Tort Liability as a Tool for Achieving Efficiency and Equity

Modified on 2009/10/14 21:34 by admin
Different observers describe tort liability as serving various combinations of purposesamong them, compensation, deterrence, risk spreading, and punishment or retribution. In economic terms, those various purposes can be related to the overarching social goals of efficiency and equity. The efficiency goal is to allocate scarce resources so as to maximize the total benefits available to society; the equity goal is to distribute those benefits in accord with some (necessarily subjective) conception of fairness or justice. Metaphorically speaking, efficiency involves making the pie as big as possible, and equity focuses on slicing it appropriately.

The Complexity of the Policy Problem

If there were just a single injury for policymakers to consider, then once that injury had occurred, the only relevant policy questions would pertain to equity. That is, the size of the pie would already be determined by the fact of the injury, and the remaining issues would involve what punishment (if any) the injurer deserved and what compensation (if any) the victim deserved.

In reality, of course, policymakers are concerned not with a single injurious event but with many such events over time
which gives rise to the efficiency question of minimizing the total cost associated with future injuries. That total includes not only the costs of the injuries themselves (in medical care, pain, decreased worker output, and so on) but also:
  • Prevention costs (the costs of efforts to avoid injuries, which tend to raise the prices of goods and services);

  • Transaction costs (the costs of legal and administrative resources, such as attorneys' fees);

  • Indirect costs to the economy (for example, from the disruptions caused by layoffs and bankruptcies); and

  • Uncertainty costs (the burden of uncertainty for potential victims and potential injurerssince driving the rate of injuries down to zero would be ruinously expensive, if not impossibleas well as the transaction costs of reducing that burden through insurance or other risk-spreading mechanisms).

That sketch of the policy goals suggests the difficulties that policymakers face in seeking to address the personal and social costs of injuries. One potential problem is trade-offs between equity and efficiency. For example, a particular conception of fairness might hold that certain victims should not be considered responsible for exercising some forms of care, although it would be more efficient if they did so. Even within the single goal of efficiency, policymakers may have trouble identifying the best approach, given that each approach might have different effects on injury costs, prevention costs, transaction costs, indirect costs, and uncertainty costs and that the relative importance of those costs might vary from one type of injury to another.

Under ideal market conditions, much of the policy problemthe part concerning injuries associated with economic activitiescould be solved easily. In particular, market forces would achieve the efficiency goal for such injuries by minimizing the sum of the related costs: producers and employers would respond to consumers' and workers' preferences by taking all cost-effective measures to make their products and workplaces safer, and risk-averse people would buy insurance to eliminate the financial uncertainty surrounding the remaining risks. Any equity goals involving additional compensation of injury victims could be met through a government program of income transfers.

In reality, the results produced by market forces can only approximate the efficient outcome, and the accuracy of that approximation depends in large part on how well potential victims understand the risks they face. Some risks (such as long-latency illnesses that result from exposure to new chemical substances) become apparent only years or decades after they are introduced into the economy. Other risks, though recognized by experts, are largely unknown or are not accurately taken into account because of biases in the way people process information about risk and uncertainty.

Incomplete information or understanding about risk raises the possibility that government interventionthrough regulations or liability rulescan improve on the efficiency of market outcomes. There is no guarantee that it will do so, however. Whether it does depends on the strengths and weaknesses of the particular interventions, as discussed below.

Liability Rules in Principle

The various forms of strict-liability and negligence standards used by the courts encourage potential injurers to exercise care and result in compensation to victims in different ways and to different extents. Neither type of standard, however, reliably induces optimal levels of care and participation by both injurers and victims, even in theory. Also, both types are prone to inefficiency in their effects on the distribution of risk.

In its purest form, strict liability compensates all victims except those judged to have caused the injury themselves or to have knowingly and voluntarily "assumed the risk" of exposure to a particular hazard. Strict liability thus gives potential injurers an incentive to make all socially efficient changes in the level or form of their activities, because they know they will face the full cost of almost any resulting harm. It may have a very different effect on potential victims, however. To the extent that they expect to be fully or almost fully compensated for their losses (which is more likely to occur in cases involving only property damage, not personal injury or death), strict liability gives potential victims little or no incentive to take reasonable precautions of their own.

