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					                   Part D-III

           The Economics of Tort Law

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    Relaxing Core Assumptions

          Rationality
          No regulations to deal with the external costs of risk
          No insurance
          No bankruptcy
          No litigation costs

    Additional concepts

          Vicarious Liability
          Joint and Several Liability With and Without

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     Relaxing Core Assumptions

    What happens if relax some of the fairly restrictive
      assumptions under which we modelled the tort
      system. What happens in the ‘real world’?

    Does the Tort system work well? Is it outdated? does it
      require wholesale reform or replacement? (product
      liability/ medical malpractice)

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As for most economic analysis we have assumed that
  economic agents were rational decision makers
  (maximizing utility, profits or something else).

           - stable, well-ordered preferences
           - able to calculate the costs and benefits of
             alternatives that they face
           - choose alternatives that yield the greatest net benefit

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The economic efficiency of the tort system depends on its
  ability to ‘send signals’ to economic agents.

Signals that cause economic agents to fully internalize the
   cost of risk where appropriate.

Rational agents that ‘receive’ such signals will then make
  rational self-interested choices and if the tort system has
  structured the signals correctly, this will lead to ‘socially
  efficient’ private choices.

All of this depends crucially on rational behaviour of individual
   agents (as does most economic analysis).

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BUT findings of Kahneman and Tversky (1981)

      1. Most individuals cannot accurately estimate (the effect)
      of low probability events. They respond by assuming that
      ‘low probability’ implies that the event ‘will not occur’
      (probability = zero).

      2. Most individuals over-estimate the probability of well-
      publicized, potentially catastrophic events (nuclear accidents,
      nuclear war, terrorists attacks, airplane accidents, visitors
      from outer space ... ). This occurs even when they possess
      objective information concerning the true probability.

WHY? Who knows? Maybe evolutionary roots for such behaviour
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What are the implication of errors in the estimation of the
  probability of an accident

Recall almost all of our results rely on the potential injurer’s or
  potential victim’s desire to minimize the expected cost of

 Expected cost of accidents

           = wv xv + p(xv, xi)A (potential victim)
           = wi xi + p(xv, xi)A   (potential injurer)

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           Rationality – low probability events

Recall many (most?) accidents are low probability events.
  Perhaps very costly if they happen, but not very likely to
  happen (car accidents, building fires, etc.).

Systematically under-estimating p(xv, xi) for ‘low probability’
  events is a serious problem.

Any efficiency claims for the tort system based on rationality are
  brought into question.

Even when the correct ‘liability/negligence’ signals are sent, if
  agents underestimate the risk, then too little precaution will
  be taken.
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 Rationality – potentially catastrophic events

Potentially catastrophic means a very large A (harm if the
  accident does occur) – nuclear power plants, airline accidents,
  terrorist attacks, nuclear war

Systematically over-estimating p(xv, xi) for ‘catastrophic’ events
  is also a serious problem.

Again efficiency claims for the tort system based on rationality
  are brought into question.

Even when the correct ‘liability/negligence’ signals are sent, if
  agents overestimate the risk, then too much precaution will
  be taken.
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Note that if individuals are truly behaving irrationally then
  providing ‘warnings’ or ‘alarming information’ in the case of
  low probability events or ‘calming information’ in the case
  of potentially catastrophic events, does little good.

The problem is that individuals tend to discount such
  information or simply ignore it.

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Possible solution (in some cases):

What under ‘rationality’ would be a bilateral precaution
  situation might best be treated as a unilateral precaution
  situation under ‘irrationality’ (power tool example from

If potential victims cannot accurately assess the risk (in
   particular if they systematically underestimate the true
   risk) then we might want the potential injurer to assume all
   of the liability (strict liability instead of a negligence rule).

For catastrophic events we might need ‘public’ precaution

Does the political process feed on this phenomenon?

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We spoke about the role of ‘regulations’ in setting standards
  of care.

But regulations are often more ‘forceful’: setting specific
  standards and if the agent fails to meet these standards
  they can be fined whether or not an accident occurs (fire
  codes, health and safety standards).

At other times, even though the agent meets the regulated
   standards, they might still be found ‘negligent’ if an
   accident occurs.

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             Regulations – redundancy?

Potential injurers/victims often face both regulation and liability.

Even if they meet the regulatory standards (fire code, safety
  code, professional code of conduct, etc.) and someone is
  injured, they still face liability.

Why have both liability and regulation? If liability is adequate,
  the potential injurer will do what is appropriate and regulation
  is redundant. (an efficient regulation should set the standard
  at the efficient level, presumably the level that defines
  negligence/non-negligence under tort liability rules.)

