Econ 522 Economics of Law Dan Quint Spring 2012 Lecture 15

1  HW3 due tomorrow Thursday (11:59 p.m.)  Second midterm Monday March 26  Cumulative – covers property and contract law  No tort law – covers everything through middle of today’s lecture Reminders

2 Going back a month…

3  IP is a tradeoff between…  dynamic (“ex ante”) inefficiency – insufficient incentives for innovation  static (“ex post”) inefficiency – monopoly deadweight loss  Article in yesterday’s New York Times  Government of India is forcing Bayer to cheaply license patent for one of its drugs to a generic manufacturer  Nexavar (sorafenib) – treats advanced kidney and liver cancer  Bayer charges $5,600 a month for the drug, hardly sells any in India  Being forced to license the patent to an Indian company, Natco Pharma, which will sell drug for $176/month, pay Bayer 6% royalty Intellectual property…

4 Results from Monday’s experiment

5  Player A starts with $10  Chooses how much of it to give to player B  That money is tripled  Player B has $10, plus 3x whatever A gave him/her  Chooses how much (if any) to give back to player A  Four treatments  Anonymous  Private  Face-to-face  Public A two-player game, similar to the investment/agency game

6  In the anonymous version, trust was an issue  On average, player A sent $5.91, so about 60% of the potential gains were realized  On average, player B sent back $9.35, so average payoffs were $13.43 and $18.40  Of those player A’s who sent something, 24% got back less than they sent, and 7% got back nothing  Knowing who you were playing with helped a lot!  In second version, average A sent $8.70, average B sent $16.21  Two-thirds of A’s sent $10, and 5/6 of those got back $20  Average payoffs of $17.51 and $19.89  Only 4% of player A’s who sent something, got nothing back Results

7 6%$16.21$8.7011%$9.34$5.91Average 6%$ %$ %$ %$ %$ %$ %$ %$ % zeroAvg B# obs% zeroAvg B# obsA sent… PRIVATE VERSION (NAMES) ANONYMOUS VERSION (STUDENT ID NUMBERS) (7%)(4%)

8 Of the Player A’s who sent $10… $18.10$17.92Average received 84%69% who got back $20 or $21 6%23% who got back $15 or $17 3%0% who got back $10 6%8% who got back $0 or $5 3113# of Player A who sent $10 PrivateAnonymous

9  Knowing the name of the person you’re playing with helped  Increased trust significantly; increased trustworthiness a little  Interacting face-to-face completely solved problem  All 5 A’s sent $10, all 5 B’s sent back $20  That worked even better than playing the game in public!  (Public version: all three A’s sent $10, got back $20, $15, and $0) Results

10 Returning to repeated interactions

11  The first purpose of contract law is to enable cooperation, by converting games with noncooperative solutions into games with cooperative solutions  The sixth purpose of contract law is to foster enduring relationships, which solve the problem of cooperation with less reliance on courts to enforce contracts  Law assigns legal duties to certain long-term relationships  Bank has fiduciary duty to depositors  McDonalds franchisee has certain duties to franchisor Repeated games and reputation

12  Suppose we’ll play agency game 60 times  $50 x 60 = $3,000 > $200, so cooperation seems like no problem  But…  In game #60, reputation has no value to me  Last time we’re going to interact  So I have no reason not to keep all the money  So you have no reason to trust me  But if we weren’t going to cooperate in game #60, then in game #59… Repeated games and the endgame problem

13  Endgame problem: once there’s a definite end to our relationship, no reason to trust each other  Example: collapse of communism in late 1980s  Communism believed to be much less efficient than capitalism  But fall of communism led to decrease in growth  Under communism, lots of production relied on gray market  Transactions weren’t protected by law, so they relied on long-term relationships  Fall of communism upset these relationships Repeated games and the endgame problem

14 One other bit I like from Friedman

15 Friedman on premarital sex

16 Friedman on premarital sex

17  Purposes for contract law:  Encourage cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Provide efficient default rules and regulations  Foster enduring relationships  Wednesday, we begin tort law That’s it for contract law End of material on second midterm

18 Let’s recap our story so far…

19  Efficiency  Maximizing total surplus realized by everyone in society  Scarce resources are owned by whoever values them most  Actions are taken if social benefit exceeds social cost  Design a legal system that leads to efficient outcomes  Once we set up the rules, we don’t expect people to act based on what’s efficient  We expect people to do whatever’s in their own best interest  So the goal is set up the rules such that people acting in their own best interest will naturally lead to efficiency Our story so far

