Economics of Public and Tax Law (Encyclopedia of Law and Economics , Vol 4)

3000 TORT LAW: GENERAL Hans-Bernd Schäfer University of Hamburg - Institute of Law and Economics © Copyright 1999 Hans-Bernd Schäfer

Abstract This chapter gives a general overview of the economic literature on tort law. It discusses the legal definitions of tort law, the development of tort law, the fundamental economic rationale of tort law and the scope of tort liability. A brief overview of the main topics of the economic analysis of tort law is given. JEL classification: K13 Keywords: Negligence, Strict Liability, Fault, Development of Tort Law

1. What is Tort Law? Tort law defines the conditions under which a person is entitled to damage compensation if her claim is not based on a contractual obligation. Damages result from the loss or impairment of property, health, life or limb, from the infringement of rights or from pure financial or non-financial losses. Economically speaking every reduction of an individual’s utility level caused by a tortious act can be regarded as a damage. Tort law rules aim at drawing a just and fair line between those noxious events that should lead to damage compensation and others for which the damage should lie where it falls. In Common Law countries tort law has developed from a large body of formerly unrelated doctrines such as conversion, tresspass, nuisance, defamation, negligence, deceit and rules from case law. On the European continent a more systematic and rationalistic approach resulted in the formulation of some basic concepts of tort law. This made it possible to formulate abstract and flexible principles and integrate them into the codifications, as in the French Code Civil. Art. 1382: Tout fait quelquonque de l’homme, qui cause à autrui un dommage, oblige celui par la faute duquel il est arrivé, à le réparer. Art. 1383: Chacun est responsable du dommage qu’il a causé non seulement par son fait, mais encore par sa négligence ou par son imprudence.

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Similar general rules were laid down in the civil codes of other continental countries. They tried to systematise and condense the large body of cases and materials to an abstract system of rules. Many important questions, however, are left open in such solemn statements, such as the precise meaning of a damage, of negligence, the concept of causation or compensation for pure financial damages. They have to be decided by the judiciary. It is therefore not surprising that modern tort law on the European continent is more or less judge-made law (Zweigert and Koetz, 1996).

2. Development of Tort Law The scope and significance of tort law has risen significantly over the last 200 years. Before the industrial revolution tort law was a rather unimportant field with shying horses as an important cause of damages. With steam engines, modern traffic (locomotive, motor vehicles) and hazardous products the number and severity of accidents rose dramatically. This gave rise to the development of modern tort law, especially the negligence doctrine and the slow expansion of strict liability for risks caused by very dangerous activities. However many of the resulting problems faced by accident victims were not solved - and may be not solvable - by the development of tort law rules alone. In many European countries tort law plays a rather insignificant role for workplace accidents. Insurance of victims as well as deterrence is organized by quite different and hybrid institutions between public and civil law. The twentieth century brought a further expansion of tort law like product liability, liability for medical malpractice, environmental liability, liability for torts in the marketplace, extended liability of the corporation. Some of the modern developments in tort law were made possible by improvements of information technology which facilitated the attribution of a damage to a tortfeasor even over long distance and time. With traditional information technology such damages had to be regarded as arising from the general risk of life and were consequently not shifted from a victim to a tortfeasor.

3. The Economic Rationale of Tort Law The welfare implications of tort law rules have been discussed by many authors, economists and lawyers over the last 200 years, especially by Victor Mataja (1888). Also Bentham, Holmes and Jhering taught that tort law rules should be based on utilitarian principles. But a coherent body of literature has existed only since the 1960s, starting with the pathbreaking works of Coase, Calabresi and Posner. Coase showed that with high transaction costs (the costs of using the market) tort law matters with respect to allocative efficiency (Coase, 1960). Posner investigated in a series of articles and books

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the most important legal doctrines of tort law with respect to their effect on the society’s wealth (Posner, 1972, 1986). Brown (1973) gave a now classical analysis of the economic effects of tort law rules. Calabresi (1970) showed that accident law has the capacity of reducing three different types of costs: primary, secondary and tertiary. Primary accident costs are the victims’ losses. The costs of avoiding damages (by increasing the care level and reducing the activity level of a dangerous activity) should be balanced against the victims’s losses and ideally the sum of these costs should be minimized. Secondary costs of accidents result, if those who bear the primary accident costs are risk-averse. In such a case any kind of risk spreading and even of shifting the primary costs to the least risk-averse party leads to a social gain. Tertiary costs include all administrative costs of putting the case through the legal system. Obviously there are trade-offs between reducing primary accident costs, comprehensive insurance coverage and reducing the costs of the legal system. Each system of accident law has to compromise on these goals. The optimal nature of these compromises might be different across time and legal orders. It depends on the level of development of private insurance markets and on the capacity of courts to process information in an unbiased way. From this point of view Posner’s observation is interesting that primitive societies often prefer(red) strict liability over negligence, because they lack legal experts, who can determine whether the injurer’s behaviour was faulty, and because strict liability can serve as a rudimentary form of insurance, if the tortfeasor in general is wealthier than the victim. It is also not obvious whether the reduction of these costs can be best organized by the system of tort law (general deterrence) in combination with private or social insurance, by regulatory law (special deterrence) or by other social mechanisms aimed at ensuring victims and providing deterrence effects to tortfeasors and/or victims.

4. Main Topics of the Economic Analysis of Tort Law Economic analysis of tort law is mostly efficiency analysis, both positive and normative. A large body of work is related to the analysis of existing legal concepts (Diamond, 1974a) such as negligence or strict liability, and to possible legal innovations such as compensation for future damages or probabilistic compensation criteria. The standard method is to analyse the efficient solution first and then ask whether or not a particular rule gives incentives to reach it. An important starting point of the economic analysis of tort law was the insight that the entitlement to compensation and imposed cost shifting is only a substitute for voluntary transactions of property rights. Any legal position can be protected either by a property rule or by a liability rule (Calabresi and Melamed, 1972). In principle a property rule is superior

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to a liability rule because it guarantees that a particular entitlement is given up only against a price which is higher than the value of that position for its owner. Thus a property rule guarantees that a right is transferred to a higher valued use. Liability rules cannot guarantee this, as damage compensation is subject to a somewhat arbitrary calculation of an outside observer (judge). Moreover some damages are not compensated (for instance sentimental values). Damage compensation is not as precise as the price for the voluntary transfer of an entitlement and might therefore lead to a wrong price and consequently to wrong decisions of those who pay this price. Therefore liability rules cannot guarantee in the same way as property rules the efficient use of resources. From this perspective tort law is a stopgap if special conditions (hold-up positions, high costs of contracting) impede voluntary transactions. For analysis of tort law rules it proved fruitful to differentiate between various categories of damages, for which the economic analysis has to be different. An important difference exists between the effects of harmful behaviour which lead to the destruction of a resource and those which lead to market imperfections. If a house burns down, the value of the capital stock of the society is diminished by the value of the destroyed house. Therefore, the damage of the victim is equal to the damage of the society and full compensation would impose a cost on the tortfeasor equal to the losses of the society. This equality of the victim’s damage, the loss of the society at large and the amount of damage compensation, however, no longer exists in some cases of pure financial loss (Bishop, 1980; Banakas 1996; Gilead, 1997). Here the harmful act often results in a redistribution of wealth if, for instance, wrong information is disclosed to the public leading to a financial loss for the shareholders (and to some gain for the other shareholders). The social dead weight loss is then different and usually smaller than the losses of victims. This leads to a different analysis of liability rules. Another important economic distinction resulting in two analytically different damage categories is between torts among strangers without any market relation (like pedestrians vis-à-vis car drivers) and torts involving parties linked to each other by a contract or a contractual chain such as where a manufacturer or seller of a defective product is sued by the buyer (Shavell, 1980, 1987). In the latter case, which is typical for consumer protection rules, the victim has to pay the expected liability costs as part of the product price, if the rules of tort law entitle him to damage compensation. This again makes the analysis different. Should it be based on contract or on tort doctrines? The economic analysis is again different, when victims as well as injurers suffer losses (Arlen, 1992) or when differences exist between individuals. Among the most important topics in this literature are the following: -

Negligence versus strict liability

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Unilateral and bilateral damages and contributory vs. comparative negligence Different rules of causation Different rules for multiple tortfeasors and victims Vicarious and corporate liability Liability for pure financial damages Liability for irreplaceable goods Valuation of life, limb and health Mass tort litigation, catastrophic accidents and class action Liability if courts have coarse information on causation and on the value of damages Civil procedure, costs of litigation and the incentive to litigate Civil liability compared with other institutions like regulation of safety, taxation of tortfeasors, and hybrid institutions between civil liability and regulatory law evolution of efficient civil liability norms efficiency, distributive justice and corrective justice in tort law.

An important result of the economic research on tort law is the finding that the large majority of common law rules leads to economic results, as if these rules had been designed to promote efficiency (Landes and Posner, 1981a, 1987). There seems to be a contrast between the economic effects of these rules and those of regulatory law. For the latter it is often easy to see that they reflect vested interests. This finding is supported by comparative legal reseach. Even though national legal orders have old traditions and legal concepts which are often as different across countries as can be, the differences of the actual solutions of tort law problems are often insignificant (Zweigert and Kötz, 1996). It is an open question whether such findings reflect a utilitarian or wealth-maximizing ethic of high court judges across countries, or whether an evolutionary force drives the civil law system towards more efficiency (Rubin, 1977) wiping out cross-county differences. In countries on the same stage of economic development, facing the same economic and social problems, some evolutionary pressure to eliminate inefficient rules and thus to reach similar solutions is likely to exist. This holds especially for the civil law system in which the decision makers are decentralized and independent and therefore not easy to capture by interest groups. An interesting feature of the analytical literature is the discovery that often first-best solutions cannot be reached by any rule of tort liability. For example: if accidents are bilateral both with respect to the care level and the activity level, no efficient liability rule exists (Shavell, 1987). If damages result from a combination of different harmful causes, full damage compensation might in principle be unsuited to provide incentives for efficient deterrence. If damages from pain and suffering form part of the

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compensation awarded by tort judgments this serves as a deterrent but leads to an inefficiently high insurance level (Friedman, 1982) as insurance against pain decreases the expected utility of the insured. In this sense absense from pain is an irreplacable good. An important part of the scientific work on tort law is empirical. Which factors explain the shift of property rights, for example from negligence to strict liability or from caveat emptor to caveat fabricator? What are the distortion effects of incentives of insurance coverage, especially of particular insurance schemes like no-fault insurance for automobile accidents? What are the comparative merits of different institutions to deter and insure risks of different categories? What is the ‘value’ of non-financial losses such as the loss of health, limb or life? This empirical research is particularly important and has corrected some abstract theorizing based on empirical assumptions about the way the system works, without actually investigating the accuracy of these assumptions. A comprehensive survey of these studies can be found in Dewees, Duff and Trebilcock (1996).

