1. Econ 522 Economics of Law Dan Quint Fall 2012 Lecture 20

2. 1 Discussion question – recapping tort law ChoiceBad LuckOutcome +  punish the choice criminal law regulations punish the combination of choice and outcome negligence rule punish the outcome strict liability rule QUESTION: What are the pros and cons of each approach?

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?  Testing how much did the “suggestion” in question (a) affect the answers to question (b)?

6. 5 Well? Did the suggestion matter?

7. 6 average: 730,981

8. 7 Well? Did the suggestion matter? 730,981

9. 8 Well? Did the suggestion matter? 730,9816,300,000 (plus one at $50 MM)

10. 9 Well? Did the suggestion matter? 730,9816,300,000 (plus one at $50 MM)

11. 10 The only statistical test one ever needs is the IOTT, or “inter- ocular trauma test.” The result just hits one between the eyes. - David H. Krantz Well? Did the suggestion matter? 6,300,000730,981Average 3,000,000350,000Median 2,627,402365,651Geometric Mean 50,000,0003,270,420Maximum 100,00020,000Minimum Asked 10,000,000Asked 10,000

12. 11 Another way to see it

13. 12 Another way to see it

14. 13 Yet another way to see it

15. 14 What about men versus women? (plus one at $50 MM) 869,5655,461,111 392,2227,810,000

16. 15  Nobody knows exactly what a leg is worth  Even among people asked exactly the same question…  …answers varied from $20,000 to $3,000,000…  …or from $100,000 to $50,000,000  Supports the point from Monday: incentive to fight!  Since no one knows the right answer, “suggestions” matter  Higher suggestion raised average from $731k to $6.3MM  Reference point bias  Framing effects What do we learn?

17. 16 Thinking about the legal process

18. 17  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 three months, we have…

19. 18  Property law  Goal was to allocate resources/entitlements efficiently…  …or, to minimize inefficiencies due to misallocation  Contract law  Goal was to further facilitate trade…  …or, to decrease inefficiencies due to unrealized Kaldor-Hicks improvements  Tort law  Goal was explicitly to minimize social costs…  …which consist of cost of accidents plus cost of precaution We’ve been thinking of normative goal of minimizing social costs

20. 19  The legal system works flawlessly  Whatever theoretical goal we set, we can implement correctly  (In tort law, we’ve considered effect of errors)  The legal system costs nothing  Gave us nice theoretical results for achieving efficiency  Example: injunctions when TC low, damages when TC high  Example: strict liability when injurer activity matters a lot; negligence when both sides’ precaution matters a lot  Next: what additional concerns are there when trying to put a legal structure in place to enforce these ideas? Implicitly, we’ve generally been assuming two things so far

21. 20  Start with the best possible benchmark  Theoretically perfect rules, implemented flawlessly and costlessly  That’s obviously the best we can hope to do  How does reality differ?  1. Rules actually implemented won’t be the perfect ones  Imperfect rules will lead to imperfect incentives, leading to less-than-perfectly-efficient actions and outcomes  Think of any loss of efficiency due to imperfections in legal system as error costs  2. Actual system won’t be costless – administrative costs  Goal of legal system: minimize sum of these two costs What is the goal of the legal system itself?

22. 21  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

23. 22  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 process not being perfect  We’ve already seen the tradeoff between these two types of costs  Tradeoff between “simpler” versus “more complex” rules  We’ve seen this several times The goal of the legal process

24. 23  Whaling law – “fast fish/loose fish” vs. “iron-holds-the-whale”  FF/LF: lower administrative costs (fewer disputes)  IHTW: lower error costs (better incentives for whaling)  Pierson v. Post (fox hunt case)  Majority: first to catch, otherwise “fertile source of quarrels”  Dissent: first to chase, hunting foxes is “meritorious”  Privatizing ownership of land  Expanding property rights adds admin costs (boundary maintenance)  But lowers error costs (better incentives for efficient use of resource)  Demsetz: privatize when gains outweigh costs  Same as: pick system with the lower sum of admin + error costs We’ve already seen tradeoff between administrative and error costs