If the regulation is adequate, then what is the point of finding
    the potential injurer negligent even though they met the
    safety code. Is this a case of tort law going too far?

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              Regulation vs Tort System
In some situations ‘tort liability’ is the more efficient (least cost)
   way to ensure efficient precaution – In some situations
   ‘regulation’ is the most efficient tool and sometimes both are

Regulation is ‘ex ante’, regulators have the power to order
  potential injurers to correct a hazard (decrease a risk) before
  an accident occurs.

Liability is ‘ex post’, giving courts the power to force injurers to
   compensate victims.

Even though both can lead to the same level of precaution, this
  basic difference explains the advantages and disadvantages of
  regulation and liability
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At times bureaucrats can more efficiently acquire information
   concerning specialized products/industries/hazards.

They have the technical knowledge and resources (time) to
  better understand the risk.

Courts are of ‘general’ jurisdiction, often with very little
  information regarding highly specialized hazards/risks and
  the appropriate precautions.

In such situations courts often defer to regulatory rules and
   potential injurers can avoid ‘ex ante’ fines and ‘ex post’
   liability by simply following the safety regulations.

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‘Good’ regulations are made when regulators develop
   information on the nature of the risks, cost of harm and
   methods and costs of precaution and then apply standard
   efficiency rules (do a cost-benefit analysis) in order to
   arrive at the socially optimal rule.

‘Good’ law should be made the same way. Courts assess the
   ‘ex ante’ risks, harm and methods and costs of precaution
   and decide on negligence (legal standard of care –
   reasonable person) and then assign liability.

Hopefully they apply the same efficiency criteria.

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So why both regulators and courts?

-    At times courts can develop more information during the
     course of a trial than can bureaucrats. (Particularly with
     respect to the cost of precaution and/or the value of harm.)

     Injurers and victims might have to reveal facts to courts
     that they do not have to reveal to regulators.

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- At times courts might believe that bureaucrats are politically
   motivated in setting safety or other standards.

           protecting large corporations or other ‘special interests’
           (set standard too low) or they have ‘given in’
           inappropriately to public interest groups (set standard
           too high).

Note that if liability law imposes a higher standard of care
  than regulation, then potential injurers will meet the tort
  standard in order to avoid liability.

if regulation imposes a higher standard of care than does tort
    law, then potential injurers will meet the regulation in order
    to avoid fines.
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- ‘Safety’ or other regulations might really be trade
     restrictions in disguise –domestic or foreign trade high
     cost/low cost (EU and ozone protection), leading courts to
     set aside the regulated ‘standard of care’.


- Regulations and bribes. The stronger the regulation the
   higher the cost of bribes, leading courts to set aside the
   regulated ‘standard of care’.

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-    We will see that some agents (individuals and firms) take
     on risks that exceed their financial resources - bankruptcy.

     If an accident occurs, then they cannot cover the cost of
     harm irrespective of the liability rule.

     Pit bulls in backyards - asbestos manufacturing

     ‘ex post’ liability will not have much effect on behaviour.

     We require ‘ex ante’ regulation/fines.

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-    large number of victims each suffering a small amount of
     harm (many forms of pollution/industrial accidents).

           The trial costs for any one victim will likely
           exceed the harm suffered by that one victim.

           Is this case, the tort system is an inefficient way to
           deal with this risk. It might be more efficient simply to
           impose regulation on the potential injurer.

     (Note class action suits?)

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   The ‘no liability’ rule causes potential victims to buy insurance
     (house fires, health care, life insurance, etc) if they are risk

   The rule of ‘strict liability’ causes potential injurers to buy
     insurance (product liability, much commercial insurance) if
     they are risk adverse.

   Insurance represents a transfer of risk from the insured to the
      insurer (the risk is said to be externalized)

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Effect of insurance on the efficiency of tort/liability rules

If victims receive compensation from their own insurer, then
    potential injurers might not take efficient precaution.

BUT ‘subrogation clauses’ assign the right to sue (cause of
  action) to the insurer if you become a victim (OHIP
  generally gets a piece of most personal injury law suits.)

 The insurance company pays the victim and then sues the

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More important effect of insurance

If potential victims, or injurers, have insurance they might not
   take efficient precaution (moral hazard).

BUT most insurance contracts provide for co-insurance (a
  share of the total loss) and/or deductibles (the first $?? of
  loss), or the rates are ‘experience rated’.