5. The Scope of Tort Liability Even after a long debate on the economic effects of tort law there is still much disagreement as to the legitimate place of tort law in modern society. Should tort law be a comprehensive and expanding deterrence system, regulating securities’ and other markets, old and new hazards and then be open to all kinds of legal innovations necessary for optimal deterrence? Or should its domain be more restricted to the classical cases and leave complicated risks and hazards to other social institutions? This depends to a great extent on two factors, the availability of private insurance against hazards and the capacity of civil courts to obtain and process information. If private insurance is easily obtainable for both victims and tortfeasors, secondary costs are independent from where the loss eventually falls. Consequently accident law can then focus on deterrence and on the reduction of administrative costs. Societies in which insurance markets are underdeveloped, however, might develop a tendency to shift the costs of accidents to the deepest pocket, which is often a large company. Some demands to shift the risk to the deep pocket may make sense as long as firstparty insurance coverage is not obtainable for victims. The rise of public compulsory social insurance in nineteenth-century Germany especially with respect to workplace accidents is another way of dealing with problems caused by undeveloped private insurance markets. In modern market systems, however, it is argued that both first-party insurance and third-party insurance are in most cases easily obtainable and that tort law can concentrate on optimal deterrence. It is however debated whether - even with highly-developed insurance markets - tort law is well suited for this job and whether a comprehensive

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tort law system will not cause excessive costs for the legal system as well as insufficient deterrence. If courts lack information they might be unable to develop rules that give proper incentives to victims and tortfeasors to balance at the margin damage prevention costs and costs of accidents. It is sometimes asserted in the Hayekian tradition (De Alessi and Staaf, 1987; Schmidtchen, 1993) that these costs are subjective to victims and tortfeasors and cannot be properly assessed by any outside observer like a judge. Overand underestimation must then result and liability rules would lead to inefficiently high or low damages. One could then argue that the domain of tort law should be limited to cases of obvious negligence, easy valuation of damages and obvious causation. Tort law should at least keep out of those categories of damages for which efficient liability rules require much information. This recommendation would reduce the domain of tort law considerably and with it the costs of the judicial system (tertiary costs). According to this view no solid statement can be made about whether the resulting distortions of incentives are higher or lower than in a comprehensive system of tort law, whose rules are necessarily based on inadequate information. This would lead to a small domain of tort law and of state interference in general. Similar arguments with respect to the legitimate domain of tort law arise if one assumes that sufficient information to balance costs and benefits and provide proper incentives are possible in principle, but that civil law courts in particular lack the capacity to collect and process the necessary information because of strict rules of civil procedure, and because judges are technical laymen unable to assess the risks and benefits of modern technologies and not well-equipped to discover the scientific truth (Huber, 1988). This argument leads to a preference of safety regulation over general deterrence by tort law. Regulatory agencies can process safety information much better than legal procedure and use experts for the setting and enforcement of safety standards. This would lead to a comparatively small domain of tort laws but to an active state regulation (Rose-Ackerman, 1991). It seems that the expansion of tort law by new types of cases such as product liability, medical malpractice, punitive damages and class action has led to adverse effects in the USA. The so-called insurance crisis gave rise to such pessimistic views with respect to the problem-solving capacity of tort law. Insurance premiums increased rapidly in the 1980s; producers took dangerous products from the market, stopped product research, municipal districts stopped summer programmes for young persons and removed play structures for fear of liability and too high insurance costs. The reasons for this development are seen in compensation payments for pain and suffering, which are higher than the damages, and in the tendency of courts to disregard negligence on the side of the victim when granting damage compensation (Priest, 1987a, 1991). These reasons, however, do not necessarily support the view that civil courts are in principle unable to

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administer rules leading to optimal safety. It seems that the jury system in the USA might lead to a deep pocket bias in tort law, which has little to to with the general incapacity of courts to process information and develop efficient rules. This argument is further enhanced since an insurance crisis as a result of overcompensation and overdeterrence can so far not be observed in European countries without jury systems, where the domain of tort law has also been extended by the introduction of new fields of tort law such as product liability and where the informational constraints of courts are basically the same. Tort law has to play a predominant role in reducing primary accident costs if one takes the view that civil courts can handle most of the informational problems properly, and that regulatory agencies, even though better endowed to collect and process information, are often influenced by well-organized interest groups. This view has been proposed by different lines of arguments. (1) Judges might be able to make at least rough approximations with respect to optimal deterrence when they set standards of due care or develop doctrines which provide deterrence incentives. (2) Courts can learn over time and improve rules even if a single court lacks the knowledge of getting incentives right (Cooter, Kornhauser and Lane, 1979; Ott and Schäfer, 1990). (3) Evolutionary pressure leads tort law to efficiency, if inefficient rules are more often attacked by litigation than efficient rules. This rather optimistic view favours a more comprehensive system of tort law. It leads to an activist state in the form of an activist tort law judiciary whereas the domain of safety regulation remains comparatively less important. Independent from informational constraints the tort system cannot be an efficient institution as long as reducing the scope of liability results in distortive incentive effects which are less costly than the resulting savings of costs of the judicial system and easier insurance coverage. As the costs per case filed are very high in the tort system, alternative institutions like no-fault insurance schemes for automobile accidents might be better suited to reduce the overall costs of accidents than tort liability. Only empirical research can then find out which system or which combination of systems is best suited to reduce accident costs (Dewees, Duff and Trebilcock, 1996). The overall efficacy of tort law vis-à-vis regulation of safety depends on various other factors (Shavell, 1984). When harm is so diffused that individuals have little incentives to sue and cannot cheaply organize as a group, this rational apathy of victims leads to systematic undercompensation and consequently to underdeterrence. This effect is most detrimental if technologies exist to convert concentrated into diffused damages. In the early days of industrialization, pollution of residential areas close to polluting factories often resulted in damage compensation. This resulted in long chimneys spreading the toxic substances over wide areas making tort law ineffective.

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The bancruptcy constraint of a firm or an individual is another weakness of tort law. If the damage exceeds the wealth of a tortfeasor, expected damage compensation is again lower than expected damages and underdeterrence results. This deficit can partly be cured for firms by piercing the corporate veil or even by shareholders’ liability (Kraakman, 1984a). But regulation with ex-ante fines based on the expected damage might then be a better way to deter harmful behaviour. Underdeterrence also results from weak causational chains and legal rules of causation designed to cope with simple accidents of the form ‘A hits B’. It is an open question whether this deficit can be cured with new doctrines of causation based on probability guesses of judges, or whether in fields of coarse causational information the problems should better be solved by regulatory statutes and specialised agencies better equipped than courts to collect and process such information (Rose-Ackerman, 1991). The nature of information might also influence the efficient domain of tort law versus safety regulation. If optimal safety standards are public goods, a more centralized system of public agencies might be better to ensure optimal safety than the decentralized court system. All in all there is little doubt that tort law can play an important but limited role in deterring and insuring accidents. In the USA tort law counts for only 9 percent of all loss shifting (Abraham and Liebman, 1993). Private and public first party insurance, workers compensation schemes, no fault liability schemes, green taxes and other institutions compete with tort law in reducing the costs of torts.

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3100 STRICT LIABILITY VERSUS NEGLIGENCE Hans-Bernd Schäfer and Andreas Schönenberger Universität Hamburg - Fachbereich Rechtswissenschaft © Copyright 1999 Hans-Bernd Schäfer and Andreas Schönenberger

Abstract The purpose of this chapter is to compare negligence rules and strict liability rules and to examine the allocative effects resulting from the application of different liability regimes. It first discusses unilateral accidents, while the more complicated bilateral cases follow afterwards. Each section starts with a discussion of the rule of no liability before moving on to various forms of negligence and ending with various strict liability rules. At the end of each section, there is a discussion on how results change when relaxing specific assumptions. The various aspects are summarised focusing on the question of whether the outcome under a specific liability regime is efficient or not. We also discuss a few more specific topics of interest, for example, the allocative effects of various liability rules when agents enter into a contractual relationship, cases of ‘joint liability’, the impact of uncertain legal standards, and the interaction between liability law and insurance. JEL classification: K0 Keywords: Negligence, Strict Liability

1. Introduction The purpose of this chapter is to compare negligence rules and strict liability rules. They are the major rules of liability used in tort law to deal with situations where one person (the injurer) causes harm to another person (the victim). In England, France and Germany, for instance, the usual forms of liability are the comparative negligence rule and strict liability with the defence of relative negligence, and in the US it is the comparative negligence rule, the negligence rule with the defence of contributory negligence, and strict liability with the same defence. The details of these rules will be discussed below. Zweigert and Kötz (1996, secs. 40-43) provide a rigorous description of tort law in England, France and Germany. For the US, a good reference is Keeton, Dobbs, et al. (1984, chs 5, 11, 13). Historically, it is interesting to observe the changes in the relative importance of different liability rules. Before the nineteenth century, for instance, strict liability was predominant in most common law jurisdictions. In 597

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the early and mid-nineteenth century, however, this changed with negligence and fault becoming the prevailing standard of tort liability, as Schwartz (1981) notes. Since the twentieth century, rules of strict liability have enjoyed a renaissance and have been applied more and more to determine who should bear the costs of an accident and to what extent. A good example of this phenomenon is the shift back to strict liability in products liability cases. Moreover, tort law is much under debate because of the increasing number of cases where compensation for losses might substantially exceed the actual damage. In the US, for instance, damages awarded may exceed the losses sustained in the presence of ‘punitive’ damages where parties acted with ill will, that is the harm was intentional, whereas in Germany higher awards are provided to give victims ‘satisfaction’ and to compensate them for nonpecuniary losses. The scope of harm and the size of judgements have become exceedingly expansive, and manufacturers pay extremely high premiums for products liability insurance to protect themselves against these awards. Many of them have withdrawn from the market entirely. This and various other results on the issue are presented by Priest (1991). Many economists and lawyers conclude that the tort system is in need of reform. Again, we need to understand the basic principles of how different liability regimes work to be able to evaluate the alternatives to reform. Tort law is one of those areas in the law where (micro)economic models can be successfully applied. Tort is about damages and has important economic implications. The economic approach to tort is therefore mainly concerned with examining the allocative effects, that is welfare effects, resulting from the application of different liability regimes. Landes and Posner (1987, p. 6) suggest that liability rules can be interpreted as a legal attempt to establish incentives for parties to achieve social efficiency objectives. One of the path-breaking studies in the development of the economic approach to tort is Calabresi (1970). The aim of tort law, he proposes, apart from the requirement for justice, is to minimise the social costs of a tort defined as the sum of total accident costs, administration costs, costs of properly allocating accident losses by means of insurance, and accident prevention costs of both the injurer and the victim. Again, the comparison between strict liability and negligence helps to determine which tort system is most suitable to improve welfare by, first, encouraging individuals to engage in safer activities by providing an incentive to do so, and second, encouraging individuals to make a given activity safer. Throughout, we will be considering models of accidents involving two individuals, the injurer and the victim. Both of them are engaged in some activity, and both of them exercise a certain level of care. The decisions the parties have to make are twofold. They have to decide how much care they want to exercise and how much they want to engage in an activity. It is plausible to assume that accident prevention costs increase with the amount of care taken,

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and that expected damages decrease with the level of care, but increase with the amount of activity the parties engage in. In the remainder of this chapter, we will discuss first, in Section 2, unilateral accidents because they describe those situations where one party, that is the victim, has no influence on the probability and the size of damages. Also, it is easier to understand the more complicated discussion of the bilateral case which follows in Section 3. Each section starts with a discussion of the rule of no liability before moving on to various forms of negligence and ending with various strict liability rules. At the end of each section, there is also a discussion on how results change when relaxing certain assumptions. In Section 4, the various aspects of the comparison between liability rules are summarised focusing on the question of whether the outcome under a specific liability regime is efficient or not. Section 5 concentrates on a few more specific topics of interest. First, we discuss the allocative effects of various liability rules when agents enter into a contractual relationship, which also implies a brief discussion on the distinction between tort law and contract law. Second, we analyse cases of ‘joint liability’, that is situations where more than one tortfeasor contributes to the occurrence of an accident.