25. 24 The legal process

26. 25  Once an accident has happened…  Victim could sue or not sue  The victim and injurer might quickly settle out of court  If the case proceeds to trial, the first step (in the U.S.) is a pre-trial exchange of information  After that, victim and injurer might still settle out of court  If the case goes to trial, victim (now plaintiff) might win or lose  Losing side at trial can choose to appeal (or not) The legal process

27. 26  Worth it for victim to sue if Sue or not sue? Expected value of legal claim Cost to initiate lawsuit >  Probability of winning at trial, times expected judgment…  Or likelihood of a settlement, times expected amount…  Minus costs expected to be incurred  “Filing fees”

28. 27  Expected value of claims should vary widely Filing fees Probability Expected value of claims Filing Fee SUE DON’T SUE

29. 28  Recall the efficient legal system minimizes the sum of administrative costs and error costs  Higher filing fees  fewer lawsuits  lower administrative costs  But, higher filing fees  more injuries go “unpunished”  greater distortion in incentives  higher error costs  Filing fee is set optimally when these balance on the margin:  Marginal cost of reducing fee = marginal benefit  Administrative cost of an additional lawsuit = error cost of providing no remedy in the marginal case How high should filing fees be?

30. 29  Error costs  If we’re only concerned with efficiency, we don’t care about distributional effects  That is, we don’t care if a particular victim is or isn’t compensated  So the size of error costs depends on how much peoples’ behavior responds to the incentives caused by liability  “The social value of reducing errors depends on whether the errors affect production or merely distribution”  When errors have large incentive effects, filing fees should be low  When errors have small incentive effects, efficiency requires higher filing fees How high should filing fees be?

31. 30  As long as there are any filing fees or other costs to litigation, some harms will be too low to justify a lawsuit  When harm is small to each individual but large overall, one solution is a class action lawsuit Filing fees Probability Expected value of claims Filing Fee SUE DON’T SUE

32. 31  One or more plaintiffs bring lawsuit on behalf of a large group of people harmed in a similar way  Example: California lawsuit over $6 bounced-check fee  Court must “certify” (approve) the class  Participating in a class-action suit eliminates victim’s right to sue on his own later  If suit succeeds, court must then approve plaintiff’s proposal for dividing up the award among members of the class  Class-action suits are desirable when individual harms are small but aggregate harms are large…  Especially when avoidance of liability has strong incentive effect  But there’s also a danger Class Action Lawsuits

33. 32 Number of lawsuits Typical level of damages not worth suing for most victims more precaution  fewer accidents

34. 33 Costly litigation

35. 34  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”

36. 35  So…  Going to trial gains you $5,000 (in expectation)  Going to trial costs me $11,000 (in expectation)  If all this is common knowledge, maybe we can avoid trial  If we settle out of 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”

37. 36  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  On the other hand, if I’m more pessimistic than you, settlement is even easier  But even then, not guaranteed if threat points are private information! An example from Polinsky, “An Introduction to Law and Economics”

38. 37  Defendant made faulty product, lots of people injured  Some sustained minor injuries ($2,000)  Some sustained major injuries ($10,000)  Before trial, defendant can’t tell scope of plaintiff’s injuries  Suppose legal costs are $500 for each side  Suppose half of plaintiffs had major injuries, so average injury = $6,000  Suppose defendant makes settlement offer of $6,000 to all victims  The ones with minor injuries will take …  …and the ones with major injuries will go to trial and win $10,000  Defendant has two choices:  Offer settlements large enough that everyone will accept  But then even people with very minor injuries, or none, might sue  Or offer only small settlements, and get stuck going to trial in many cases Failures in negotiations due to private information – example

39. 38  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 social cost of an accident includes both 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 Why does costly litigation matter?