In cases alleging defective productsa major category of tort claims subject to strict liabilityU.S. courts typically do not apply strict liability in its pure form. Instead, they use a doctrine of comparative negligence. Under that variant of the standard, the compensation paid by an injurer is reduced if the victim is found to have contributed to the injury through his or her own negligence, as defined by some explicit or implicit legal standard. (In 1996, about 16 percent of all awards in tort trials in the nation's 75 largest counties were reduced because of the plaintiff's own negligence. Those reductions averaged 43 percent.) Taking comparative negligence into account is likely to improve the efficiency of strict liability to the extent that plaintiffs' negligence is a broader concept than plaintiffs' causation (or assumption of risk) and thus gives potential victims an incentive to avoid more types of careless behavior. But it still does not give them cause to adjust the scale of their risky activities, since standards for due care do not consider scale itself. For example, a negligence standard may dictate that bicyclists wear helmets and obey traffic rules, but it will not address how often they ride.

The same analysis applies in reverse when injurers are judged according to a negligence standard. If the standards of due care are set at ideal levels, potential injurers will make all efficient adjustments in the way they conduct their activities. In addition, potential victims who expect injurers to escape liability through the "safe harbor" of due care have an incentive to take all efficient precautions because they will bear the costs of any injuries. However, the standards for care typically do not provide any incentives about the scale of potential injurers' activities. Thus, for example, a manufacturer whose rate of production defects is low enough to be considered nonnegligent will have no incentive to consider the costs of injuries associated with its defects when it decides how many units to produce.

Some observers point to another shortcoming of liability rules: by compensating victims for pain, suffering, and other nonpecuniary losses, those rules provide a kind of excessive and unwanted insurance that distributes risk inefficiently. (That issue applies less strongly to negligence, to the extent that injurers are able to avoid paying damages by meeting the standards of due care.)

The argument is that pecuniary losses such as medical expenses and lost income increase a victim's need for money (technically, the marginal utility of an additional dollar), but nonpecuniary losses do not and hence are not worth insuring against. Persuasive evidence for this argument is the fact that insurance policies bought directly by consumers typically do not cover events such as the death of a young child. Notwithstanding the great suffering they would feel, consumers apparently do not find it worthwhile to buy coverage that reduces their wealth now (by the amount of the insurance premium) in order to increase it in the event of such a loss. But liability awards for pain and suffering shift wealth in precisely that fashionthe prices that a firm charges for its goods and services reflect the future liability claims it expects to pay on them, and thus consumers fund the awards through higher prices that reduce their preinjury wealth. Whether such shifts are equitable depends on subjective judgments (on the one hand, they help compensate victims; on the other hand, they benefit a few at the expense of the many). Nevertheless, they do appear to distribute risk inefficiently.

Liability Rules in Practice

The efficiency of liability rules is restricted not only by theoretical limitations but also by practical problems. The most obvious such problem is the transaction costs of the legal system
particularly, the costs of plaintiffs' and defendants' lawyers. Underlying that problem is the fundamental issue that information (in this case, information about the cause of a tort injury) is generally incomplete and costly to acquire. The lack of complete information allows room for disagreement between plaintiffs and defendants and encourages attorneys to expend effort to unearth and document additional information favorable to their case.

Incomplete information also allows errors to occur. Some torts go unchallenged, unjudged, or undercompensated; conversely, some defendants pay claims for losses for which they were not truly liable or in excess of the harm they caused. For example, one study of medical malpractice torts found that only 1.5 percent of people classified as likely victims of medical error sued and that relatively few of those who did sue appeared to have legitimate claims. Such errors reduce the equity of the liability system. They may also reduce its efficiency (as discussed more fully below) by prompting potential injurers to overspend or underspend on precautions or to try to avoid liability in ways that do not reduce the actual risk of injuries.

Concerns about such errors underlie much of the debate about punitive damages. One efficiency-based rationale for punitive damages is that they serve an important corrective role for torts that have a significant probability of going undetected. Potential injurers who expect to be held liable only one-third of the time will not have efficient incentives to exercise care unless they expect to pay treble damages on the occasions when they are held responsible.

Conversely, punitive damages may reduce efficiency if they do more to create errors than to correct them. Critics argue that punitive damages are awarded arbitrarily, at the whim of juries not guided by any clear or coherent standards, and are often erroneous. As evidence, they cite cases in which the punitive damages were tens or hundreds of times larger than the compensatory damages or were awarded even though the injurer had good reason to believe that it was not negligent (in other words, that its behavior satisfied a relevant standard of due care). Whether such criticisms are valid for only a few cases or for punitive damages in general is an open question in need of further study.

Errorsand information problems more broadlyalso underpin much of the debate about the class-action procedure. By combining many claims that cover similar factual ground, that procedure reduces transaction costs that could otherwise make it impractical for plaintiffs to pursue claims that may be large as a whole but are small individually. However, critics argue that class actions are susceptible to erroneous judgmentsin part because plaintiffs' attorneys have wide latitude to bring them in certain courts that are thought to be biased against out-of-state corporate defendantsand that such errors can have nationwide implications. In some cases, plaintiffs' attorneys may be able to leverage the possibility of such errors to achieve lucrative settlements of even frivolous claims, if defendants are sufficiently averse to risk. Also, because class members may have little incentive or opportunity to exercise effective oversight, plaintiffs' attorneys in such cases may pursue settlements that benefit them but are not in the best interest of their clients.