2. Unilateral Accidents The discussion here is mainly based on Schäfer and Ott (1995) and Shavell (1987). In the case of unilateral accidents which we focus on in this section, it is assumed that the victim cannot influence the amount of expected damages. Also, to keep things simple, we further assume that the level of activity is constant. (This assumption will be relaxed below.) Therefore, if we denote accident prevention costs by c, the level of care by x, and if d measures the total amount of expected damages, then, abstracting from administration costs and assuming risk neutrality, the social objective function takes the form of: min c (x) + d (x) (1) Setting the first derivative with respect to x equal to zero we obtain the following solution: c' (x) = − d' (x) (2) which simply states that the marginal cost to the injurer of taking an additional unit of care (left-hand side of equation (2)) should equal the marginal benefit to the victim represented by a reduction in the total amount of expected damages (therefore the negative sign on the right-hand side of equation (2)). It should now be clear why microeconomic models can be applied so easily in

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law and economics as equation (1) is an extremely simple example of a standard optimisation problem recurring very frequently in any area of economic analysis. We now consider the behaviour of the injurer under various liability rules providing important insights as to the efficiency of these rules.

3. Rule of No Liability If the injurer cannot be held liable for the harm she causes, and if she therefore does not have to bear the costs of an accident, she will choose the lowest possible level of precaution in order to minimise her costs. Since we assume that the total amount of damages is a decreasing function of the precaution level the accident costs will be extremely high. As a result, the outcome of this liability rule is clearly not socially optimal.

4. Negligence Under the negligence rule, the injurer will be held liable only if she exercised precaution below a level usually determined by the law and/or by the court. This level is called reasonable care or due care. Posner (1972) proposed an economic efficiency criterion which could be used to identify the efficient precaution level to establish it as the legal standard. It should be borne in mind that one of the most important objectives of tort law is to give the injurer an incentive to apply the efficient level of care fulfilling the optimality condition (2). Interestingly enough, the first person to describe this legal standard of care was not an economist, but a judge. Learned Hand (1947) suggested that an injurer is liable if her burden B of adequate precautions is less than the probability P that the accident occurs, multiplied by the size L of the injury. Note that Judge Hand's statement of the rule is unclear as to whether it refers to total or marginal levels of benefits and costs of caretaking, but we assume that he had marginal values in mind. Stated in algebraic terms, an injurer is negligent if the condition B < PL (3) holds; and equality denotes optimality. If the injurer exercised due care she will not be held liable for the costs of the accident. Let us now suppose that the court or the law would set the level of due care equal to the socially optimal level of care. Would the negligence rule result in the socially optimal level of care being taken? The answer is yes, as can be seen very easily by noting that a self-interested person will choose her level of precaution to minimise her private costs. Would she therefore want to choose a precaution level above the level of due care? No, because any care

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taken in excess of the standard set by the court would be more costly without reducing the costs of compensation since due care is enough to be non-liable. Would she, on the other hand, want to choose a precaution level below due care? No, because now she is running the risk of bearing the total amount of the expected damages.

5. Relaxing Assumptions Note that in the previous section we made a few simplifying assumptions. First, we assumed that the court would set the level of due care equal to the socially optimal level. Second, it was assumed that the legal sanction imposed equals the harm actually caused and, third, the level of activity was supposed to be constant. We will now examine how the results change if we relax these assumptions one by one, that is, we will discuss the effects of relaxing only one assumption at a time. Some of these issues are clearly presented by Cooter and Ulen (1997, chs 8 and 9). Let us first examine the question of how the results of the previous section change when the court sets a level of due care that is not equal to the socially optimal level. Suppose, for instance, that the court does not require any precaution at all. Under these circumstances, it is obviously cheapest for the injurer not to exercise any care, because she will escape liability even without taking any care at all. Taking greater care would have no advantage, but would involve additional costs. Put more generally, the potential injurer will satisfy the legal standard even if it is pegged below the socially efficient level. The same applies to a legal standard above the socially efficient level, with one important exception, though. If the amount of precaution costs at the legal standard exceeds the total amount of precaution and expected damage costs at the socially optimal care level, then the potential injurer will ignore the legal standard and set her caretaking level at the lower socially optimal care level. This result changes if the injurer is not held liable for the entire accident losses, but only for the amount of damage in addition to the damage that would have been caused if the injurer had exercised the level of care set by the courts (partial liability). See, for instance, § 249 BGB under German law. For the US, see Kahan (1989). The first authors to describe this case are Schäfer and Ott (1986). Here, it is optimal for the injurer to exercise socially optimal care even if the legal standard is pegged above the socially efficient level. This is because by exercising the efficient level of care instead of the higher legal standard, precaution costs decrease by more than the imposed legal sanction increases. In general, however, we can say that in order to obtain an efficient outcome the court needs to set the due level of care equal to the socially optimal level of care.

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Note also that it is very difficult for courts, legislatures and authorities to identify the efficient level of care in order to establish it as the legal standard. Due or reasonable care is usually identified by comparing what a reasonable person would have done under the circumstances with the actual precautionary activity of the injurer. An illustration of the reasonable person standard is provided by Posner (1992, p. 167). However, this standard is very vague and ‘flexible’. Therefore, an alternative to decide whether an injurer was negligent or not without a specific standard of care would be, first, to ask what an injurer could have done (alternatively or in addition) to prevent the damage or to reduce the probability that it occurs. Then, the costs of the alternative or of the additional precaution activity are determined. If either the difference between the actual precaution costs and the costs of the alternative precaution activity or the costs of the additional precaution activity are less than the reduction in the total amount of expected damages as a result of the alternative or additional activity, the injurer will be liable. Another assumption we made in the previous section is that the legal sanction imposed equals the harm actually caused. What will happen if we relax this assumption? Endres (1991, pp. 51-87) provides a rigorous and rather formal analysis of this question which is beyond the scope of this article. From a rather intuitive and less formal perspective we can say that, under the negligence rule, an equality between harm and sanction is not essential as long as the sanction is sufficiently large so that the private costs of the injurer are minimised by conforming to the legal standard. However, once the legal sanction falls below a certain level, the injurer will minimise her costs by taking less precaution than the legal standard. Finally, we relax the assumption of a constant level of activity to study the effects of an increase in the injurer’s level of activity that will result in a proportional increase in the total amount of expected accident damages, given a specific level of care. This is essential when it comes to assessing the social utility of an activity. Finsinger and Pauly (1990) point out that the total net utility of a risky activity ought to be positive. The first aspect can be dealt with quite easily by slightly modifying the optimisation problem as represented in equation (1). The social objective function now has to take into account that various levels of activity influence the utility u of the actor, that is the injurer. It is plausible to assume that utility is an increasing function of activity. Those who are familiar with optimisation problems should also note that for a unique solution to exist it is necessary to assume further that the utility function is well-behaved. From the total amount of utility we need, of course, to subtract the total costs of care which are assumed to be equal to the level of activity multiplied by the level of care, x. Eventually, we need to subtract the total amount of expected damages d. Thus we obtain as the social objective function

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max u (a) − a x − a d (x) (4) To solve this maximisation problem we first have to determine the optimal level of care x* by minimising the total costs of taking care represented by the second and third terms in equation (4). Substituting into (4) and differentiating with respect to the level of activity we obtain u' (a) = x* + d (x*) (5) which is the equivalent of equation (2) in the case of a constant level of activity. The interpretation is straightforward. The injurer should raise her activity as long as the marginal increase in utility she derives from raising activity exceeds the increment to total costs caused by doing so. We can now move on to discussing whether the negligence rule can guarantee that an activity is socially useful. A simple example might illustrate this point. Assume that the utility of an activity is 100. The costs of the optimal level of precaution are 80, and the amount of total damages is 30. Since the victim has to bear the costs of the accident when the injurer exercises due care and, therefore, is not liable, the injurer has a benefit of 20 by engaging in her activity. However, the net utility of the activity is clearly negative meaning that the injurer should not engage in the activity in the first place. Since injurers will escape liability by taking due care they have no reason to consider the effect that their activities have on accident damages. As a result, the rule of negligence can create incentives to exercise an optimal level of precaution, but it is not able to make sure that the social utility of an activity is positive. Yet, there are exceptions where it can be easy for courts to observe the (lack of) social utility of an activity. In these cases, courts can set legal standards for both the optimal level of care and the optimal level of activity. However, because of information costs it is generally difficult for courts to set both standards of caretaking and/or activity levels. Shavell (1987), and Landes and Posner (1987) focus on this issue.

6. Strict Liability We will now turn the discussion to the major alternative of the rule of negligence: the rule of strict liability. Again, we start off by assuming that the legal sanction equals the actual damage and that the activity level is constant. Under strict liability, the courts do not have to set any level of due care because the injurer has to bear the costs of the accident regardless of the extent of her precaution. In this case, the expected amount of costs to the injurer of taking care x is

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c (x) + d (x) (6) that is, the injurer faces the total amount of costs caused by the accident. Since it is the self-interested injurer’s objective to minimise her private costs and since, under strict liability, the total social costs just equal her private costs, the injurer will have an interest to minimise total accident costs. In other words, the social objective function (1) and the private objective function resulting from minimising equation (6) are obviously identical. Therefore, under the rule of strict liability in the case of unilateral accidents, the injurer will choose the socially optimal level of care. As a result, both the rule of strict liability and the rule of negligence achieve the socially optimal level of care. There are, however, also quite a few differences. For instance, the division of costs under each rule is different. Under strict liability, the injurer has to bear the total amount of expected damages, whereas under the negligence rule, the victim has to bear the accident costs if the injurer exercised due care. Further differences appear when relaxing the assumptions we made.