40. 39  Disclosure (“discovery”) rule in the U.S. very extensive  Parties reveal basic arguments they’ll make, evidence that supports them, names of witnesses, nature of each witness’s testimony  Each side can inspect other’s evidence, question its witnesses  Witnesses or evidence not disclosed during discovery may not be allowed at trial  Most European countries have little or no pre-trial discovery  Europe: juries rarely used in civil cases  Delays and interruptions less costly, more common  Under civil law, judges take more active role in developing arguments and exploring evidence In the U.S., before going to trial, the two parties must exchange information

41. 40  Cooter and Ulen: Trials occur when the parties are relatively optimistic about their outcome, so that each side prefers a trial rather than settlement on terms acceptable to the other side. When the parties are relatively optimistic, at least one of them is uninformed. Pooling of information before trial that reduces relative optimism promotes settlement. Furthermore, by revealing private information to correct the other side’s false optimism, the party making the disclosure increases the probability of settling on more favorable terms. Exchange of information might facilitate out-of-court settlement

42. 41  Involuntary disclosure leads to information being shared that the parties would otherwise choose to withhold  This is usually information that corrects relative pessimism  So forced disclosure may make settlement less likely  On the other hand, involuntary disclosure reduces uncertainty, makes two sides’ threat points more clear  May make reaching a settlement more likely  So overall effect is unclear But some exchange of information would happen voluntarily anyway

43. 42  Nuisance suit – lawsuit with no legal merit, purely meant to extract an out-of-court settlement  Suppose trial costs $10,000 for plaintiff but $50,000 for defendant  If case goes to trial, plaintiff will get nothing  Threat points are -10,000 and -50,000  Gains from cooperation if settlement reached are 60,000  If gains are split evenly, defendant pays settlement of $20,000, even though case had no merit With costly litigation comes possibility of “nuisance suit”

44. 43  In U.K., loser in a lawsuit often pays legal expenses of winner  Discourages nuisance suits  But also discourages suits where there was actual harm that may be hard to prove  In U.S., each side generally pays own legal costs  But some states have rules that change this under certain circumstances Who pays the costs of a trial?

45. 44  Rule 68 of Federal Rules of Civil Procedure “At any time more than 10 days before the trial begins, a party defending against a claim may serve upon the adverse party an offer [for a settlement]… If the judgment finally obtained by the offeree is not more favorable than the offer, the offeree must pay the costs incurred after the making of the offer.”  “Fee shifting rule”  Example  I hit you with my car, you sue  Before trial, I offer to settle for $6,000, you refuse  If you win at trial, but judgment is less than $6,000…  …then under Rule 68, you would have to pay me for all my legal expenses after I made the offer Who pays the costs of a trial?

46. 45  Rule 68 does two things to encourage settlements:  Gives me added incentive to make a serious settlement offer  Gives you added incentive to accept my offer  But not actually as generous as it sounds  Attorney’s fees not always included in fees that are covered  Asymmetric  Plaintiff is penalized for rejecting defendant’s offer  Defendant is not penalized for rejecting offer from plaintiff Who pays the costs of a trial?

47. 46  In Europe…  Judges in civil trials take active role in asking questions and developing case  “Inquisitorial system,” since judge asks questions  In U.S…  Lawyers’ job to develop case  Judge is more of a passive referee  “Adversarial system,” since competing lawyers are adversaries Trial

48. 47  Trial has to answer two questions:  Is defendant liable?  If so, how much are damages?  Unitary trial considers liability and damages at same time  Economies of scope  Segmented trial considers liability first, then damages later (if necessary)  Damages phase may not be necessary  In U.S., judges have discretion over which type of trial Unitary versus Segmented Trials

49. 48  Rules for what evidence court can pay attention to  Textbook gives examples where rules seem inconsistent, if goal is simply to maximize probability of “right outcome”  When we focus on efficiency, we care only about outcomes, not about process  But in real-world legal system, process is important in its own right Rules of evidence

50. 49  In U.S., three levels of federal courts  District courts, circuit courts of appeals, Supreme Court  (Many state court systems also have three levels, but this varies by state)  Parties in district court cases have right of appeal  Circuit court is required to consider their appeal  Parties in circuit court cases do not  Supreme Court has discretionary review – chooses which cases to hear  In common law countries, appeals courts tend to only consider certain issues  Appeals generally limited to matters of law  Matters of fact generally not considered Appeals

51. 50  Recall goal of legal system  Minimize administrative costs + error costs  Clearly, appeals process increases administrative costs  So only efficient if it reduces error costs  Reasons why appeals process may reduce error costs  Appeals courts are more likely to reverse “wrong” decisions than “right” decisions…  …which leads to losing parties appealing more often when decision was “wrong” Appeals