A final problem associated with limited information is the difficulty of setting the standard of due care in a negligence rule at an efficient level. Courts often defer to a community's customary standard of care in defining negligence, and a custom that has stood the test of time in a competitive market may be a good approximation of the efficient solution. But customary standards may be hard to apply or nonexistent in cases of new risks or new products. Moreover, any general rule may not be detailed enough to take into account the specific opportunities and constraints facing each potential injurer and potential victim and thus may set the bar too high for some and too low for others.

Should Tort Rules Be Set at the Federal or State Level?

Although tort cases are primarily governed by state law, the Congress has broad Constitutional authority to change tort rules under its power to regulate interstate commerce. Federal intervention in tort law can have two main benefits. First, it can lower costs by giving manufacturers and other nationwide businesses a single set of standards under which to operate. Advocates of greater federal involvement argue that state preeminence may have been appropriate when most goods were produced locally, but it is inefficient now that firms typically manufacture products in a few locations to sell nationally. Second, whereas state legislatures and courts have an incentive to favor state residents, and thus to design or interpret their legal rules to benefit in-state plaintiffs at the expense of out-of-state defendants, the federal government can potentially take the broad view (in economic terms, "internalize the externality") and craft rules that take equal account of the interests of all parties nationwide.

Supporters of a more decentralized approach argue that federal involvement in state tort law may not provide equal treatment of all costs and benefits. Rather, it may reflect concentrations of political influence, which can tilt toward plaintiffs at one time and defendants at another. In that view, maintaining state preeminence in tort law reduces the risk of nationwide errors in policy. It also allows greater scope for state innovation and experimentation and a wider range from which people can choose the type of liability regime that appeals to themone with more extensive protection of injured parties or one with lower costs for businesses (and hence, presumably, lower prices for consumers).

Tort Liability Versus Insurance and Regulation

As noted above, tort liability is only one of the tools that society uses to try to supplement market mechanisms, such as contracts and private insurance. Other tools are regulation and public compensation programs (such as the workers' compensation system). All of those policy tools have strengths and weaknesses
as do marketsso using them in combination may be beneficial. However, the interactions among different tools and the market can be complex and even counterproductive.

The interplay between liability and private insurance is perhaps the most complicated. From the point of view of potential victims, tort liability acts as a partial substitute for their own insurance
the more comprehensive the set of injuries for which they receive tort damages, the fewer the injuries ultimately compensated by their own coverage. Conversely, from the perspective of potential injurers, liability increases uncertainty, leading many of them to buy liability insurance to control that uncertainty. The extensive use of such insurance makes analyzing the efficiency of tort liability more complicated, because it may undermine potential injurers' incentives to exercise care. The degree to which it does so hinges on the precautions (if any) that insurance companies require as a condition for providing coverage and also on the thoroughness of their underwriting. The more they tailor their premiums to policyholders' specific practices or experiences, the more incentive potential injurers still have to take cost-effective precautions.

The interactions between liability and regulation are perhaps less complexbut in that case also the two can be complements as well as substitutes. In particular, tort lawsuits can be used as a private mechanism for enforcing regulations, particularly when government agencies lack the resources to monitor compliance or prosecute violations themselves. Such lawsuits may be explicitly authorized by statute, as in the case of some civil rights laws. Alternatively, judges may decide that tort claims are an appropriate means by which to carry out the intent of particular statutes. For example, a court may allow a tort claim of deceit under a statute that makes it a crime to roll back an automobile's odometer.

As alternatives to each other, regulation is a more centralized policy tool than liability is. The centralized approach may be more or less efficient for particular classes of injuries
on the one hand, it tends to have lower transaction costs; on the other hand, the regulations it produces can only be as good as the information available to the central decisionmakers. Whereas tort claims arise after specific injuries occur, efficient regulation requires before-the-fact information about risks of injury, types of precaution, and the costs and benefits associated with particular regulatory standards. In addition, the more diverse that a given group of potential injurers is, the greater the amount of information that will be necessary to craft regulations that appropriately reflect the group's various circumstances. In practice, the efficiency of regulations can also be lessened by political factors, such as pressure from interest groups or excessive influence from the regulated entities.

Information Obtained Through the Congressional Budget Office. 

See Also

  1. Tort Reform
  2. Federal Preemption
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