7. Relaxing Assumptions As mentioned in the previous section, the courts do not have to set a level of due care. Under strict liability, all the courts need to do is to determine the size of the damage, whereas, under the negligence rule, the courts also need to determine the level of due care as a legal standard for the socially optimal level, and they have to determine the level of care actually taken in order to see whether the injurer was negligent or not. Proving negligence, however, can be difficult and costly. Shavell (1987, p. 264) argues that under strict liability the number of claims is likely to be higher than under negligence because the victim has an incentive to make a claim whenever her damages exceed the costs of making the claim. Under negligence, on the other hand, the injurer can escape liability by demonstrating that she has not violated the legal standard of care. Since under the rule of strict liability it is not necessary to establish that the injurer was negligent, the probability of trial should be less, because it is easier to predict who is likely to win the case. Consequently, voluntary payments made in the shadow of the law should be much more probable. There is not only more potential for disagreement leading to trial under the negligence rule, it is also plausible to assume that the average administrative cost per claim is higher under negligence because the issue of negligence must be adjudicated, as was mentioned above. As a result, one can expect the average costs of resolving claims to be higher under negligence because of both a higher probability of

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trial and higher costs per trial. Another advantage of the rule of strict liability is that it is the injurer who has to bear the cost of searching for the optimal level of care, as Finsinger and von Randow (1991, p. 89) suggest. In many cases, he is better at deciding what precautions to exercise and to what extent he should do so because he is likely to be familiar with the activity that can cause an accident. Another assumption we made is that the legal sanction equals the damage actually caused. In the previous section we saw that equality is not essential as long as the sanction is sufficiently large for the injurer to conform to the legal standard. Under strict liability, this result changes quite drastically. Whenever damages are not perfectly compensatory, that is, compensation is below the level that would make the victim indifferent between no accident and an accident with compensation, the potential injurer does not have an efficient incentive to exercise the socially optimal level of care. The easiest way to see this is by recalling optimality condition (2) which states that the marginal cost to the injurer of taking an additional unit of care should equal the marginal benefit to the victim represented by a reduction in the total amount of expected damages. Let us assume that the costs of taking care is a linear and increasing function of the level of care, that is any increase in the level of care leads to a proportional increase in accident prevention costs. We also assume that the functional relationship between the level of care and the reduction in accident damages is such that the exercise of precaution reduces expected damages, but at a decreasing rate. Expressed in more mathematical terms, the first derivative of this function is positive and the second derivative is negative. We now assume that the potential injurer knows and expects that the legal sanction generally does not equal the total amount of the accident damages, but that it equals a fraction of them only, because the tortfeasor remains anonymous, damages are higher than her personal wealth, victims are fully insured by first party or social insurance, or the damage is dispersed, which leaves the victim little incentive to litigate. This leads to a proportional downward shift of the damage reduction function. The crucial impact of the proportional shift is that, holding the level of care constant, the marginal reduction in damage and thus the marginal benefit of taking an additional unit of care is less than in the case of perfect compensation. Since, on the other hand, the cost function of taking care is assumed to be linear, the marginal cost of taking care remains constant. As a result, the optimality condition is not met any longer under the circumstances given. In order for the cost minimising condition to be satisfied again, the potential injurer will reduce her level of care which leads to an increase in the marginal reduction in damage by taking care. As a result, the potential injurer does not exercise the socially optimal level of care when damages are not perfectly compensatory.

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Suppose that the tort-liability system works imperfectly in the sense that only a fraction of all victims actually brings suit and recovers. Let us call the ratio of compensated victims to the total number of victims the enforcement error. The efficiency loss due to enforcement errors can be offset by augmenting compensatory damages with punitive damages. In order to restore efficient incentives for the potential injurer to exercise optimal care we need a punitive multiple (multiplicative factor by which compensatory damages are adjusted to offset the enforcement error) that equals the inverse of the enforcement error. If, for instance, only half of the total number of victims actually bring suit then the courts should double compensatory damages when calculating total damages. Thus, compensatory damages and punitive damages add up to total damages. References for issues related to punitive damages and their allocative effects are Cooter (1982) and Kolstad, Ulen and Johnson (1990). Finally, we relax the assumption of a constant level of activity. Recall that under negligence the net utility of an activity could be negative because the injurer had no reason to consider the effect that her activity had on others as she can escape liability by taking due care. Under strict liability, however, the injurer has to bear the total social costs of an accident, that is the sum of the total precaution costs and the total accident damages, regardless of the level of precaution she takes. She cannot escape liability, and the effects of activity on risk and accident costs are fully internalised. Therefore, the injurer will engage in an activity if and only if the net utility of that activity is positive. Put more generally, given the possibility of escaping liability, the injurer will not be motivated to consider the effect on the total amount of harm of the level at which she engages in her activity. She will consider her private benefits only. Any increase in activity, however, will raise the total amount of expected accident damages given the level of care. Thus, the injurer will choose too high a level of activity (see for example Polinsky, 1980). Under strict liability, the injurer internalises the total amount of social costs and reduces the level of activity to the socially optimal level. This conclusion was first clearly stated by Shavell (1980).

8. Bilateral Accidents We now extend the analysis made above to cases where both parties in an accident may contribute to the accident costs. Again, this section is based mainly on Schäfer and Ott (1995), Shavell (1987), but also on Adams (1985), and Cooter and Ulen (1997). One of the first economists to study these issues was Brown (1973) who introduced the use of the assumption that the probability that an accident will not occur is a function of the caretaking of both the tortfeasor and the victim. In fact, it is rare that an accident is due to one

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party (that is the injurer) only. It is much more common that the victim can also exercise some precaution to prevent an accident. What makes bilateral accidents quite a complicated issue to look at is the interdependence of the parties' behaviour. We will see that in many cases the choice of one party in terms of levels of activity and care essentially depends on the other party’s choice. Since we now also have to take into account the victim’s ability to reduce the probability or size of an accident, we need to modify the social objective function given above. If we denote the level of care taken by the injurer by x, as before, and if y measures the level of care taken by the victim, the social objective function now becomes min c (x) + c (y) + d (x,y) (7) where d(x,y) denotes the total amount of expected damages which, of course, depends on the level of care exercised by both parties. Let x* and y* denote the socially optimal values of x and y. There are now two conditions determining the optimal levels of care. First, c' (x) = − dx (x,y*) (8) with dx being the partial derivative of d with respect to x and with y assumed to be optimal. What it says is that the marginal cost to the injurer of taking an additional unit of care should equal the marginal benefit of the reduction in the expected cost of the accident, provided that the victim chooses the socially optimal level of care. Second, c' (y) = − dy (x*,y) (9) which says that the marginal cost to the victim of increasing her level of care should equal the marginal benefit of the expected reduction in accident costs, provided that the injurer chooses the socially optimal level of care. The fact that the socially optimal solution requires that both parties exercise optimal care will be crucial in the analysis that follows.

9. The ‘Cheapest Cost Avoider’ Before discussing and comparing the various liability rules in the case of bilateral accidents we want to examine cases which exhibit properties of both unilateral and bilateral accidents. This version can emerge when either the injurer or the victim (or a third person) are able to prevent the accident. Note the distinction: unlike in the case of unilateral accidents, it is now not only the injurer, but also the victim who can prevent the accident. And unlike in the case of bilateral accidents where typically both parties need to exercise care to achieve the socially optimal and efficient outcome, it is now either the injurer

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or the victim who has to take care to achieve the socially optimal result. As Calabresi (1970) argues, in these cases, the person should be held liable who could have prevented the accident with the least cost of taking care (cheapest cost avoider). The idea is quite simple: We know that as long as property rights are well-defined and there are no transaction costs, trade between agents would result in an efficient allocation of resources when there is an externality, a conclusion commonly known as the Coase Theorem (see Coase, 1960). Furthermore, note that what is known as causation in tort law can be reinterpreted as an externality in economics. An externality can be defined as a cost that the action of a person imposes on others without their consent. The prevention of an accident would therefore be undertaken by the party who could do so with the least cost (cheapest cost avoider). However, this solution will not be achieved because of prohibitive ex ante costs of bargaining about who should be held liable for possible accident damages. In this case, the courts should place the burden of covering the costs of the accident on the individual who can avoid the accident at the lowest cost no matter whether it is the injurer, the victim, or a third party.

10. Rule of No Liability As before, if the injurer cannot be held liable for the harm she causes, she will choose the lowest possible level of care, that is zero, to minimise her cost. This may also lead the victim to exercise excessive care. As we have seen in the previous section, this is clearly not optimal because accident costs will be excessively high.

11. Negligence Recall that the rule of negligence imposes the obligation to satisfy a legal standard of care usually defined as due care. The injurer is therefore liable unless he can prove that he has exercised due care. We now continue our analysis by introducing, discussing, and comparing several forms of the negligence rule (see for example Wittmann, 1986; Haddock and Curran, 1985). Let us begin with the simplest form of negligence. Simple Negligence The properties of this rule are basically the same as in the unilateral case, that is, the injurer is liable if and only if her level of precaution is below the legal standard regardless of the precaution level exercised by the victim. Assume now that the level of due care chosen by the courts equals the socially optimal level.

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Injurers will therefore have an incentive to exercise due care in order to escape liability. Hence, the victim faces the costs c (y) + d (x*,y) (10) and will choose the level of care that minimises this expression. Setting the first derivative with respect to y equal to zero we obtain equation (9), one of the two optimality conditions in the bilateral case. If the injurer expects that the self-interested victim will exercise due care, the same arguments as in the unilateral case apply. The injurer faces the costs c (x) + d (x,y*) (11) and will choose the level of care that minimises this expression. Again, setting the first derivative with respect to x equal to zero we obtain equation (8), the other optimality condition in the bilateral case. Therefore, we can conclude that the simple negligence rule leads to socially optimal levels of care. The outcome is a Nash equilibrium which can be expected to emerge straightaway because a rationally self-interested person will assume that another equally self-interested person has decided to exercise efficient precaution and, that being so, it is reasonable for that person also to exercise efficient precaution. Generally, a pair of strategies is said to be a Nash equilibrium if player A’s choice is optimal given B’s choice, and player B’s choice is optimal given A’s choice. It is standard in the literature to assume the existence of a Nash equilibrium. However, there might be problems of existence, even in the case of well-behaved functions (see, for example, Endres and Querner, 1995). It is also standard to discuss bilateral accidents in the context of a Nash framework (for a reference that points to alternative approaches (see Endres, 1992). Finally, note that under the rule of simple negligence there is no need to establish a legal standard of care for the victim. This conclusion changes under the following rules. Negligence with the Defence of Contributory Negligence Under this rule, the injurer will be held liable if she does not take due care, and if, in contrast to this, the victim does take due care. The injurer will not be held liable if she either takes due care or if the victim does not take care. In other words, in comparison to simple negligence, the injurer now has, apart from the exercising of due care, an additional possibility to escape liability by showing that the victim failed to take due care. To see whether this rule leads to a socially optimal outcome, we can use the same line of argument as before. If the injurer assumes that the victim takes due care to avoid liability, she will also have an incentive to do so for the same reason. This, in turn, leads the victim to take due care because she now has to bear the total amount of damages. She can minimise these costs by taking due

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care. Since the injurer is aware of this, it is reasonable for her to take due care herself and so on. Again, we have a stable and unique equilibrium, and a socially optimal result will be achieved. Comparative Negligence Rule The difference between this rule and the two previous ones is that, when both parties are negligent, the accident costs are divided between them in proportion to the extent of their negligence. One way of doing this is to calculate the ratio of the differences between the due level of care and the actual level of care. If the courts choose optimal levels of due care, then both the injurer and the victim will exercise due care. The rationale is precisely the same as before. Again, we can conclude that the outcome under this rule is socially optimal. When comparing the various versions of the negligence rule we come to the conclusion that none of these versions is more or less efficient than the others (efficiency equivalence theorem, see Orr, 1991; Rubinfeld, 1987). They all lead to socially optimal outcomes, provided that the courts set the legal standard of precaution at the efficient level, because self-interested agents have an incentive to choose the legal standard of care. The reason for this is, in essence, that whenever one party exercises due care, then it is entirely upon the other party to decide whether it alone will be held liable by failing to take due care. However, as White (1989) argues, there is empirical evidence that, in contrast to the equivalence theorem, contributory negligence provides better incentives to avoid accidents. An analysis of how these results change when relaxing and modifying some of the underlying assumptions will be given later. First we will examine various forms of strict liability.

