Econ 522 Economics of Law

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Econ 522Economics of Law
Dan Quint Fall 2012 Lecture 16
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Reminder

• HW3 due tomorrow night
• MT2 November 19

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Today

• A few last odds and ends from contract law
• The basic economic model well be using for tort
  law

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Contract Law
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Repeated games
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Repeated games
Player 1 (you)
Trust me
Dont
Player 2 (me)
(100, 0)
Share profits
Keep all the money
(150, 50)
(0, 200)

• Suppose well play the game over and over
• After each game, 10 chance relationship ends,
  90 chance we play at least once more

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Repeated games

• Suppose youve chosen to trust me
• Keep all the money I get 200 today, nothing
  ever again
• Share profits I get 50 today, 50 tomorrow, 50
  day after
• Value of relationship
• Since this is more than 200, we can get
  cooperation

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Repeated games

• Suppose youve chosen to trust me
• Keep all the money I get 200 today, nothing
  ever again
• Share profits I get 50 today, 50 tomorrow, 50
  day after
• Value of relationship
• Since this is more than 200, we can get
  cooperation

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Repeated games and reputation

• Diamond dealers in New York (Friedman)
• people routinely exchange large sums of money
  for envelopes containing lots of little stones
  without first inspecting, weighing, and testing
  each one
• Parties to a contract agree in advance to
  arbitrationif one of them refuses to accept
  the arbitrators verdict, he is no longer a
  diamond merchant because everyone in the
  industry now knows he cannot be trusted.

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Repeated games and reputation

• The first purpose of contract law is to enable
  cooperation, by converting games with
  noncooperative solutions into games with
  cooperative solutions
• The sixth purpose of contract law is to foster
  enduring relationships, which solve the problem
  of cooperation with less reliance on courts to
  enforce contracts
• Law assigns legal duties to certain long-term
  relationships
• Bank has fiduciary duty to depositors
• McDonalds franchisee has certain duties to
  franchisor

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Repeated games and the endgame problem

• Suppose well play agency game 60 times
• 50 x 60 3,000 gt 200, so cooperation seems
  like no problem
• But
• In game 60, reputation has no value to me
• Last time were going to interact
• So I have no reason not to keep all the money
• So you have no reason to trust me
• But if we werent going to cooperate in game 60,
  then in game 59

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Repeated games and the endgame problem

• Endgame problem once theres a definite end to
  our relationship, no reason to trust each other
• Example collapse of communism in late 1980s
• Communism believed to be much less efficient than
  capitalism
• But fall of communism led to decrease in growth
• Under communism, lots of production relied on
  gray market
• Transactions werent protected by law, so they
  relied on long-term relationships
• Fall of communism upset these relationships

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One other bitI like from Friedman
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Friedman on premarital sex
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Friedman on premarital sex
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Thats it for contract law

• Purposes for contract law
• Encourage cooperation
• Encourage efficient disclosure of information
• Secure optimal commitment to performance
• Secure efficient reliance
• Provide efficient default rules and regulations
• Foster enduring relationships

End of material on second midterm
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Tort Law
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Monday

• Two liability rules well be looking at
• Strict Liability
• If I cause an accident, I owe victim damages
• (Harm Causation ? Liable)
• Negligence
• If I cause an accident, I only owe victim damages
  if I was negligent
• (Harm Causation Breach of Duty/Negligence ?
  Liable)

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Classic legal theory of torts

• Harm
• Causation
• Breach of Duty

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Element 3 Breach of Duty
(Sometimes required, sometimes not)
Negligence
Strict Liability

• Harm
• Causation
• Breach of duty (fault)

• Harm
• Causation

• When someone breaches a duty he owes to the
  defendant, and this leads to the harm, the
  injurer is at fault, or negligent
• Injurers owe victims the duty of due care
• Negligence rule Im only liable if I failed to
  take the required standard of care not if I was
  careful and the accident happened anyway

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Hence the language in the trolly example
A tree fell on a moving trolly, injuring
passengers. One of them sued. He succeeded in
demonstrating that in order for the trolly to be
where it was when the tree fell on it the driver
had to have driven faster than the speed limit at
some point during the trip. Breaking the law is
per se negligence, so the driver was legally
negligent whether or not his driving was actually
unsafe. If he had not driven over the speed
limit, the trolly would not have been under the
tree when it fell, so, the plaintiff argued,the
drivers negligence caused the injury.
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So under a negligence rule

• If I breach my duty of due care and injure you, I
  am liable
• If I exercise the appropriate level of care but
  still injure you, Im not liable
• How is the standard of care determined?
• That is, how careful do I have to be to avoid
  liability, and who decides?
• Is it negligent to drive 40 MPH on a particular
  road at a particular time of day? What about 41
  MPH? 42?