20  Coase gives us one way to do that  If property rights are clearly defined and tradable, and there are no transaction costs, people have incentive to trade until each resource is efficiently owned  So initial allocation of rights doesn’t matter for efficiency  But if there are transaction costs, we may not get efficiency this way  Led us to two normative views of the legal system:  1. Minimize transaction costs (“lubricate” private exchange)  2. Allocate rights as efficiently as possible  Tradeoff between injunctive relief and damages Our story so far

21  Property law works well for simultaneous trade  Contracts allow for non-simultaneous trade  Contract law can…  Enable cooperation  Encourage efficient disclosure of information  Secure optimal commitment to performance  Secure efficient reliance  Supply efficient default rules and regulations  Foster enduring relationships Our story so far

22  So far, we’ve been talking about voluntary exchange  Coase is predicated on exchange being voluntary for both parties  Contracts are an extension of voluntary trade  Up next: “involuntary trade”  You’re bicycling to class, I’m texting while driving and I hit you  You didn’t want to deal with me, I didn’t want to deal with you… Our story so far

23  To put it another way…  Property law covers situations where transaction costs are low enough to get agreement ahead of time  Exceptions to property law – private necessity, eminent domain – when this isn’t the case  Contract law covers situations when transaction costs are low enough for us to agree to a contract, high enough that we may not want to renegotiate the contract later  Tort law covers situations where transaction costs are too high to agree to anything in advance Our story so far

24 Tort law

25 An example

26 An example ChoiceBad LuckOutcome +  punish the choice criminal law regulations

27 An example ChoiceBad LuckOutcome +  punish the choice criminal law regulations punish the combination of choice and outcome “negligence” punish the outcome “strict liability”

28  Tort, noun. from French word meaning injury  Contract law: situations where someone harms you by breaking a promise they had made  Tort law: situations where someone harms you without having made any promises  “If someone shoots you, you call a cop. If he runs his car into yours, you call a lawyer.” Tort law

29  I hit you with my car, do $1,000 worth of damage  You’re $1,000 worse off  (No damage to me or my car)  Should I have to pay you damages? As always, we’ll be focused on achieving efficiency –1,000 Combined payoffs –50,000–1,0000My payoff 49,0000–1,000Your payoff I owe $50,000I owe $1,000I owe nothing

30 Something to remember distribution but not efficiency efficiency

31  Question: how to structure the law to get people to behave in a way that leads to efficient outcomes?  Deliberate harms: make punishment severe (criminal law)  Accidental harms: trickier  Goal isn’t “no accidents”; goal is “efficient number of accidents” Tort law

32  Question: how to structure the law to get people to behave in a way that leads to efficient outcomes?  Deliberate harms: make punishment severe (criminal law)  Accidental harms: trickier  Goal isn’t “no accidents”; goal is “efficient number of accidents”  Unlike nuisance law, injunctive relief is not an option  Unlike contract law, no agreement ahead of time  Cooter and Ulen: essence of tort law is “the attempt to make injurers internalize the externalities they cause, in situations where transaction costs are too high to do this through property or contract rights” Tort law

33  Plaintiff – person who brings a lawsuit  Defendant – person who is being sued  In a nuisance case, the defendant caused a nuisance, plaintiff was bothered by it, might be asking for injunction or damages  In a contract case, defendant breached a contract or violated its terms  In a tort case, defendant caused some harm to plaintiff, plaintiff is asking for damages  Plaintiff is the victim (person who was harmed)  Defendant is the injurer (person who caused the harm) Cast of characters

34  Harm  Causation  Breach of Duty “Classic” legal theory of torts

35  For a tort to exist, the plaintiff needs to have been harmed  “Without harm, there is no tort”  Gas company sold gas with a defective additive  Dangerous for cars with turbocharged carburetors  You have a car with normal carburetors  You might be angry; but you weren’t harmed, so you can’t sue  Similarly, no compensation for exposure to risk  Manufacturer exposed workers to some chemical  Exposure will cause 15% of them to develop cancer later in life  Can’t sue now – have to wait, see who gets cancer, then they can sue Element 1: Harm

36 Element 1: Harm Money Health  Perfect compensation  restores victim to original level of well-being  generally done through money damages

37 Perfect Compensation Emotional harm Pain and suffering Loss of companionship Medical costs Lost income Damaged property Intangible harmsTangible harms  In theory, perfect compensation should cover all losses  Historically, courts have been less willing to compensate for intangible or hard-to-measure losses  Over time, U.S. courts have started compensating for more intangible harms  Pro: the closer liability is to actual harm done, the better the incentive to avoid these harms  Con: disparity in award sizes, unpredictability

38  Harm  Causation  Breach of Duty “Classic” legal theory of torts

39  For a tort to exist, the defendant needs to have caused the harm to the plaintiff  Cause-in-fact  “But for the defendant’s actions, would the harm have occurred?” Element 2: Causation