12. Strict Liability As in the previous section, there are several forms of the strict liability rule to consider. We begin with the simplest form of strict liability. Simple Strict Liability In this case, the injurer has to bear the total amount of accident costs regardless of the extent of her precaution. Conversely, the victim will be compensated for all costs imposed on her which implies that the marginal benefit to the victim of taking an additional unit of care is zero for any level of care. Thus, it is optimal for the victim to choose a zero level of care because at zero level the marginal cost of taking care equals zero, and her private optimality condition is satisfied. Of course, optimality condition (9) is not met and the outcome is not socially optimal because the marginal benefit of increasing the level of care

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exceeds the marginal cost to the victim. Strict Division of Losses Under this liability rule, the injurer has to pay a fraction f of the accident costs. Hence, the injurer faces the costs c (x) + f . d (x,y) and the victim faces the costs

(12)

(13) c (y) + (1 − f) . d (x,y) It is crucial to note that the size of the fraction is assumed to be independent of their levels of care. Thus, the first order conditions are c' (x) = − f . dx (x,y)

(14)

and (15) c' (y) = − (1 − f) . dy (x,y) Comparing these optimality conditions with conditions (8) and (9) it is clear that, at any level of care, the marginal benefit of taking care is less under strict division. Since parties save only a fraction of the true reduction in accident losses by taking care, they have too little incentive to exercise a socially optimal level of care. Strict Liability with the Defence of Contributory Negligence Under this rule, the injurer is liable for the accident losses unless the victim's level of care was less than her due level of care. It is straightforward to show that under this rule the outcome is socially optimal, provided that the courts choose the level of care for victims equal to the socially optimal level of care. The rationale is the same as under the various versions of the negligence rule. Since injurers will be liable for accident damages if victims take due care and therefore will not bear the accident costs, injurers will exercise due care to minimise accident costs. On the other hand, victims will exercise due care because they do not want to be found contributorily negligent. Again, we obtain a socially optimal Nash equilibrium as a result. Strict Liability with the Defence of Relative Negligence This rule is basically the same as the previous one with the following difference: if the victim is found negligent because she failed to take due care, she will have to bear only a fraction of her losses. If the fraction depends on the victim's actual level of care relative to due care, if it is sufficiently large, and if the courts choose the legal level of care equal to the socially optimal level of care, then the outcome is socially efficient. The rationale is the same as before.

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13. Relaxing Assumptions Recall the first simplifying assumption that the court sets the level of due care equal to the socially optimal level. In the section on unilateral accidents, we conclude that under strict liability the courts need only determine the size of the damage, whereas under negligence the courts must in addition calculate the socially optimal level of due care, and they have to determine the level of care actually taken in order to see whether the injurer was negligent or not. In bilateral accidents, however, this result holds true only for the rule of simple strict liability which, as we saw in the previous section, does not achieve socially efficient results. Those forms of strict liability that lead to socially optimal outcomes have the same requirements with respect to their ease of application as the various rules of negligence. The only difference affecting the ease of application of the two rules is that under strict liability the courts do not need to determine the actual level of care of the injurer. The second assumption concerns the equality between the legal sanction and the damage actually caused. In the case of unilateral accidents we see that, whenever damages are not perfectly compensatory, the potential injurer does not have an efficient incentive to exercise the socially optimal level of care. In the case of bilateral accidents, this result holds true only for, first, the potential injurer, and second, under the rule of simple strict liability. For instance, it is important to note that, under simple strict liability, undercompensation would tend to create an incentive for the victim to exercise precaution by creating some residual liability. This is also how insurance companies deal with the problem of moral hazard. Since, however, the incentive problem of the potential injurer remains unsolved, undercompensation cannot lead to socially optimal results. Also, we should note that, under the rules of strict liability with the defence of contributory or relative negligence, equality between the legal sanction and the harm does not matter as long as the sanction is sufficiently large so that the private costs of the parties are minimised by conforming to the legal standard. These are, of course, the same results as under the rules of negligence. Finally, the third assumption eventually refers to the constant level of activity. Recall that in the case of unilateral accidents the rule of strict liability and the rule of negligence produced different results. Under negligence, the injurer had no reason to consider the effect that her activity has on others and would therefore choose too high a level of activity. Under strict liability, on the other hand, the injurer internalises the total amount of social costs and therefore reduces the activity level to the socially optimal level. The crucial condition in order for any liability rule to lead to a socially efficient level of activity is that the parties engaging in some activity must bear the total amount of accident losses. Otherwise only a fraction of the activity’s costs are

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internalised, and the level of activity will be too high. As a matter of fact, though, it is impossible for both parties to bear the accident losses. Therefore, results change quite drastically in the case of bilateral accidents as compared to unilateral accidents. As Shavell (1987, p. 29) puts it, the reason, in essence, is that for injurers to choose the correct level of activity they must bear accident losses, but for victims to choose the correct level of activity they, too, must bear accident losses. Yet, of course, injurers and victims cannot both bear accident losses under a liability regime, but the problem can be nicely solved by using Pigou taxes, which has led Baumol and Oates (1988) to prefer a system of Pigou taxes to liability as a matter of principle. As a result, in bilateral accidents no liability rule leads to socially optimal levels of activity. This implies that the net utility of an activity can be negative, as the following example illustrates. In bilateral accidents, an activity is socially useful if the utility to the injurer less the precaution costs to both the injurer and the victim less the costs of the accident is positive. Assume now that the utility is 100, optimal precaution cost to the injurer is 40, optimal precaution cost to the victim is 30, and the expected accident cost is 50. Obviously, the activity is not socially useful because its net utility is negative. Note, however, that under both the rule of negligence and the rule of strict liability the injurer will engage in the activity. Under negligence, his private utility is 100 - 40 = 60, and under strict liability, his private utility is 100 - 40 - 50 = 10. This is because, as noted above, the injurer does not take into consideration the precaution cost of the victim. A theoretical possibility to achieve a socially optimal outcome would be to establish the legal obligation for the injurer to bear her own precaution cost, the accident cost, and also the precaution cost of the victim (see for example, Rose-Ackerman, 1989).

14. Comparing Strict Liability and Negligence Let us now summarise some of the main results of the previous sections. In the case of unilateral accidents, both the rule of strict liability and the rule of negligence achieve a socially optimal outcome, provided that courts set the level of due care equal to the socially optimal level of care, that the legal sanction equals the harm, and that the level of activity is constant. Relaxing these assumptions provides further insights favouring the rule of strict liability. Under strict liability, all the courts need to do is to determine the size of the damage, whereas, under the negligence rule, the courts also need to determine the level of due care as a legal standard for the socially optimal level, and they have to determine the level of care actually taken in order to see whether the injurer was negligent or not. These information requirements are difficult and costly to acquire. Moreover, the average costs of resolving claims tend to be

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higher under negligence. A major drawback of the rule of strict liability in unilateral accidents, though, emerges when we relax the second assumption. Whenever damages are not perfectly compensatory, that is, compensation is below the level that would make the victim indifferent between the case of no accident and that of an accident with compensation, the potential injurer does not have an efficient incentive to exercise the socially optimal level of care. Another important advantage of the rule of strict liability emerges when allowing for variable levels of activity. Under negligence, the injurer has no reason to consider the effect that her activity has on others because she can escape liability by taking due care. Thus, the injurer will choose too high a level of activity. Under strict liability, the injurer internalises the total amount of social costs and reduces the level of activity to the socially optimal level. So far the results suggest that the rule of strict liability achieves socially optimal results provided that damages are set at the perfectly compensatory level. What happens, though, when an accident is bilateral requiring both parties to take precaution against accidents? Now the efficiency of the rule of strict liability becomes problematic because, even though strict liability may at first create the right incentives for potential injurers, it will create an incentive problem for potential victims and will in return lead injurers to exercise suboptimal care. This can be seen by noting that strict liability is the mirror image of no liability. One rule fails to create incentives for precaution by the victim, the other rule fails to create incentives for precaution by the injurer. Therefore, our analysis suggests that in the case of bilateral accidents we should apply either one of the negligence rules or the rules of strict liability with the defence of contributory or relative negligence. All of them lead to socially optimal outcomes, provided that the courts set the legal standard of precaution at the efficient level, because self-interested agents have an incentive to choose the legal standard of care. This conclusion is reinforced when allowing for inequality between the legal sanction and the damage actually caused. Under any of the negligence rules and under the rules of strict liability with the defence of contributory or relative negligence, equality between legal sanction and harm does not matter as long as the sanction is sufficiently large so that the private costs of the parties are minimised by conforming to the legal standard. When allowing for various levels of activity, finally, we concluded that no liability rule at all leads to socially optimal levels of activity. This conclusion again confirms that in the case of bilateral accidents the negligence rules or the rules of strict liability with the defence of contributory or relative negligence are equivalent.

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15. Liability and Contracts In the previous sections of this article, we concentrated on situations where parties do not enter into contractual relationships because of high transaction costs such as the costs of bargaining. The notion of transaction costs, however, is crucial for the analysis of liability and deterrence. Recall the basic insight of the Coase Theorem which says that when parties can bargain with each other in order to settle their disagreements, their behaviour will be efficient regardless of the underlying rule of law. This implies that, whenever transaction costs are low, people enter into contractual relationships and the rules of contract law apply. Conversely, whenever transaction costs are high, people do not enter into contractual relationships and the rules of tort apply. There are a few areas, however, where tort law and contract law seem to merge, such as ‘products liability’ and ‘implicit contracts’. We now examine the allocative effects of various forms of liability rules in those cases where parties have entered into contractual relationships. We assume profit-maximising behaviour of firms and perfect competition. That is, the price of a product equals total unit costs including liability costs. It is also assumed that rational consumers buy a product only if the utility of the product exceeds its perceived price, that is, the price actually charged plus expected accident costs not covered by liability payments. If the customers’ knowledge of risk is perfect, firms will take optimal care under any liability rule, even under the rule of no liability. This is because customers would immediately notice whether firms took less than optimal care or not. Thus, the perceived price of the product including expected losses would be higher than the product price of firms exercising optimal care. The potential loss of customers forces firms to exercise optimal care regardless of the underlying rule of liability. Also, the level of consumption is optimal because the price of the product as compared by customers with their utility includes expected accident losses. These results change, however, once we assume that customers have imperfect knowledge of the risk associated with a product. If customers cannot determine product risks, they will not reward firms for making products safer. Therefore, firms do not have any incentive to take optimal care unless there is some rule of liability. Moreover, under the rule of no liability and under the negligence rule, the level of consumption will not be optimal. Only under strict liability does the misperception of risks not matter, because customers are fully compensated for their losses anyway, and market prices reflect the true risk of accident losses. In all other cases, market prices, and thus consumption, are either too high or too low.

