This Led Us to the Following Table

Econ 522 – Lecture 18 (Nov 82007)

Tuesday, we examined the effects of several different liability rules on the level of precaution taken by both the injurer and the victim. We found that whoever bears the cost of accidents has an incentive to take the efficient level of precaution, but that a party who does not bear the cost of the accident takes no precaution. We also found that a negligence rule – holding a party liable unless they could show they took sufficient care – could lead to efficient precaution by both parties.

This led us to the following table:

Legal Rule / Victim’s Precaution / Injurer’s Precaution
No liability / Efficient / Zero
Strict liability / Zero / Efficient
“Any” negligence rule with efficient standards of care / Efficient / Efficient

However, as we alluded to Tuesday, there is another dimension in which peoples’ choices affect the likelihood of an accident: activity level. I can choose to drive carefully or recklessly, and I can also choose to drive more or less often. You can look both ways before crossing the street, or not; and you can choose how many streets to cross.

First, let’s think about what happens under no liability. Under no liability, I’m never responsible if I hit you. So I don’t consider the cost of accidents when I decide how carefully to drive, or how much to drive; my precaution level will be too low (relative to the efficient level), and my activity level will be too high.

What about you? You bear the costs of all accidents; so you look to maximize the benefit of walking, minus the cost of precaution (paranoia?), minus the expected cost of accidents. Your actions have no externalities (since only you get hurt by accidents, not me); so your incentives are correct, and you will set the efficient level of precaution and the efficient activity level.

The exact opposite will happen under strict liability. Under strict liability, you know you will be compensated for any accidents, so you don’t worry about their costs. Therefore, you take insufficient precautions, and you set too high an activity level. On the other hand, I know I’m paying for any accidents that happen, so I consider their costs when I make my decisions; I take efficient precautions, and set an efficient activity level.

What happens under a negligence rule? First, consider simple negligence. I know I won’t be liable as long as I take sufficient care; so under a simple negligence rule, I’ll take efficient precaution. But once I’m doing that, I don’t have to worry about the cost of accidents, since I’m not going to owe any damages; so I don’t consider the cost of accidents when I choose my activity level, and therefore I set it too high. Under a simple negligence rule, I’ll drive carefully, but I’ll still drive too much.

As for you, you know I’ll be driving carefully, so you know that you’ll still be incurring the costs of any accidents that occur; so you set both your precaution level and your activity level efficiently.

The same will be true for a rule of simple negligence with a defense of contributory negligence, or a rule of comparative negligence. We know that both these rules lead to efficient precaution; but as long as we’re both taking efficient precaution, I’m still not liable for damages. So you still bear the “residual risk” of accidents, and I don’t; so you set your activity level efficiently, and I set mine too high. Once again, under any of these rules, I drive carefully; but since I’m driving carefully, I know I won’t be liable for accidents, so I choose to drive too much.

Finally, what happens under a strict liability rule with a defense of contributory negligence? Here, I’m liable for damages unless I can show you were negligent. We know that this will lead you to take efficient precaution; which means I expect to be held liable for any damages that occur. Thus, I internalize their cost, and set both my precaution level and my activity level efficiently. On the other hand, since you’re being careful, you know that you won’t bear the cost of accidents; so you ignore their cost, and set your activity level too high.

Legal Rule / Victim Precaution / Injurer Precaution / Victim Activity / Injurer Activity
No liability / Efficient / Zero / Efficient / Too High
Strict liability / Zero / Efficient / Too High / Efficient
Simple Neg / Efficient / Efficient / Efficient / Too High
Simple Neg, Contrib Neg / Efficient / Efficient / Efficient / Too High
Comparative Neg / Efficient / Efficient / Efficient / Too High
Strict Liab, Contrib Neg / Efficient / Efficient / Too High / Efficient

Which rule is the most efficient, then, depends on the situation. That is, it depends on whose choices have the bigger impact.

In situations with unilateral precaution – situations where only one party needs to take steps to avoid accidents – no liability or strict liability work perfectly well. In situation with bilateral precaution, negligence rules give appropriate incentives for precaution on both sides. However, under any negligence rule, one of the two parties still bears whatever losses do occur – one party is the residual bearer of the harm of accidents, and the other party is not. Any negligence rule yields an efficient activity level by the residual risk bearer, but an inefficient activity level by the other party. Thus, the optimal rule depends on whose activity level is most important.

