econ 522 economics of law dan quint spring 2012 lecture 19

Econ 522Economics of Law

Dan Quint

Spring 2012

Lecture 19

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Midterm 2 is graded, will be returned after lecture

Homework 4 is online Due May 3 Longer than others

Logistics

3

Monday’sexperiment

4

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.

Experiment

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What were we trying to test?

(a) Should the plaintiff in this case be awarded more or less than $10,000?

(b) How much should the plaintiff receive? (Please give a number.)

(c) Are you male or female?

The other half were asked…Half of you were asked…

(a) Should the plaintiff in this case be awarded more or less than $10,000,000?

(b) How much should the plaintiff receive? (Please give a number.)

(c) Are you male or female?

The question: how much did the “suggestion” affect answers to question (b)?

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So, what happened?

0%

20%

40%

60%

80%

100%

0 250,000 500,000 750,000 1,000,000 1,250,000

average: 322,125

people given the $10,000 “suggestion”

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So, what happened?

0%

20%

40%

60%

80%

100%

0 5,000,000 10,000,000 15,000,000

10k

10MM

322,125 4,138,095

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Another way to see it

0

2

4

6

8

10

12

14

< 300k 300-900k 900k-2.5MM 2.5MM-7.5MM 7.5MM+

10k

10MM

9

What about men vs. women?

0%

20%

40%

60%

80%

100%

0 5,000,000 10,000,000 15,000,000

10k

10MM

322,125 4,138,0953,990,909368,571

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Nobody knows what a leg is worth

“Reference point bias”

“Framing effects”

What does it mean?

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Back to work…

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What’s a lifeworth?

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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”

What’s a life worth?

$72,000,000,000Proposed OSHA formaldehyde standard

$ 104,200,000EPA asbestos regulations

$ 89,300,000OSHA asbestos regulations

$ 1,300,000Car side door protection standards

$ 200,000Airplane cabin fire protection

Estimated cost per life savedRegulation

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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 Health

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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


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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


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What does Viscusi find?

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24 studies based on wage differentials

0

5,000,000

10,000,000

15,000,000

20,000,000

Kniesn

er &

Lee

th (1

991)

Smith

& G

ilber

t (19

84)

Thaler

& R

osen

(197

6)

Arnou

ld & N

ichols

(198

3)

Dilling

ham

(198

5)

Butler

(198

3)

Brown

(198

0)

Gegax

et.

al. (1

991)

Moo

re &

Visc

usi (

1988

)

Mar

in & P

sach

arsp

oulos

(198

2)

Kniesn

er &

Lee

th (1

991)

Cousin

eau

et a

l (19

88)

Dilling

ham

(198

5)

Viscus

i (19

78, 1

979)

Smith

(197

6)

Olson

(198

1)

Viscus

i (19

81)

Smith

(197

4)

Moo

re &

Visc

usi (

1988

)

Moo

re &

Visc

usi (

1988

)

Kniesn

er &

Lee

th (1

991)

Viscus

i & M

oore

(198

9

Herzo

g & S

chlot

tman

(198

7)

Leigh

& F

olso

m (1

984)

Leigh

& F

olso

m (1

984)

Leigh

(198

7)

Garen

(198

8)

Moo

re &

Visc

usi (

1990

)

Moo

re &

Visc

usi (

1990

)

Implicitvalueof life

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7 studies using other risk-money tradeoffs

4.0Prices of new automobilesAutomobile accident risks, 1986

2.0Purchase price of smoke detector

Fire fatality risks without smoke detectors, 1968-1985

0.7Estimated monetary equivalent of effect of risk info

Cigarette smoking risks, 1980

0.8Property values in Allegheny Co., PA

Mortality effects of air pollution, 1978

0.6Purchase price of smoke detectors

Fire fatality risks without smoke detectors, 1974-1979

1.2Estimated disutility of seat belts

Automobile death risks, 1972

0.07Value of driver time based on wage rates

Highway speed-related accident risk, 1973

Implicit Value of life($ millions)

Component of theMonetary Tradeoff

Nature of Risk,Year

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6 studies based on surveys

1.2Series of contingent valuation questions, New Zealand survey, 1989-1990

Traffic safety

2.7 (median)9.7 (mean)

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

Automobile accident risks

3.8Willingness to pay for risk reduction, U.K. survey, 1982

Motor vehicle accidents

3.4 (pay),8.8 (accept)

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

Job fatality risk

15.6Mail survey willingness to accept increased risk, small (30) U.K. sample, 1975

Airline safety and locational life expectancy risks

0.1Willingness to pay question, door-to-door small (36) Boston sample

Improved ambulance service, post-heart attack lives

Implicit Value of Life ($ millions)

SurveyMethodology

Nature ofRisk

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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


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Punitivedamages

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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

Inconsistency of damages

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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

(One problem with inconsistent damages: more incentive to fight hard)

90, -110 40, -95

155, -210 55, -145

Cheap Expensive

Cheap Lawyer

Expensive Lawyer

Defendant

Pla

intif

f

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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 damages

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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

Punitive damages

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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…

Example of punitive damages: Liebeck v McDonalds (1994) (“the coffee cup case”)

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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 (1994)

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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

Liebeck v McDonalds (1994)

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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

What is the economic purpose of punitive damages?