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16. Multiple Tortfeasors We now turn to the case of multiple tortfeasors. Landes and Posner (1980) were the first authors to study the incentives to take care in the case of multiple tortfeasors, yet restricting their attention to negligence. For a more general discussion see Kornhauser (1989). We will consider situations where there is more than one injurer affecting the probability of accident losses. Furthermore, we need to distinguish between cases where injurers act independently with the victim’s harm being indivisible, and cases where injurers act together (in concert) to cause the victim’s harm. Under strict liability, injurers who act independently will not always act optimally in equilibrium. Assuming that each injurer is liable for a fixed fraction of losses only, any increase in the injurer’s exercise of care diminishes her liability by only a fraction of the reduction in expected losses which induces the injurer to take a level of care clearly below the optimal level of care. When injurers act together, however, their minimisation problem obviously turns into a situation exactly equivalent to the one where there is only a single injurer. Thus, under strict liability and if injurers act in concert, injurers take optimal care. Note that this result is not obtained if injurers pay a fraction identical to their probability of causation. Under the rule of negligence, we obtain different results. Injurers will now act optimally (they will take due care) in equilibrium both in cases where they act independently and in cases where they act together, provided that the due level of care is optimally determined, of course. Again, the analysis is straightforward and is precisely analogous to the previous analysis of situations of bilateral accidents. If one injurer alone fails to take due care, she will be held liable for the total amount of accident losses. A rationally self-interested injurer will now assume that another equally self-interested injurer has decided to exercise efficient precaution and, that being so, it is reasonable for that injurer also to exercise efficient precaution. Note that this outcome is unique and stable, and that it also holds true if injurers act in concert.

17. Risk Aversion, Liability Law and Insurance So far we have constrained our analysis to the case of risk-neutral parties. We will now extend the analysis by allowing for risk-averse individuals, and we will discuss the interaction between risk aversion, liability law and insurance. Risk aversion depends on the concavity of the utility function of wealth, that is the rate at which utility losses grow with losses of wealth. The concavity of the utility function implies that a $1,000 loss will cause greater harm to a person with assets of $10,000 than to a person with assets of $100,000. The

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shifting of risks from the more to the less risk-averse will raise social welfare given that social welfare is the sum of the individuals’ expected utilities. Social welfare will also increase if risks are shared among risk-averse parties thereby reducing the potential extent of the losses that each party might suffer. One way of shifting and sharing risks is by insurance. Insurance can be described as a private system of liability law in which contracts determine the allocation of risks. In the theory of insurance, a distinction has to be made between the cases in which the insured persons can influence risks and the cases in which they cannot. In the situations where the probability of damage cannot be affected by the actions taken by the insured persons, an insurance policy that offers complete coverage is socially optimal. If the insured, however, can influence risks, complete reimbursement creates the problem of moral hazard: the individual has no incentive to take care at all. We now turn to the discussion of the interaction between risk aversion, liability law and insurance. Under the assumption that injurers are subject to liability, but that there is no insurance, the comparison of liability rules shows that the rule of negligence is preferable when victims are less risk-averse than injurers, and the rule of strict liability is preferable when the reverse holds true. The rationale behind these results is that under the negligence rule injurers will not bear risk when taking due care, whereas victims will bear their losses. Thus, social welfare will be lower if victims are more risk-averse than injurers. The outcome is quite different under the rule of strict liability. Injurers will bear risk regardless of the level of care they take. If injurers are more risk-averse than victims social welfare will decrease. Under the assumption that insurance is available, both the rule of negligence and the rule of strict liability yield socially optimal outcomes because individuals, if risk-averse, can obtain liability insurance. The more efficient rule is the one that costs less. Assuming, for instance, that consumers can insure more cheaply than manufacturers strict product liability should be limited.

18. Liability and Uncertain Legal Standards In the real world, legal standards are frequently uncertain. Factors leading to uncertainty are, amongst others, courts’ errors in determining due levels of care, courts’ errors in assessing a party’s true level of care, and parties’ inability to control their momentary level of care. Craswell and Calfee (1984) focus on this issue. These sources of uncertainty change the deterrent impact of legal rules by creating two opposing effects. The first effect can give even risk-neutral parties an incentive to overcomply, that is injurers take more precaution than is prescribed by the legal standard of care. Overcompliance enables potential injurers to increase the chance that they will not be held

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responsible for the social costs of their behaviour, thus giving themselves a margin of error to be sure that they avoid liability. However, uncertainty also reduces incentives to comply by creating a positive chance that someone who violates the legal standard will not be held liable. In order to determine whether the net incentives are to undercomply or to overcomply we need to know the relative strength of these two effects. It is difficult, however, to identify the exact relationship between a defendant’s behaviour and the actual probability of her being held liable. In general, uncertainty will tend to lead parties to take more than due care as long as there is a positive probability of underassessment of their levels of care and uncertainty is relatively small. If there is, on the other hand, a high enough chance of overassessment of care and if the uncertainty generated by the legal system is relatively broad, parties are likely to take less than due care. More specifically, under the two seemingly plausible assumptions that uncertainty is distributed normally around the optimal level of compliance and that the distribution of errors is not too dispersed, the result under any liability standard will be too much precaution. Note, however, that overprecaution is less under comparative negligence than it is under any other form of the negligence rule because under comparative negligence losses are shared between the two parties rather than being concentrated on one party. This possible effect of an uncertain precautionary standard cannot, of course, arise under a system of strict liability. The picture changes drastically, however, if an uncertain legal standard is combined with a total damage compensation which is higher than the total loss of society. This possibility arises especially in the case of economic losses. Wrongful behaviour can lead to economic losses for some parties and, at the same time, to economic gains for other parties that are such that the total social losses are only a small fraction of the economic losses. Thus, a system of strict liability results in overcompensation and overdeterrence. Under a negligence rule, overcompensation does not distort the incentives if the standard of due care is precisely defined as the tortfeasor can avoid excessive cost by complying with the legal standard. If, however, the standard is not precise, negligence will almost certainly lead to overcompliance because there is an extra pay-off decreasing the probability of being held liable. In some legal orders, this problem is solved by negligence rules which restrict compensation to cases of obvious negligence or to wilful behaviour such as in § 826 of the German Civil Code. This makes the negligence standard more precise and thus avoids overdeterrence.

Acknowledgments The authors are indebted to two anonymous referees for their helpful

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comments. The usual disclaimer applies.

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Other References Baumol, William J. and Oates, Wallace E. (1988), The Theory of Environmental Policy, Cambridge, Cambridge University Press. Coase, Ronald H. (1960), ‘The Problem of Social Cost’, 3 Journal of Law and Economics, 1-44. Keeton, W.P., Dobbs, D. et al. (1984), Prosser and Keeton on Torts, St. Paul, West Publishing Company. Zweigert, Konrad and Kötz, Hein (1996), Einführung in die Rechtsvergleichung, Amsterdam, NorthHolland.

Cases United States v. Carroll Towing Co., 159 F.2d 169 (2nd Cir.1947).

3200 JOINT TORTFEASORS Lewis A. Kornhauser Alfred and Gail Engelberg Professor of Law New York University School of Law

Richard L. Revesz Professor of Law New York University School of Law © Copyright 1999 Lewis A. Kornhauser and Richard L. Revesz

Abstract This chapter compares the properties of joint and several liability with those of non-joint liability. It considers three criteria: deterrence, settlement inducing properties and fairness. The analysis is performed for both full and limited solvency. The central conclusion is that neither rule dominates the other. With respect to deterrence, the relative desirability of the two rules depends on the levels of solvency of the defendants. In contrast, with respect to settlements and fairness, the comparison turns on the correlation of the plaintiff’s probabilities of succes against the defendants. JEL classification: K1, K2, K4 Keywords: Joint and Several Liability, Settlement, Joint Tortfeasors, Hazardous Waste Regulation

1. Introduction The law and economics analysis of joint tortfeasors focuses on the comparison between joint and several liability and non-joint (several only) liability. Part A provides a brief background of the legal regimes. Parts B, C and D compare, respectively, the deterrence, settlement effects and fairness of the two rules.

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A. Legal Regimes 2. Legal Regimes The choice between joint and several liability and non-joint liability arises in situations in which the plaintiff’s injury results from the actions of multiple parties. Under joint and several liability, if the plaintiff litigates against many defendants and prevails against only one, he can recover his full damages from that defendant; if the plaintiff prevails against all defendants but some are insolvent, he can recover his full damages from the solvent defendants; and if the plaintiff prevails against all defendants and all are solvent, he can nonetheless choose to recover his full judgment from any defendant or to a recover a portion from each. In contrast, under non-joint liability, the plaintiff can recover from a losing defendant only the share of the damages attributable to that defendant. For joint and several liability, the legal regime needs to be specified further. As shown in Kornhauser and Revesz (1993), the various choices presented below can affect the economic analysis of the consequences of joint and several liability. First, a right of contribution permits a defendant that has paid a disproportionately large share of the plaintiff’s damages as a result of the application of joint and several liability to obtain compensation from a defendant that has paid a disproportionately small share of these damages. Absent a right of contribution, such reallocation is not possible. Second contribution shares are usually determined either pro rata (equal division among the defendants) or by reference to comparative fault. Third, the question of an appropriate set-off rule arises when the plaintiff settles with one defendant and litigates against the other. Under the pro tanto set-off rule, the plaintiff’s claim against the non-settling defendant is reduced by the amount of the settlement. In contrast, under the apportioned share set-off rule (sometimes referred to as a proportional set-off rule), the plaintiff’s claim against the non-settling defendant is reduced by the share of the liability attributable to the settling defendant. Fourth, under the pro-tanto set-off rule, when one defendant settles and the other litigates and ultimately loses, the question arises whether the settling defendant is protected from contribution actions. Fifth, the legal regime must also specify whether settling defendants are entitled to bring contribution actions against defendants who settled for less than their share of the liability. Sixth, under the pro-tanto set-off, if the plaintiff enters into an inadequately low settlement with one defendant, the other defendant is responsible for the shortfall if he litigates and loses. To protect the interests of non-settling defendants, courts sometimes require ‘good faith’ hearings on the adequacy of settlements.

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Seventh, if the plaintiff joins all the joint tortfeasors in a single suit, his claims against all of them will be adjudicated in the same proceeding. If the plaintiff chooses not to join all the tortfeasors as defendants, the question arises whether a named defendant can join another tortfeasor as a third-party defendant. Otherwise, the named defendant would have to file a separate action for contribution after the adjudication of his liability to the plaintiff.