40  For a tort to exist, the defendant needs to have caused the harm to the plaintiff  Cause-in-fact  “But for the defendant’s actions, would the harm have occurred?”  Proximate cause  Immediate cause – defendant’s action can’t be too distant from the harm  Palsgraf v Long Island Railway (NY Ct Appeals, 1928):  Guard pushed a passenger to help him onto train, passenger dropped fireworks he was carrying, they went off, explosion knocked down scales at the other end of the platform, which fell on Mrs. Palsgraf  Guard’s actions were not the proximate cause Element 2: Causation

41 “A tree fell on a moving trolly, injuring passengers. One of them sued. He succeeded in demonstrating that in order for the trolly to be where it was when the tree fell on it the driver had to have driven faster than the speed limit at some point during the trip. Breaking the law is per se negligence, so the driver was legally negligent whether or not his driving was actually unsafe. If he had not driven over the speed limit, the trolly would not have been under the tree when it fell, so, the plaintiff argued, the driver’s negligence caused the injury.”  Court ruled driver’s negligence “had not caused the accident in the legally relevant sense” Element 2: Causation

42  Harm  Causation  Breach of Duty “Classic” legal theory of torts

43 Element 3: Breach of Duty Harm Causation Breach of duty (fault) Harm Causation NegligenceStrict Liability  When someone breaches a duty he owes to the defendant, and this leads to the harm, the injurer is at fault, or negligent  Injurers owe victims the duty of due care  Negligence rule: I’m only liable if I failed to take the required standard of care – not if I was careful and the accident happened anyway (Sometimes required, sometimes not)

44 “A tree fell on a moving trolly, injuring passengers. One of them sued. He succeeded in demonstrating that in order for the trolly to be where it was when the tree fell on it the driver had to have driven faster than the speed limit at some point during the trip. Breaking the law is per se negligence, so the driver was legally negligent whether or not his driving was actually unsafe. If he had not driven over the speed limit, the trolly would not have been under the tree when it fell, so, the plaintiff argued, the driver’s negligence caused the injury.” Hence the language in the trolly example

45  If I breach my duty of due care and injure you, I am liable  If I exercise the appropriate level of care but still injure you, I’m not liable  How is the standard of care determined?  That is, how careful do I have to be to avoid liability, and who decides?  Is it negligent to drive 40 MPH on a particular road at a particular time of day? What about 41 MPH? 42? So under a negligence rule…

46  Some settings: government imposes safety regulations that are also used as standard for negligence  Speed limits for highway driving  Requirement that bicycles have brakes  Workplace regulations  Some standards are left vague  “Reckless driving” may depend on road, time of day, weather…  Common law focuses on duty of reasonable care  Level of care a reasonable person would have taken  (Civil law relies less on “reasonableness” tests, tries to spell out what level of care is required) How is the standard of care determined?

47  Strict liability rule: plaintiff must prove harm and causation  Negligence rule: must prove harm, causation, and negligence  A little history  Early Europe: strict liability was usual rule  By early 1900s, negligence became usual rule  Second half of 1900s, strict liability became more common again, especially for manufacturer liability in American consumer products  U.S. manufacturers now held liable for harms caused by defective products, whether or not they were at fault Strict liability versus negligence

48  Harm  Causation  Breach of Duty “Classic” legal theory of torts

49 Economic model (didn’t get to this)

50  The more carefully I drive, the less likely I am to hit you  But, driving more carefully is also more costly to me  Must be some efficient level of care  Similarly…  Construction company can reduce accidents with better safety equipment, better training, working shorter days, all of which cost money  Manufacturer can reduce accidents by designing/inspecting products more carefully – again, more expensive Precaution

51 Actions by both injurer and victim impact number of accidents drive carefully drive drunk while texting careful quality control cheap, hasty manufacturing install smoke detectors, other safety equipment save money drive slowly speed like hell wear helmet and use light bicycle at night wearing black GREATER EFFORT TO PREVENT ACCIDENTS LESS EFFORT TO PREVENT ACCIDENTS “MORE PRECAUTION”“LESS PRECAUTION”

52  Precaution: anything either injurer or victim could do to reduce likelihood of an accident (or damage done)  The next two questions should be obvious…  How much precaution do we want?  What is efficient level of precaution?  How do we design the law to get it? We will call all these things precaution

53  Car hits a bicycle  In real life: driver probably has insurance  In real life: some damage to bicycle, some damage to driver’s car  In real life: driver and bicyclist may not even know what the law is  We’ll simplify things a lot, by assuming…  Only one party is harmed  Parties know the law, don’t have insurance (for now)  We’ll focus on one party’s precaution at a time To answer these questions, we’ll introduce a very simple model of accidents