ALSO to the extant that the insurer assumes the risk, from
  either the potential victim or the potential injurer, they
  have an incentive to ‘manage the risk’ (private safety
  codes, private negligence standards, private regulation)

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Consider a world in which there is perfect insurance

Perfect insurance means perfect compensation for any loss –
  the insured is indifferent between suffering an accident and
  not suffering an accident.

Perfectly insured individuals do not care about accidents but
  they do care about insurances rates

As insurance markets become more complete and approach
  perfect insurance, the focus shifts to insurance cost.

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           Insurance – Private Liability Law
Costs of accident allocated through private contracts

Private system of regulation that imposes safety standards.

Insurance markets privatize liability and regulate precaution –
   Private Liability Law.

If insurance premiums are experience rated then potential injurers
    will have an incentive to take precaution.
Insurance companies will monitor the behaviour of potential injurers
    (firms, doctors, etc.) and this will lead to the appropriate

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                 Insurance and Tort Law

   a ‘no liability’ rule causes potential victims to buy insurance,

   a ‘strict liability’ rule transfers the risk to the potential injurers
      causing them to buy insurance.

   Tort law determines who will bear the risk and therefore who
     will buy the insurance.

   Who can buy the insurance most cheaply?

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Question: Does tort law provided ‘too much’ compensation?

Consider that the victim of accident (car, fire, etc.) covered by
  his/her own insurance is generally paid out-of-pocket losses
  (property, earnings, medical). When no liability applies
  individuals do not insure against pain and suffering.

BUT the victim of an accident in which injurer is liable under
  tort law is generally paid out-of-pocket losses (property,
  earnings, medical) plus pain and suffering. Tort law forces
  potential injurers to insure against pain and suffering of

Conclusion: Tort law forces potential injurers to buy more
  insurance for potential victims than they would buy
  themselves. (Canada capped at $320,000.)

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                 Mandatory Insurance
                      – adverse selection
Individuals buy insurance - they turn uncertain outcomes into
  certain outcomes.

Insurance companies sell insurance because they can take
   advantage of the ‘law of large numbers’ and ‘risk pooling’

What is not predictable for any individual is predictable for the
  larger group. Note, they never know if your particular
  house will burn but they know ‘on average’ how many
  houses will burn.

Such information on population probabilities allows insurance
  companies to predict the total number of claims and
  therefore set insurance premiums.

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Consider two groups of individuals:

‘high risk’ group and ‘low risk’ group

Insurance companies cannot identify which individual belongs
   to which group

Insurance premiums are set consistent with the ‘average risk’
   and insurance is offered for sale

‘High risk’ group – good deal – buy’s insurance
‘Low risk’ group – bad deal – do not buy insurance

Insurance company goes bankrupt
                         - victim of adverse selection

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As a result of the above insurance markets can never really
  be complete.

Some types of insurance will never be offered in the private

           Flood insurance, disaster insurance,
           unemployment insurance, AIDS insurance (insurance
           against specific diseases)

           - also we have the problem of moral hazard

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    Why does it cost your employer $3,500 to provide you
      with extended health benefits BUT you would have
      to pay $5,000 if you bought it directly?

    Why are EI, WSIB public schemes?

    Why is some insurance mandatory (EI, WSIB, Auto)?

    Note also: adverse selection and the spiraling collapse of insurance schemes

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The following will be discussed in terms of potential injurers who are
  firms but the essentials of the analysis hold for private, non-business
  injurers also.

Rule of strict liability causes potential injurers to internalize the
  cost of harm and choose the optimal level of precaution.

Why? Because they face the full social costs of accidents:

   SC = wi xi + p(xv, xi)A ,    where A = D (compensation under
                                              a liability rule )

But what if the firm’s net worth is less than A (=D)
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If the firm’s net worth is less than A (=D) and an accident
    occurs, the firm is bankrupt.

The firm knows this, so its optimal strategy would be to
             cost of accidents = wixi + p(xv, xi)NW,

              where NW is the net worth of the firm.

BUT the firm can control its own net worth.

So, in fact it can minimize the costs of accident by minimizing
  its net worth.

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Recall that the concept of a limited liability corporation implies
  that the liability of firm owners is limited to their initial

What is the value of their initial investment? The net worth of
  the firm.

The firm’s NW (capitalization) is given by:

    Total Assets (incl. ret. earn.) – Total liabilities

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  How does a profitable firm minimize NW?