B. Deterrence 3. Deterrence: Several Remarks We compare here the deterrence effects of joint and several liability and non-joint liability, when coupled with both rules of negligence and strict liability. We perform the comparison first for cases in which the defendants are fully solvent (Kornhauser and Revesz, 1989) and then consider the effects of limited solvency (Kornhauser and Revesz, 1990). We develop our argument by reference to a model in which two firms, Row and Column, dump hazardous wastes at a single landfill. The actors benefit from this dumping because the wastes are the byproduct of profitable economic activity. At some time in the future, these wastes may leak into the environment and cause serious damage; we think of this damage as the cost of cleaning up the landfill and the surrounding area affected by the release. We take the damage function to be convex (the additional damage caused by one unit of waste increases with increasing amounts of waste in the landfill). The expected damage of a release is a ‘social’ loss because it does not fall directly on the dumpers absent a legal provision shifting the liability to them. Instead, it falls on the victim that would have legal responsibility for the cleanup, or, alternatively, that would suffer the consequences if the problem were left unattended. Under our model, each dumper chooses the amount of waste that it will dump. The socially desirable amount of waste is that which maximizes the social objective function: the sum of the benefits derived by the actors minus the social loss. An economically rational firm, however, does not make this decision based on the social objective function. Instead, it seeks to maximize its private objective function: the benefit that she derives from the activity that leads to the production of the waste minus whatever share of the social loss the legal regime allocates to her. We model a joint and several liability regime with contribution shares determined by reference to the amount of waste dumped. (Other rules are considered in Landes and Posner, 1980; Kornhauser and Revesz, 1989; Tietenberg, 1989 and Wright, 1988, pp. 1169-1179.) We assume that a plaintiff, say for example the government, sues both defendants in the same proceeding and we exclude the possibility of settlement (the deterrence effects

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of joint and several liability when settlement is possible are analyzed in Kahan, 1996 and Spier, 1994).

4. Full Solvency: Negligence We assume in the case of negligence that the standard of care will be chosen at the level that maximizes social welfare; departures from the social optimum in setting the standard of care are considered in Kornhauser and Revesz (1989, pp. 862-870). For expositional convenience, we assume that negligent actors are liable only for the losses that would have been prevented through due care (in this example, for the additional losses that result if a firm dumps more than the socially optimal amount, rather than the socially optimal amount). We show in Kornhauser and Revesz (1989) that essentially the same results hold if negligent actors are responsible for the full losses (even ones that would have occurred with due care). Under these circumstances, joint and several liability will produce the socially optimal result. If one of the actors, say Row, is non-negligent, it would not be rational for Column to be negligent. If this actor were contemplating dumping more than the standard of care, she would face liability for the full increase in the resulting damage. If the standard of care is set at the social optimum, the increased benefits that this actor would obtain through negligent conduct would be less than the increase in the damage for which she would be liable. Thus, assuming that one of the actors is non-negligent, the remaining actor will be non-negligent as well. This argument shows that it is a Nash equilibrium for each actor to meet her standard of care. We now show that this efficient Nash equilibrium is unique. Consider whether it would be rational for both actors to be negligent. These actors will, jointly, face liability equal to the full increase in the resulting damage. If negligent action on the part of these actors were preferable to non-negligent action for each of them, then the total social welfare would exceed that attainable when all actors meet the standard of care which, once again, is not possible if the standard of care is set at the social optimum. Thus, regardless of how the increased damage was allocated between the defendants, at least one of them would have to pay more than the increased benefit that it obtained by acting negligently. An equilibrium in which both actors are negligent is therefore not possible. The analysis is different for a non-joint liability rule, under which a negligent defendant would not be liable for the share of the damage attributable to the non-negligent defendant. Instead, the negligent defendant would be liable for an amount proportional to waste that it had dumped. Assume that Row is non-negligent and that Column is contemplating dumping more than the standard of care. Column would then pay only a fraction of the increase in damage. Under this apportionment rule, the remainder of the increase would

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be attributable to Row and would be unrecoverable by the plaintiff as a result of Row’s lack of negligence. Thus, in this situation, non-joint liability leads to under-deterrence.

5. Full Solvency: Strict Liability The analysis is different for strict liability. Under strict liability, as long as both actors are fully solvent, there is no difference between joint and several liability and non-joint liability. Strict liability ensures that the victim is compensated for the full damage and thus the question whether the victim will have to bear the share of the damage caused by the actions of non-negligent defendants does not arise. Assume that Row is dumping the optimal amount of waste (the amount that would have met the standard of care if a rule of negligence had been in effect) and that Column is contemplating whether to dump more than this amount. Such a decision on the part of the Column would, of course, increase the damage to the victim. Column would, in turn, be liable for a larger share of the damage, as he would pay in proportion to the amount of waste that he dumped. As long as the damage function is convex, however, the increase in Column’s liability is less than the increase in the social loss. Thus, Column’s decision to dump more than the socially optimal amount has the effect of increasing Row’s liability as well. As a result of this externality, strict liability leads to under-deterrence, regardless of whether it is coupled with joint and several liability or non-joint liability. Miceli and Segerson (1991) consider a modification of the strict liability rule that does in fact lead to efficiency both in terms of the level of care adopted and of entry into the activity. Under their formulation, each actor is responsible for the marginal damage that it causes. This rule, coupled with the assumption of convex costs, implies that the total payments from two defendants would exceed the plaintiff’s actual damages.

6. Limited Solvency Here, each defendant is defined not only by her benefit function (the rate at which her generation of waste is transformed into net benefits) but also by a fixed solvency, which represents the actor’s available amount of assets to offset her share of the social loss. Under this formulation of the problem, the actors cannot shed their solvencies over time. We present here the analysis for strict liability, which makes it possible to explain the basic intuitions. The comparison of joint and several liability and non-joint liability under negligence when the actors have limited solvency is presented in Kornhauser and Revesz (1990). Consider a situation under which Row’s solvency is zero and Column’s solvency is infinite, and that both firms are otherwise identical. The liability

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rule thus transmits no deterrence incentive to Row. Row will therefore dump up to the point at which any additional benefit (in terms of reduced costs of production) from additional dumping becomes zero. This amount, which we call xH, is greater than x(4), the amount that Row would have dumped if both defendants had been infinitely solvent. Note that, as a result of the underdeterrence caused by strict liability, discussed above, x(4) is in turn larger than x*, the socially optimal amount of dumping by Row. Under joint and several liability, because Row has no solvency, Column will be responsible for the whole liability and will dump an amount a (smaller than x*), which is the optimal amount of dumping by Column conditional on Row being insolvent. The equilibrium is thus (xH, a). If Column is not infinitely solvent, there are two possible equilibria: (xH, a), if Column’s solvency is greater than a critical solvency which we call sj or (xH, xH), if Column’s solvency is lower. In contrast, under non-joint liability, Column is not responsible for the whole liability, but only for its proportional share. If Column has infinite solvency, it will dump b, an amount larger than a, though smaller than x*. Here, too, there are two possible equilibria if Column is not infinitely solvent: (xH, b), if Column’s solvency is greater than a critical solvency which we call snj or (xH, xH), if Column’s solvency is lower. Because for any level that it dumps Column faces less liability under a rule of non-joint liability, over a larger range of solvencies it chooses to act as if it were infinitely solvent rather than wholly insolvent. Thus, snj is smaller than sj. Table 1 summarizes the relevant equilibria. Table 1 Equilibria Under Joint and Several Liability and Non-Joint Liability Region

Column’s Solvency

Equilibria Joint and Several Liability

Non-Joint Liability

A

0 - snj

(xH, xH)

(xH, xH)

B

snj - sj

(xH, xH)

(xH, b)

C

sj - 4

(xH, i)

(xH, b)

In region C in Table 1, joint and several liability is therefore preferable to non-joint liability. From a social welfare perspective, an equilibrium at (xH, a) is preferable to an equilibrium at (xH, b). When one actor is generating xH, joint and several liability makes the other actor see the full social cost of its actions, whereas non-joint liability does not. Thus, a is the optimal response by Column to Row’s choice of xH.

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In region B, however, the reverse is true. Joint and several liability induces Column to act in the same manner that it would if it were wholly insolvent, dumping xH, whereas non-joint liability induces Column to act in the same manner that it would if it were infinitely solvent, dumping b. Thus, in this region, non-joint liability has better social welfare properties. (Of course, in region A, both rules have the same properties.) This discussion illustrates that, when solvency is limited, neither rule dominates the other. (The same is true under negligence (Kornhauser and Revesz, 1990.) The intuition behind this result is that Row’s insolvency creates a ‘domino’ effect, leading Column, under certain circumstances, to act as if it were insolvent as well. Because under joint and several liability Column is responsible for a greater proportion of the total harm, the range under which this ‘domino’ effect occurs is greater. In a model in which an actor’s probability of insolvency is independent of the other actor’s solvency (or probability of insolvency), a ‘domino’ effect is not possible and the results are different (Watts, 1998).

C. Settlements 7. Settlement: Basic Framework The basic framework for the analysis of the impact of joint and several liability on settlements is set forth in Kornhauser and Revesz (1994a), which deals with fully solvent defendants, and Kornhauser and Revesz (1994b), which deals with potentially insolvent defendants. The discussion here proceeds by reference to a numerical example, as in Kornhauser and Revesz (1993, 1995), which serves to illustrate in a straightforward manner the game-theoretic interactions generated by the competing rules. We model the following rule of joint and several liability. First, there is a right of contribution among defendants found jointly and severally liable. Second, in contribution actions, the relevant shares are determined by reference to the amount of waste dumped. Third, following a settlement, the plaintiff’s claim against the nonsettling defendants is reduced by the amount of the settlement (a pro tanto set-off rule); the effects of different formulations of the apportioned share set-off rule are analyzed in Kornhauser and Revesz (1993, p. 465-469) and Klerman (1996). Fourth, a settling defendant is protected from any contribution actions. Fifth, a settling defendant can bring contribution actions against non-settling defendants. Sixth, there is no detailed judicial supervision of the substantive adequacy of settlements. Seventh, the claims involving the joint tortfeasors are litigated together in a single proceeding. Kornhauser and Revesz (1993) show that the results derived here are robust to many changes in the legal regime governing joint and several liability.