54  Unilateral harm – just one victim  Precaution – costly actions that make accident less likely  Could be taken by either victim or injurer  We’ll focus on one at a time  Notation  x – the amount of precaution that is taken  w – the cost of each “unit” of precaution  so total cost of precaution is wx  p(x) – probability of an accident, given precaution x  p is decreasing in x  A – cost of accident (to victim)  so expected cost of accidents is p(x) A Model of unilateral harm x level of precaution w marginal cost of precaution p(x) probability of an accident A cost of an accident

55 Model of unilateral harm x level of precaution w marginal cost of precaution p(x) probability of an accident A cost of an accident Precaution (x) $ p(x) A (Cost of Accidents) wx (Cost of Precaution) wx + p(x) A (Total Social Cost) x* (Efficient Level of Precaution) efficient precaution: min x { wx + p(x) A } w + p’(x) A = 0 w= – p’(x) A marginal social cost of precaution marginal social benefit of precaution x < x*x > x*

56  We haven’t yet said who is taking precaution  Some situations, only injurer can reduce accidents  Some situations, victim can too  Bilateral precaution – we’ll look at the two parties one at a time  Wednesday: consider effect of different liability rules on precaution Model of unilateral harm

57 Effect of Liability Rules on Precaution (won’t get to this)

58  Three rules we’ll consider:  No liability  Strict liability  Negligence Effect of liability rules on precaution

59  In a world with no liability…  Victim bears the cost of any accidents, plus the cost of any precaution he takes  Injurer bears cost of any precaution he takes, does not have to pay for accidents Rule 1: No Liability

60 Rule 1: No Liability Injurer precaution x $ p(x) A wx wx + p(x) A x*  Injurer’s private cost is just wx  Injurer minimizes private cost by setting x = 0 Private cost to injurer

61 Rule 1: No Liability Victim precaution x $ p(x) A wx wx + p(x) A x*  Victim’s private cost is wx + p(x) A  To minimize this, victim takes efficient level of precaution Private cost to victim

62  So in a world with no liability…  Injurer takes inefficiently low level of precaution  (zero, or minimal amount)  Victim takes efficient amount of precaution Rule 1: No Liability

63  Perfect compensation: damages D = A  Under strict liability…  Injurer pays damages for any accidents he causes  So injurer bears cost of accidents, plus his own precaution  Victim pays only for his precaution Rule 2: Strict Liability

64 Rule 2: Strict Liability Injurer precaution x $ p(x) A wx wx + p(x) A x*  Injurer’s private cost is wx + p(x) A  Injurer minimizes this by taking efficient level of precaution Private cost to injurer

65 Rule 2: Strict Liability Victim precaution x $ p(x) A wx wx + p(x) A x*  Victim’s private cost is wx  No incentive to take any precaution, victim sets x = 0 Private cost to victim

66 Effect of liability rules on precaution EfficientZeroStrict Liability ZeroEfficientNo Liability Injurer precaution Victim precaution

67  When it’s the injurer who can take precautions, a rule of strict liability is more efficient  When it’s the victim who can take precautions, a rule of no liability is more efficient  Each rule works well for one incentive, poorly for other  Similar to paradox of compensation we saw in contract law  Negligence rule may allow us to get both incentives right So for accidents with unilateral precaution…

68  “Simple Negligence” rule  Legal standard of care x n  Injurer is liable for damages if precaution level was below the legal standard of care  x < x n  D = A  x  x n  D = 0  So on our graph from before, private cost to injurer is…  wx + p(x) Afor x < x n  wxfor x  x n Rule 3: Simple Negligence

69 Rule 3: Simple Negligence Injurer precaution x $ p(x) A wx wx + p(x) A x n = x*  Private cost is wx + p(x) A if x < x n, only wx otherwise  If standard of care is set efficiently (x n = x*), injurer minimizes private cost by taking efficient precaution Private cost to injurer

70 Rule 3: Simple Negligence Victim precaution $ p(x) A wx wx + p(x) A x*  What about victim?  We just said, injurer will take efficient precaution  Which means injurer will not be liable  So victim bears costs of any accidents  (Victim bears residual risk)  So victim’s private cost is wx + p(x) A  Victim minimizes private cost by taking efficient level of precaution too! Private cost to victim (assuming injurer takes efficient level of precaution and is therefore not liable for damages)

71 Effect of liability rules on precaution Efficient Simple Negligence, with x n = x* EfficientZeroStrict Liability ZeroEfficientNo Liability Injurer precaution Victim precaution