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Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 19.

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1 Econ 522 Economics of Law Dan Quint Fall 2011 Lecture 19

2 1  MT2 graded, will be returned today  HW4 (last one) online – due Thurs Dec 8  Longer than last couple Logistics

3 2 Monday’s experiment

4 3 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

5 4 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)?

6 5 The results

7 6

8 7

9 8 1,000,000100,00025 th Percentile 80%36% at least $1 MM 22,500,00010,750,806Largest 4.6 x 5,000,0001,000,00075 th Percentile 1,600,000250,000Median 140,00050,000Smallest 5.5 x2,086,764382,653Geometric Mean 3,892,0001,294,355Average Ratio Asked $10,000,000 Asked $10,000 3.0 x

10 9 The results

11 10  Nobody knows what a leg is worth  “Reference point bias”  “Framing effects” What does it mean?

12 11 Back to work…

13 12 Punitive damages

14 13  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

15 14  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

16 15  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

17 16  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”)

18 17  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)

19 18  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)

20 19  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?

21 20  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…

22 21 Some empirical observations about tort system in the U.S.

23 22  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

24 23  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

25 24  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

26 25  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

27 26  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

28 27  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

29 28  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

30 29 “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…

31 30 The legal process

32 31  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…

33 32  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…

34 33  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”

35 34  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… An example from Polinsky, “An Introduction to Law and Economics”

36 35  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 An example from Polinsky, “An Introduction to Law and Economics”

37 36  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 An example from Polinsky, “An Introduction to Law and Economics”

38 37  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 An example from Polinsky, “An Introduction to Law and Economics”

39 38  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 An example from Polinsky, “An Introduction to Law and Economics”

40 39  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?

41 40 The legal process

42 41  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

43 42  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

44 43  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

45 44  Nice job!  Similar distribution to first – mean 84, median 85  Again, not actually assigning letter grades till after final…  …but roughly, 80-88 is about the B range Midterm A-GN-ZH-M

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