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How is the standard of care determined?

• Some settings government imposes safety
  regulations that are also used as standard for
  negligence
• Speed limits for highway driving
• Requirement that bicycles have brakes
• Workplace regulations
• Some standards are left vague
• Reckless driving may depend on road, time of
  day, weather
• Common law focuses on duty of reasonable care
• Level of care a reasonable person would have
  taken
• (Civil law relies less on reasonableness tests,
  tries to spell out what level of care is required)

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Strict liability versus negligence

• Strict liability rule plaintiff must prove harm
  and causation
• Negligence rule must prove harm, causation, and
  negligence
• A little history
• Early Europe strict liability was usual rule
• By early 1900s, negligence became usual rule
• Second half of 1900s, strict liability became
  more common again, especially for manufacturer
  liability in American consumer products
• U.S. manufacturers now held liable for harms
  caused by defective products, whether or not they
  were at fault

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Next question

• Like with contract law, our main concern is with
  the incentives created by liability rules
• So what incentives are we interested in?

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Precaution
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Precaution

• The more carefully I drive, the less likely I am
  to hit you
• But, driving more carefully is also more costly
  to me
• Must be some efficient level of care
• Similarly
• Construction company can reduce accidents with
  better safety equipment, better training, working
  shorter days, all of which cost money
• Manufacturer can reduce accidents by
  designing/inspecting products more carefully
  again, more expensive

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Actions by both injurer and victim impact number
of accidents

• drive slowly

• speed like hell

• drive carefully

• drive drunk while texting

• careful quality control

• cheap, hasty manufacturing

• install smoke detectors, other safety equipment

• save money

• wear helmet and use light

• bicycle at night wearing black

GREATER EFFORT TO PREVENT ACCIDENTS
LESS EFFORT TOPREVENT ACCIDENTS
MORE PRECAUTION
LESS PRECAUTION
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We will call all these things precaution

• Precaution anything either injurer or victim
  could do to reduce likelihood of an accident (or
  damage done)
• The next two questions should be obvious
• How much precaution do we want?
• What is efficient level of precaution?
• How do we design the law to get it?

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To answer these questions, well introduce a very
simple model of accidents

• Car hits a bicycle
• In real life driver probably has insurance
• In real life some damage to bicycle, some damage
  to drivers car
• In real life driver and bicyclist may not even
  know what the law is
• Well simplify things a lot, by assuming
• Only one party is harmed
• Parties know the law, dont have insurance (for
  now)
• Well focus on one partys precaution at a time

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Simple economic modelfor thinking about tort law
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Model of unilateral harm
x level of precautionw marginal
cost of precautionp(x) probability of an
accidentA cost of an accident

• Unilateral harm just one victim
• Precaution costly actions that make accident
  less likely
• Could be taken by either victim or injurer
• Well consider both, but one at a time
• Notation
• x the amount of precaution that is taken
• w the cost of each unit of precaution
• so total cost of precaution is wx
• p(x) probability of an accident, given
  precaution x
• p is decreasing in x
• A cost of accident (to victim)
• so expected cost of accidents is p(x) A

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Model of unilateral harm
x level of precautionw marginal
cost of precautionp(x) probability of an
accidentA cost of an accident

• efficient precaution minx wx p(x) A
• w p(x) A 0
• w p(x) A

marginal social benefit of precaution
marginalsocial cost of precaution
wx p(x) A(Total Social Cost)
wx (Cost of Precaution)
p(x) A (Cost of Accidents)
Precaution (x)
x (Efficient Level of Precaution)
x lt x
x gt x
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Effect of liability rules on precaution

• We know whats efficient
• Level of precaution that minimizes total social
  cost wx p(x) A
• Well consider what happens if there is
• no liability rule in place
• a strict liability rule
• a negligence rule

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Benchmark what happens without any liability
rule?
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Benchmark No Liability

• In a world with no liability
• Injurer does not have to pay for accidents
• So, bears cost of any precautions he takes, but
  does not receive any benefit
• Injurer has no incentive to take precaution
• Victim bears cost of any accidents, plus cost of
  precaution he takes
• (Victim precaution imposes no externality on
  injurer)
• Victim precaution will be efficient

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Benchmark No Liability

• Injurers private costis just wx
• Minimized at x 0
• Victims private costis p(x) A wx
• Minimized at efficientprecaution level x x
• So rule of no liability leads to efficient
  precaution by victims, no precaution by injurers