The Shavell paper on the syllabus, “Strict Liability versus Negligence,” is all about these incentives. Shavell looks at a number of different cases – accidents between strangers (such as car accidents), like we’ve been discussing, as well as accidents between sellers and their customers in a competitive market (which we’ll come back to at the end of today’s lecture), and accidents between sellers and strangers (other than their customers). In the case of sellers and customers, he points out that it is important to know whether the customers can perceive the riskiness of the products they buy. If they do not, then different liability rules can lead to very different results.

(The Shavell paper is an excellent read.)

Friedman has a different take on activity levels. He argues that reducing your activity level is just another type of precaution; but it’s a type of precaution where it’s impossible for the court to determine the efficient level. (A court might be able to figure out that it’s efficient for me to drive with my headlights on at night, but unable to figure out how many miles it’s optimal for me to drive in a given day. Therefore, a court might find me negligent if I was driving without headlights; but it’s hard for a court to decide whether a particular trip was socially efficient, and therefore whether I was negligent by being in my car!)

Instead of distinguishing precaution from activity levels, Friedman distinguishes observable precaution from unobservable precaution. He points out that any negligence rule only causes an efficient level of observable precaution, since that’s all that can be used to determine whether someone exercised due care or was negligent. So a negligence rule does not lead to an efficient level of unobservable precaution. Strict liability, on the other hand, leads the injurer to internalize the cost of accidents, so it leads to efficient levels of both observable and unobservable precaution – the same result as we already saw, just in different words.

Friedman mentions that Posner uses this to explain why highly dangerous activities (blasting with dynamite, or keeping a lion as a pet) are often governed by strict liability; if they’re dangerous enough, the only meaningful type of precaution may be to not do them at all. Strict liability leads to efficient levels of both care (if you choose to do them) and a choice of whether or not to do them in the first place.

All our talk about negligence rules, and especially about efficiency, has been under the assumption that courts are able to set a legal standard of care equal to the efficient level. That is, a negligence rule gets the level of precaution to the legal standard x~. Efficiency requires it be set at the level that minimizes the total social cost of accidents, x*. So negligence rules are only efficient if x~ = x*.

In many cases, this is exactly what the courts try to do. This is based on a 1947 case, United States v Carroll Towing Company, in which Judge Learned Hand formulated a rule for deciding on negligence. The case (as described in Cooter and Ulen) was this:

A number of barges [in New YorkHarbor] were secured by a single mooring line to several piers. The defendant’s tug was hired to take one of the barges out to the harbor. In order to release the barge, the crew of the defendant’s tug, finding no one aboard in any of the barges, readjusted the mooring lines. The adjustment was not done properly, with the result that one of the barges later broke loose, collided with another ship, and sank with the cargo. The owner of the sunken barge sued the owner of the tug, claiming that the tug owner’s employees were negligent in readjusting the mooring lines. The tug owner replied that the barge owner was also negligent because his agent, called a “bargee,” was not on the barge when the tug’s crew sought to adjust the mooring lines. The bargee could have assured that the mooring lines were adjusted correctly.

Judge Learned Hand, in his decision, wrote the following:

It appears from the foregoing review that there is no general rule to determine when the absence of a bargee or other attendant will make the owner of a barge liable for injuries to other vessels if she breaks away from her moorings… Since there are occasions when every vessel will break away from her moorings, and since, if she does, she becomes a menace to those around her; the owner’s duty, as in other similar situations, to provide against resulting injuries is a function of three variables: (1) the probability that she will break away; (2) the gravity of the resulting injury, if she does; (3) the burden of adequate precautions. Possibly it serves to bring this notion into relief to state it in algebraic terms: if the probability be called P; the injury, L; and the burden, B; liability depends upon whether B is less than L multiplied by P.

Thus, Judge Hand argued that if precaution (in this case, having a bargee on board your barge) cost less than its expected benefit, then it was negligent not to do it. So the legal standard for what constituted negligence was whether the precaution was efficient.

Since having an agent on board the barge is a yes-no decision, not a continuous variable, these were stated as absolutes; but if we reinterpret them as marginal terms, we get back to our old rule for efficiency: that if w, the incremental cost of precaution, is less than

–p’A, the incremental benefit, the injurer is negligent. Implicitly, this is the same as setting the legal standard for care, x~, equal to the efficient level, x*.

Cooter and Ulen argue that successive application of the Hand rule over time will lead to people figuring out what the legal standard for precaution is. I’m careless, I cause an accident, I get sued. The court rules that a little more precaution would have been justified, so I’m held liable. The next guy is a little more careful; an accident happens, he gets sued, he’s found negligent. The next guy is a little more careful. Eventually, we reach a level of care where a little bit more would not have been cost-justified; that guy is found not to be negligent, and not held liable, and then we all know what level of care is required.