      - pay out all earnings to the owners of the firm

      - borrow against the firm’s assets (real and
      imagined). Secured creditors get their money first

      - securitize future revenue

      Such a firm will become ‘undercapitalized’
      Total Assets will be very small as compared to total
      liabilities (perhaps smaller than)

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                      Bankruptcy –Risky Business

Consider a firm involved in a very risky business (hazardous waste, a
  bar, etc)

                               Victim             ACCIDENTS

per unit

   $1.00              0.0001   $10,000             $1.00      $2.00

for a million units

   $1 mil.            0.0001   $10,000 x 1 mil.   $1 mil.     $2 million

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                Bankruptcy –Risky Business
Now what if the firm sets net worth to zero
                                      Victim           ACCIDENTS

for a million units net worth > or = $1 million

   $1 mil.        0.0001            $10,000 x 1 mil.   $1 mil.     $2 million

for a million units net worth = 0

   $1 mil.        0.0001            $10,000 x 1 mil.   $0          $1 million

Since there is no chance of having to pay damages the expected cost of
   accidents is zero. Will this firm take any precaution? What if one firm in
   this industry plays this game, what will happen to the other firms?

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 This is called ‘judgment proofing’

 There is another strategy that is more common for
 ‘respectable’ firms. If reputation matters then you can play
 the bankruptcy game only once.

 But what if your production/sales chain has 10 links and only
 one of these links is very risky?

 Why put all of your assets at risk?

 Why not ‘spin off’ the risky part of your business as a small
 stand alone firm (owned and operated by former employees –
 preferably in Latin America or Asia)

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What can be done about the impact of insolvency on our
‘efficient’ tort outcomes?

    - compulsory insurance

    - posting bonds

    - ‘ex ante’ regulation

    - negligence rule as opposed to strict liability
      (if cost of precaution is small relative to
          expected cost of harm)

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Think about private individuals owning dangerous pets (pit
  bulls) or participating in dangerous activities – private
  individuals can easily create risk which have an expected
  cost of harm beyond their financial resources.

It might appear harsh to ban pit bulls but …

    Again     - compulsory insurance
              - ‘ex ante’ regulation

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                     Litigation Costs

Litigation can be very costly.

Cost of litigation causes victims to enforce their rights less
  frequently, hence allowing potential injurers to take less

Cost of litigation causes potential injurers to take more
  precaution in order to avoid costly litigation.

We cannot reach a general conclusion as to whether or not
  costly litigation leads to too much or too little precaution
  (or the right amount).

This issue is studied as part of Legal Process
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                      Vicarious Liability

One person (or firm) is responsible for a tort committed by
  another person. The third person (or party) is said to be
  vicariously liable

           from agent to principle
           from child to parent (increasingly popular)
           from employee to employer (most common)

An employer can be held liable for the actions of his/her
  employee acting ‘within the scope of his or her

You sue the city if a policeman misbehaves, the hospital if a
  nurse makes a mistake, etc.

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What is the logic of this rule?

An employer is best able to monitor the actions of the
  employee (can monitor most efficiently)

- competence, responsibility, equipment

The employer should then internalizes the cost associated with
  accidents caused by the employee.

    Parent - child

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            Joint and Several Liability With and Without
Consider the situation in which several parties have caused harm
  to a victim.

Injurers are jointly liable if the victim can sue the injuring parties
   simultaneously (same trial), recovering the total cost of harm
   from the injuring parties jointly.

Injurers are severally liable if the victim can sue the injuring
   parties separately (separate trials)

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Injurers are jointly and severally liable if each injurer is liable for
   all of the victim’s losses not just a portion of the total loss.
   Then the victim can decide which injurer to sue (the hospital or
   the nurse - the hospital of course - deeper pockets).

If the two injurers are jointly and severally liable and one is sued
    but can claim contribution from the other, the rule is said to be
    joint and several liability with contribution.

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Example: Dr. A, with the assistance of staff at Hospital B completes a
  medical procedure on Mr. C. Something goes wrong and Mr. C
  suffers $100 worth of harm.

Under a rule of joint liability, C can sue both A and B and recovering
  a total of $100.

Under a rule of several liability, C can sue A and B separately and
  recover $100 from each of them ($200 in total) - several liability
  with no contribution and ensures that all potential injurers
  internalize the total cost of harm.

Under a rule of joint and several liability, C can sue A and/or B and
  recover $100 in total. C can pick his defendant. The victim need
  not prove who caused the harm among the joint and severally
  liable defendants. The victim can select the plaintiff with the
  ‘deepest pockets’, thereby assuring full recovery.
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In practice, it is often the case that in medical malpractice the
   victim initially sues everyone but then lets off the least
   negligent party in exchange for information useful against
   the remaining injurers.

The point is that when you enter the operating room for your
  heart bypass, you would want all health care professionals
  and the hospital jointly and severally liable with no

You want everyone to internalize the full costs of an

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