Private cost to injurer
Private cost to victim
wx p(x) A
wx
p(x) A
x
x
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Benchmark No Liability
Victim Precaution
Injurer Precaution
Efficient
Zero
No Liability
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Precaution isnt the only thing that determines
number of accidents

• Precaution actions which make an activity less
  dangerous
• Driving carefully
• Wearing bright-colored clothing while bicycling
• The amount we do each activity also affects the
  number of accidents
• I decide how much to drive
• You decide how much to bicycle
• Liability rules create incentives for activity
  levels as well as precaution

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With no liability rule

• With no liability, Im not responsible if I hit
  you
• I dont consider cost of accidents when deciding
  how fast to drive
• and I also dont consider cost of accidents when
  deciding deciding how much to drive
• So I drive too recklessly, and I drive too much
• (or if there is no liability, social cost of
  driving includes cost of accidents, but private
  cost to me does not
• driving imposes negative externality, so I do it
  too much)
• So with no liability, injurers activity level is
  inefficiently high

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What about victims?

• With no liability, victim bears full cost of
  accidents
• Greater activity by victim (more bike-riding)
  leads to more accidents
• Victim weighs cost of accidents when deciding how
  carefully to ride, and when deciding how much to
  ride
• (Private cost social cost)
• Victim takes efficient level of precaution, and
  efficient level of activity
• A rule of no liability leads to an inefficiently
  high level of injurer activity, but the efficient
  level of victim activity

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Benchmark No Liability
Victim Activity
Injurer Activity
Victim Precaution
Injurer Precaution
Efficient
Too High
Efficient
Zero
No Liability
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Next what happens under a strict liability rule?
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Strict Liability

• Perfect compensation damages D A
• Under strict liability
• Injurer pays damages for any accidents he causes
• So injurer bears cost of accidents, plus his own
  precaution
• Injurer internalizes externality his actions
  cause ? chooses efficiently
• Victim is fully insured, no incentive for
  precaution

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Strict Liability

• (Damages A)
• Injurers private costis p(x) A wx
• Minimized at efficientprecaution level x x
• Victims private costis just wx
• Minimized at x 0
• So rule of strict liability leads to efficient
  precaution by injurers, no precaution by victims

Private cost to injurer
Private cost to victim
wx p(x) A
wx
p(x) A
x
x
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Strict Liability
Victim Activity
Injurer Activity
Victim Precaution
Injurer Precaution
Efficient
Too High
Efficient
Zero
No Liability
Zero
Efficient
Strict Liability
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What about activity level?

• Under strict liability, injurer internalizes cost
  of accidents
• Weighs benefit from driving against cost of
  accidents
• Takes efficient activity level
• Under strict liability, victim does not bear cost
  of accidents
• Ignores cost of accidents when deciding how much
  to bike
• Sets inefficiently high activity level
• A rule of strict liability leads to the
  efficiently level of injurer activity, but an
  inefficiently high level of victim activity

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Strict Liability
Victim Activity
Injurer Activity
Victim Precaution
Injurer Precaution
Efficient
Too High
Efficient
Zero
No Liability
Too High
Efficient
Zero
Efficient
Strict Liability
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So

• For both precaution and activity level
• No liability leads to inefficient behavior by
  injurer, efficient behavior by victim
• Strict liability leads to efficient behavior by
  injurer, inefficient behavior by victim
• Reminiscent of paradox of compensation
• One rule sets multiple incentives
• cant get them all right
• But in tort law, we have a trick

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Negligence(wont get to)
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Negligence Rule

• Negligence rule injurer is liable if he breached
  the duty of due care
• Within our model
• Legal standard of care xn
• Injurer owes damages if precaution level was
  below that level
• x lt xn ? D A
• x ³ xn ? D 0
• So on our graph from before, private cost to
  injurer is
• wx p(x) A for x lt xn
• wx for x ³ xn
• Best shot at achieving efficiency is to set xn
  x

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Simple Negligence Injurer precaution

Private cost to injurer
wx p(x) A
wx
p(x) A
x
xn x

• Private cost is wx p(x) A if x lt xn, only wx
  otherwise
• If standard of care is set efficiently (xn x),
  injurer minimizes private cost by taking
  efficient precaution

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Simple Negligence Victim precaution

• What about victim?
• We just said, injurer will take efficient
  precaution
• Which means injurer will not be liable
• So victim bears costs of any accidents
• (Victim bears residual risk)
• So victims private cost is wx p(x) A
• Victim minimizes private cost by taking efficient
  level of precaution too!