Another alternative, of course, is for laws and regulations to specify a legal standard. Highway officials could compute the efficient speed for a particular road – accounting for the value of getting somewhere sooner, and the effect of speed on the likelihood of accidents – and set the speed limit to the be efficient speed.

And of course, a third alternative is for the law to enforce social norms or best-practices of an industry when it comes to standards of care. That is, if a community or an industry has been facing this problem for a long time, and evolved its own norms or practices for what level of care is required, it’s plausible that this level is efficient, and the court may just choose to enforce it. The book gives the example of a residential community setting rules concerning the maintenance of steps leading up to houses, or the accounting industry having standards regarding auditing.

All our analysis so far has been under the assumption of unilateral harm – that is, both the injurer and the victim may affect the likelihood of an accident, but all the direct harm from the accident is borne by the victim.

Obviously, in some cases, this isn’t true. Two cars collide on the highway – both cars end up damaged. Bilateral harm is harder to analyze. Often, the easiest thing is to hypothetically separate the accident into two separate events – the harm that happens to you (seeing you as victim and my as injurer), and the harm that happens to me (seeing me as victim and you as injurer). Often, this is what happens legally – both sides sue each other for damages. We’re not really going to deal with the case of bilateral harm – pretty tough to analyze.

Cooter and Ulen point out that American courts have consistently made a mistake in the way they’ve applied the Hand rule. In terms of calculating the efficient level of precaution, marginal cost should be balanced against the total social benefit of reducing accidents, which includes both the reduction in risk to the plaintiff (“risk to others”) and the risk to the injurer himself (“risk to self”). For example, when I drive recklessly, I risk hitting a pedestrian, and I also risk destroying my own car. The reduction in both these risks constitutes the social benefit of driving more carefully. However, courts have tended to only consider the reduction in “risk to others” when assessing the benefits of precaution.

(Cooter and Ulen also point out the idea of “hindsight bias” – once something happens, we tend to assume it was likely to happen. That is, if something is extremely low-probability, but then occurs, we may change our mind about how unlikely it initially was to happen. This would lead to an overestimate after the fact of the probability of an accident.)

We’ve shown that a negligence rule creates efficient incentives for precaution by both the victim and the injurer, while a strict liability rule only creates efficient incentives for the injurer. However, over the course of the 1900s, the incidence of strict liability rules increased. Why?

The answer has to do with information. It’s easy to prove harm and causation – my coke bottle explodes and takes out my left eye. Clearly, I got hurt; and clearly, the bottle did it. It’s very hard to prove that Coca-Cola was negligent in their bottling process – I’d have to understand their whole manufacturing process, understand the likelihood of accidents, how the likelihood of accidents responds to precautionary measures they could have taken, and so on. Under a negligence rule, it might be too hard to prove negligence; and so the manufacturer might not have to take precautions, knowing they can avoid liability anyway. On the other hand, under strict liability, the company bears the cost of accidents, so it faces the incentive to reduce accidents directly, not just avoid having appeared negligent.

(To put it another way, negligence requires me to figure out the efficient level of care Coca-Cola should have taken; strict liability requires Coca-Cola to figure out the efficient level of care. If Coca-Cola has better knowledge of their manufacturing process than I do, this may be better.)

This leads us to errors and uncertainty in evaluating damages, and the effects that these have on incentives for precaution.

First, put aside the question of whether or not someone is liable, and think only about the problem of calculating the amount of damages owed. There are two types of mistakes a court can make: systematic mistakes, and random mistakes.

Random mistakes mean that, if an accident caused $10,000 in harm, the court might end up setting damages either higher or lower than $10,000, but on average will get it right. (DRAW IT.)

Systematic mistakes are when damages, on average, are set either higher or lower than the actual harm.

C and U refer to systematic mistakes as “errors,” and to random mistakes as “uncertainty”.

First, let’s look at the effects of errors under a strict liability rule. Under a strict liability rule, the injurer minimizes the sum of two things: cost of precaution, plus expected damage payments. (With perfect compensation, damage payments = cost of accidents, and so the injurer minimizes the total social cost of accidents.)

Random errors in damages awarded have no effect on injurer incentives under a strict liability rule. This is because the injurer is only concerned with the expected level of damages he will have to pay; as long as damages are right on average, he will still internalize the expected cost of accidents, and still take the same level of precaution.