compare with the legal standard of precaution. In the presence of non-observable precautions, it is clear that individuals would rationally limit their investment to observable precaution to avoid negligence and refrain from investing in non-observable precautions, since they could not draw much benefit from such investment. In the law and economics literature the case of non-observable precautions is generally treated under the discussion of care levels versus activity levels. The most common example of activity level is the repetition of a dangerous action, as driving. Although courts may occasionally take into account the frequency of an activity in their assessment of negligence, often no threshold of “optimal frequency” can be easily utilized by legal rules as a liability allocation mechanism, given the difficulty of pinpointing a critical value to separate efficient from excessive activity. Since courts cannot be asked to balance unascertainable costs and benefits and cannot be asked to evaluate nonobservable precaution levels, it is clear that the types of precautions that are evaluated for the finding of negligence are generally confined to care levels, not
activity levels. Therefore, the introduction of the criterion of negligence troduces a dichotomy between care-type and activity-type precaution investments(Shavell, 1980a). No such distinction between care and activity level is relevant in regimes of strict liability and no liability 2.2 Negligence rules under which the Victim is the Residual Bearer Hereafter we shall analyze those rules that are generally referred to as negligence rules. It will soon be clear that we can think of them as being constructed by adding a negligence defense to a rule of no liability Simple negligence. Within negligence regimes, the most straightforward lle is simple negligence. Under simple negligence an injurer is liable for damages only if he is found negligent. The victim bears the so-called residual liability, in the sense that he has to bear the consequences of the accident if the injurer cannot be blamed for negligence. In this sense, simple negligence is 10-liability rule, because it leaves residual With unilateral-precaution accidents, when the victim is the avoider, the ajurer cannot be declared negligent since it is not possible for him to take effective precautions. Therefore, the victim bears the cost of the accident and he will have incentives to take the optimal level of precautions(care and activity level) as under no liability. If the avoider is the injurer, he will have to pay only when he does not take at least the due level of care. If the injurer is negligent he has to bear the cost of care and the expected accident cost(pay damages the victim). On the contrary, if he takes due care he avoids liability and bears only the cost of care. If due care is set at the efficient level, the injurer will have incentives to take due care. We can conclude that in unilateral-precaution cases
9 activity levels. Therefore, the introduction of the criterion of negligence introduces a dichotomy between care-type and activity-type precaution investments (Shavell, 1980a). No such distinction between care and activity level is relevant in regimes of strict liability and no liability. 2.2 Negligence rules under which the Victim is the Residual Bearer Hereafter we shall analyze those rules that are generally referred to as negligence rules. It will soon be clear that we can think of them as being constructed by adding a negligence defense to a rule of no liability. Simple Negligence. Within negligence regimes, the most straightforward rule is simple negligence. Under simple negligence an injurer is liable for damages only if he is found negligent. The victim bears the so-called residual liability, in the sense that he has to bear the consequences of the accident if the injurer cannot be blamed for negligence. In this sense, simple negligence is analogous to a no-liability rule, because it leaves residual liability on the victim. With unilateral-precaution accidents, when the victim is the avoider, the injurer cannot be declared negligent since it is not possible for him to take effective precautions. Therefore, the victim bears the cost of the accident and he will have incentives to take the optimal level of precautions (care and activity level) as under no liability. If the avoider is the injurer, he will have to pay only when he does not take at least the due level of care. If the injurer is negligent, he has to bear the cost of care and the expected accident cost (pay damages to the victim). On the contrary, if he takes due care he avoids liability and bears only the cost of care. If due care is set at the efficient level, the injurer will have incentives to take due care. We can conclude that in unilateral- precaution cases