Private cost to victim (assuming injurer takes
efficient level of precaution and is therefore
not liable for damages)
wx p(x) A
wx
p(x) A
x
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Simple Negligence
Victim Activity
Injurer Activity
Victim Precaution
Injurer Precaution
Efficient
Too High
Efficient
Zero
No Liability
Too High
Efficient
Zero
Efficient
Strict Liability
Efficient
Efficient
Simple Negligence, xn x
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Other negligence rules

• Rule we just saw is called simple negligence
• Only consider injurers actions in determining
  liability
• But we could also consider whether victim was
  negligence in deciding whether injurer is liable
• Negligence with a defense of contributory
  negligence injurer owes nothing if victim was
  also negligent
• Comparative negligence if both were
  negligent, share cost
• Strict liability with defense of contributory
  negligence injurer is liable (even if he
  wasnt negligence), unless victim was negligent
• Any of these rules (with efficient standard of
  care) will lead to efficient precaution by both
  parties!

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Discrete example ofbilateral precaution
A 1,000w 20 for either partyp 10 / 6 / 2

• No levels of precaution each party can either
  take precaution or not
• Each accident causes 1,000 of harm
• Precaution costs 20 for each party
• Chance of an accident is
• 10 if nobody takes precaution
• 6 if one party takes precaution
• 2 if both parties take precaution
• Note that precaution is efficient for both
  parties
• Costs 20 reduces expected accidents by 4 X
  1,000 40

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Different negligence rules
A 1,000w 20 for either partyp 10 / 6 / 2
Does injurer owe victim damages when
Both parties negligent?
Only injurer negligent?
Only victim negligent?
Neither party negligent?
Yes
Yes
No
No
Simple Negligence
No
Yes
No
No
Negligence with Defense of Contributory Negligence
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Negligence with a Defenseof Contributory
Negligence
A 1,000w 20 for either partyp 10 / 6 / 2

• Injurer is liable if he failed to take
  precaution
• Unless victim did too
• Precaution is alwaysbest-response for victim
• If injurer is not takingprecaution, victim
  wantsto avoid liability
• If injurer is takingprecaution, victim
  bearsresidual risk, wants tominimize accidents
• For injurer, precaution is the best-response to
  precaution
• Both take precaution is the only Nash
  equilibrium
• And, is the efficient outcome

victim pays for precaution, and any accidents
that happen
injurer pays for precaution, not liable for
accidents
Victim
Precaution
None
-20, -40
-20, -60
Precaution
Injurer
-60, -20
0, -100
None
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Different negligence rules
A 1,000w 20 for either partyp 10 / 6 / 2
Does injurer owe victim damages when
Both parties negligent?
Only injurer negligent?
Only victim negligent?
Neither party negligent?
Yes
Yes
No
No
Simple Negligence
No
Yes
No
No
Negligence with Defense of Contributory Negligence
Partial
Yes
No
No
Comparative Negligence
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Comparative Negligence
A 1,000w 20 for either partyp 10 / 6 / 2

• If both parties were negligent
• divide cost proportionally
• Precaution is again adominant strategy
  forvictim
• Now its a dominant strategyfor injurer too
• Again, both take precaution is the only
  equilibrium
• (And the efficient outcome)

Victim
Precaution
None
-20, -40
-20, -60
Precaution
Injurer
-60, -20
-50, -50
None
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Different negligence rules
A 1,000w 20 for either partyp 10 / 6 / 2
Does injurer owe victim damages when
Both parties negligent?
Only injurer negligent?
Only victim negligent?
Neither party negligent?
Yes
Yes
No
No
Simple Negligence
No
Yes
No
No
Negligence with Defense of Contributory Negligence
Partial
Yes
No
No
Comparative Negligence
No
Yes
No
Yes
Strict Liability with Defense of Contributory
Negligence
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Strict Liability with a Defenseof Contributory
Negligence
A 1,000w 20 for either partyp 10 / 6 / 2

• Now, injurer is liable,regardless of whetherhe
  took precaution
• unless victimwas negligent
• Once again, bothtake precaution isthe only
  equilibrium

Victim
Precaution
None
-40, -20
-20, -60
Precaution
Injurer
-60, -20
0, -100
None
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Negligence
Victim Activity
Injurer Activity
Victim Precaution
Injurer Precaution
Efficient
Too High
Efficient
Zero
No Liability
Too High
Efficient
Zero
Efficient
Strict Liability
Efficient
Efficient
Simple Negligence
assuming all relevant standards of care are set
to the efficient levels
Efficient
Efficient
Negligence with a Defense of Contributory
Negligence
Efficient
Efficient
Comparative Negligence
Efficient
Efficient
Strict Liability with Defense of Contributory
Negligence