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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

This suggests…

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Some empirical observations about tort system in the U.S.

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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 system

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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 system

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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 system

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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

U.S. tort system

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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 Sabin 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

Vaccines

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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…

Mass torts

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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

Cooter and Ulen’s overall assessment of U.S. tort system

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“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.”

To wrap up tort law, a funny story from Friedman…

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Scores lower than the first one

Average 82, median 83

Again, not actually assigning letter grades till after final…

…but I’d still think of 80-90 being roughly the B range, 65-75 roughly the C range

Second Midterm

A-H Q-ZI-P

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The legalprocess

(won’t get to this)

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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

Over the last 2 ½ months, we have…

44

To achieve efficiency, we’ve generally tried to set a party’s liability equal to the harm he caused someone else Damages in nuisance law Expectation damages in contract law Compensatory damages in tort law That way, he internalizes the externality he imposes, leading to

efficient decisions

In doing this, we’ve been making two big assumptions: The legal system works flawlessly The legal system costs nothing

Over the last 2 ½ months, we have…

45

I hit you with my car and did $10,000 worth of damage We both know I was negligent But courts aren’t perfect If we go to trial, 80% chance I’ll be found liable, 20% I won’t If I’m held liable, damages are correctly set at $10,000 So on average, if we go to trial, you expect to recover $8,000

But if we go to trial, we both have to hire lawyers Suppose this costs us each $3,000 Now your expected gain from going to trial is $8,000 – 3,000 = 5,000 And my expected cost is $8,000 + 3,000 = 11,000

An example from Polinsky, “An Introduction to Law and Economics”

46

So… Going to trial gains you $5,000 (in expectation) Going to trial costs me $11,000 (in expectation)

Maybe we can settle out of court If we avoid going to court and I pay you any settlement between

$5,000 and $11,000, we’re both better off So maybe this happens

But…


47

Suppose I’m more pessimistic about my chances than you You think I’m 80% likely to be found liable I think I’m 90% likely to be found liable

You think your expected gain is $8,000 – 3,000 = $5,000

I think my expected cost is $9,000 + 3,000 = $12,000

Now the range of possible settlements is even wider Any settlement between $5,000 and $12,000 is a Pareto-improvement

over going to trial So settling is more likely


48

Now instead, suppose I’m more optimistic about my chances than you You think I’m 80% likely to be found liable I think I’m only 10% likely to be found liable

You think your expected gain is $8,000 – 3,000 = $5,000

I think my expected cost is $1,000 + 3,000 = $4,000

Now an out-of-court settlement is impossible There are no settlements that you and I would both agree to


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And, even if our beliefs are compatible and there are settlements that we would both prefer to trial…

…private information might lead to failure to reach a settlement Remember from before: if our threat points are private

information, we might fail to reach an agreement because each of us is holding out for too big a share

So even if we had the same beliefs about what will happen at trial, private information could prevent settlement


50

So when litigation is costly… If the two parties agree on the likely outcome of a trial, there are

gains from settling out of court, and a range of settlements they would both prefer to going to trial

If the two parties are relatively pessimistic, settlement is even more likely

If the two parties are relatively optimistic, settlement may be impossible

Even if the two have the same beliefs or are relatively pessimistic, private information may lead to failures in bargaining


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Under strict liability… We said injurers internalize cost of accidents efficient precaution But this assumes cost of being sued = damage done If courts are unpredictable and litigation is costly, private cost of being

sued for damages could be > or < cost of accident Which could lead to too much or too little precaution

But also… If settlement talks break down and cases go to trial… …then total social cost of an accident includes the harm done, and the

resources expended during the trial! If trial costs $6,000, then social cost of the accident isn’t $10,000, but

$16,000 – which increases the efficient level of precaution!

So what?

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The legalprocess

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Tort law: efficiency meant minimizing the total social cost of accidents Actual cost of accidents Plus cost of actions taken to prevent them (precaution)

Goal of the legal process: minimize its social costs Direct (administrative) costs Error costs

The goal of the legal process

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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 aren’t efficient Error costs are costs of distortions in actions people take

(precaution, activity levels, etc.) due to flaws in legal system

Administrative costs and error costs

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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 that process not being perfect

The goal of the legal process

econ 522 economics of law dan quint spring 2012 lecture 19

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