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To perform the comparison between joint and several liability on the one hand and non-joint liability on the other, we consider a situation in which the plaintiff has a claim of $100 against two defendants, Row and Column, each equally at fault. All the parties are risk neutral. We assume initially that the defendants are sufficiently solvent that they can satisfy the plaintiff’s judgment. Later, we consider the effects of limited solvency. The probability that the plaintiff will prevail against each defendant is 50 percent. All the parties have accurate information about this value and the costs of litigation are zero. As shown in Kornhauser and Revesz (1994a), the results derived here hold even if the two defendants were not equally at fault, if the plaintiff’s probability of success were not 50 percent, and if litigation costs are not zero. With respect to the relationship between the plaintiff’s probabilities of success against the two defendants, we consider two polar situations. In the first, these probabilities are independent. Thus, the plaintiff’s probability of success against one defendant is 50 percent regardless of whether the plaintiff has prevailed against, lost to, or settled with, with the other defendant. In the second case, the probabilities are perfectly correlated. Thus, if the plaintiff litigates against both defendants, it either prevails against both (with a probability of 50 percent) or loses to both (also with a probability of 50 percent). The parties may either litigate or settle the claim. Settlement negotiations have the following structure. The plaintiff makes settlement offers to the two defendants. Row and Column decide simultaneously whether to accept these offers. (The effects of different offer structures are examined in Donohue, 1994; the effects of ‘Mary Carter’ agreements between the plaintiff and a subgroup of defendants is analyzed in Bernstein and Klerman, 1995). We assume that defendants’ costs of coordinating their actions are sufficiently high that they act non-cooperatively. The plaintiff then litigates against the non-settling defendants, if any. We adopt the convention that, if a party is indifferent between settlement and litigation, it settles. The central conclusion of our analysis is that the comparison of the settlement inducing properties of joint and several liability and non-joint liability depends critically on the correlation of the plaintiff’s probabilities of success. When these probabilities of success are independent, joint and several liability unambiguously discourages settlements, relative to non-joint liability. When, in contrast, these probabilities are perfectly correlated, joint and several liability has a more complex effect: it encourages settlement when the litigation costs are low, but may discourage settlements when these costs are high (Kornhauser and Revesz, 1994a). Earlier analyses had focused, implicitly, only on perfectly correlated probabilities (Easterbrook, Landes, and Posner, 1980; Polinsky and Shavell, 1981). A recent experimental study of auditors’ liability considers a more complicated correlation structure under which the probabilities are perfectly correlated if the manager is not liable (because under the securities’ laws the

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auditor then cannot be liable) but independent if the manager is liable (Dopuch, Ingberman, and King, 1997). 8. Non-Joint Liability The analysis of the choice between settlement and litigation under non-joint liability is straightforward. The plaintiff’s expected recovery from litigation is $50: she has a 50 percent probability of obtaining $50 from each defendant; each defendant’s expected loss is therefore $25. Absent litigation costs, the plaintiff and the defendants are indifferent between litigation and settlement. For any level of litigation costs, settlement becomes preferable. For example, if each party’s litigation costs were $5, the plaintiff’s expected recovery from litigation would be only $20 and each defendant’s expected loss would be $30. The plaintiff and each defendant would prefer any settlement between $20 and $30 to litigation. The result that under non-joint liability the parties are indifferent between settlement and litigation in the absence of litigation costs and prefer to settle for any level of litigation costs does not change if the defendants have limited solvency. Say, for example, that Row’s solvency is only $20. Then, in the absence of litigation costs, the plaintiff and Row are indifferent between litigation and a settlement for the plaintiff’s expected recovery of $10 (a 50 percent probability of recovering Row’s solvency of $20). For any level of litigation costs, the parties prefer to settle. Thus, while limited solvency affects the expected value of the plaintiff’s claim as well as amount at which the case would settle, it does not affect the choice between settlement and litigation.

9. Joint and Several Liability Independent Probabilities As a consequence of joint and several liability, the plaintiff recovers his full damages not only if he prevails against both defendants but also if he prevails against one and loses to the other. When the plaintiff’s probabilities of success against the two defendants are independent, each of four different scenarios carries a probability of 25 percent: that the plaintiff prevails against both defendants, that the plaintiff prevails against Row and loses to Column, that the plaintiff prevails against Column and loses to Row, and that the plaintiff loses to both defendants. In the first three cases, carrying an aggregate probability of 75 percent, the plaintiff recovers his full damages of $100. Thus, his expected recovery from litigating with both defendants is $75. In turn, each defendant’s expected loss is $37.50. We proceed by analyzing a situation in which litigation costs are zero. A risk-neutral plaintiff will not accept a settlement with both defendants that yields less than $75, but would find acceptable an aggregate settlement for

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$75 or more. What would happen if the plaintiff made settlement offers to the two defendants for $37.50 each, so that its aggregate recovery was equal to the expected recovery of litigating against both defendants? If one defendant, say Row, accepted the offer, would the other defendant accept it as well? Column would accept the settlement only if his expected loss from litigation is at least $37.50. Under the pro tanto set-off rule, Column’s exposure in the event of litigation is reduced to $62.50: the plaintiff’s damages of $100 minus Row’s settlement of $37.50. But Column faces only a 50 percent probability of losing the litigation. Thus, in light of Row’s settlement, its expected loss from litigation is only $31.25. It therefore follows that if the plaintiff were to make offers of $37.50 to each defendant, at least one of them would reject the offer. The plaintiff’s expected recovery would then be $68.75 (Row’s settlement of $37.50 plus an expected recovery of $31.25 from litigating against Column). This amount is lower than the plaintiff’s expected recovery from litigating against both defendants. Thus, the plaintiff would never make offers of $37.50 to each defendant. Similar logic establishes that no other pair of offers would give the plaintiff an expected recovery of at least $75 and yet be acceptable to the two defendants. Also, there is no scenario under which the plaintiff would receive an expected recovery of at least $75 by settling with one defendant and litigating against the other. This phenomenon has two sources (1) the surplus that the plaintiff obtains from litigation as a result of joint and several liability when its probabilities of success against the defendants are independent, and (2) the benefit that a non-settling defendant receives from the set-off created by the plaintiff’s settlement with the other defendant. If the plaintiff were litigating against only one defendant rather than two,his expected recovery from litigation would be $50 rather than $75: he would have a 50 percent probability of recovering from that defendant its full damages of $100. Similarly, as we have indicated, if the plaintiff were litigating against two defendants under non-joint liability, his expected recovery would also be $50: he has a 50 percent probability of recovering $50 from each of the defendants. Finally, if the plaintiff were litigating against two defendants under joint and several liability but his probabilities of success against the defendants were perfectly correlated, he would also have an expected recovery of only $50 (a 50 percent probability of recovering his full damages if he prevails against both defendants). As a result of the surplus that the plaintiff obtains from litigating under joint and several liability when the probabilities of prevailing are independent, the plaintiff will not accept from one defendant a settlement that is too low even if he intends to litigate against the other. Say, for example, that the plaintiff accepted a settlement of $0 from Row and litigated against Column. His expected recovery would then be only $50 (a 50 percent probability of recovering $100); the settlement with Row would have reduced his expected recovery by $25. If the plaintiff accepted a settlement of $10 from Row, his

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expected recovery from litigating with Column would be $45 (a 50 percent probability of recovering $90), for a total expected recovery of $55; the loss from the low settlement with Row would be $20. So as not to lose his surplus, the plaintiff would thus have to demand a sufficiently high settlement from Row. But a settlement that is sufficiently desirable for the plaintiff to accept confers a benefit upon Column. If, for example, the plaintiff were to settle with Row for $25, Column’s expected loss from litigation would be $37.50 - the same expected loss as if Row litigated. Any higher settlement with Row reduces Column’s expected loss. We have already shown that a settlement with Row for $37.50 reduces Column’s expected loss from $37.50 to $31.25, giving him a benefit of $6.25. In order to recover $75, the plaintiff would have to obtain from Row a settlement of $50 (which would leave an expected recovery from Column of $25 and confer upon Column a benefit of $12.50). Row, however, would not agree to such a settlement because, given that Column litigates, he is better off litigating as well and facing an expected loss of only $37.50. We have thus illustrated why the plaintiff cannot capture the full benefit of Row’s settlement if his probabilities of success are independent. Part of this settlement confers an external benefit upon Column. It is this externality that stands in the way of settlement. Indeed, the only way that the plaintiff can obtain the full benefit of a defendant’s payment is by litigating, because if he settles, part of the benefit accrues to the other defendant, reducing the plaintiff’s expected recovery from litigation. The role of joint and several liability in discouraging settlements is not limited to the case in which litigation costs are zero. The externality described above also impairs the possibility of settlement when litigation when litigation costs are positive but lower than a particular threshold. Perfectly Correlated Probabilities The problem changes considerably when the plaintiff’s probabilities of success against both defendants are perfectly correlated. If the plaintiff litigates against both defendants, he either prevails against both (with a probability of 50 percent) or loses against both (also with a probability of 50 percent). His expected recovery from litigation is $50 rather than $75; each defendant’s expected loss is then $25. In the case of perfectly correlated probabilities, the plaintiff will settle with both defendants. It is easy to see that the plaintiff will settle with at least one of the defendants. Say that the plaintiff settles with Row for $10. He faces a 50 percent probability of recovering $90 from Column, and his total expected recovery is $55 - $5 higher than his recovery from litigating against both defendants. The effect of this settlement is to give the plaintiff $10 with certainty, but reduce his expected recovery from litigation by $5. As a result, settlement with one defendant and litigation against the other is always more attractive to the plaintiff than litigation against both defendants. Unlike the

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case of non-joint liability, where the parties are indifferent between settlement and litigation when litigation costs are zero, here there is a positive surplus that the plaintiff and a defendant can divide if a settlement takes place. It is also easy to show that, for the example that we are analyzing, the plaintiff in fact settles with both defendants, for $25 and $37.50, respectively. Given that Row settles for $25, Column’s expected loss through litigation is $37.50 (a 50 percent probability of paying the plaintiff’s damages of $100 minus Row’s settlement of $25), and would therefore accept a settlement for that amount. Moreover, given that Column settles for $37.50, Row’s expected loss through litigation is $31.25 (a 50 percent probability of paying the plaintiff’s damages of $100 minus Column’s settlement of $37.50), and would therefore prefer to settle for $25. The same argument establishes that the plaintiff would be no better off settling with one defendant and litigating against the other. We show elsewhere that, for perfectly correlated probabilities, the plaintiff settles with both defendants if their shares of the liability are sufficiently similar, and settles with one defendant--the one with the larger share of the liability - and litigates against the other if the defendant’s shares of the liability are sufficiently different (Kornhauser and Revesz, 1994a). The Effects of Limited Solvency As indicated above, under non-joint liability, the limited solvency of the defendants does not affect the choice between settlement and litigation. The situation is different under joint and several liability. We consider first how limited solvency would affect the choice between settlement and litigation if the plaintiff’s probabilities of success are independent. If one of the defendants, say Row, has limited solvency, the plaintiff nonetheless litigates against both defendants if this solvency is above a threshold. For example, if Row’s solvency is $80 and the plaintiff litigates against both defendants, his expected recovery is $37.50 from Column but only $32.50 from Row (with a probability of 25 percent, the plaintiff prevails against both defendants and recovers $50 from Row, and, also with a probability of 25 percent, the plaintiff prevails only against Row and recovers Row’s solvency of $80 rather than its full damages of $100). In contrast, if the plaintiff settles with Column for $37.50, Row’s expected loss from litigation, and consequently the maximum settlement that it would offer, would be only $31.25 (a 50 percent probability of paying the plaintiff’s damages of $100 minus Column’s settlement of $37.50). When Row’s solvency is sufficiently low, however, the plaintiff settles with both defendants. Consider the case in which Row’s solvency is $40. If the plaintiff litigates against both defendants his expected recovery is $60 (with a probability of 25 percent, he prevails only against Column and recovers $100; with a probability of 25 percent, he prevails against both and recovers $40 from Row and $60 from Column; and with a probability of 25 percent, he prevails only against Row and recovers $40). In turn, Row’s expected loss is $20 and Column’s expected loss is $40.

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If the plaintiff offered Row a settlement of $20, his expected recovery from Column is $40 (a 50 percent probability of recovering his damages of $100 minus Row’s settlement of $20), and Column would be willing to settle for this amount. In turn, if the plaintiff offered Column a settlement of $40, his expected recovery from Row is $20 (a 50 percent probability of recovering his solvency of $40), and Row would be willing to settle for this amount. Thus, as in the case of non-joint liability, when the solvency of one of the defendants is sufficiently low and litigation costs are zero, the parties are indifferent between settling and litigating. In summary, the result that joint and several liability discourages settlements when the plaintiff’s probabilities of success are independent holds over a range of solvencies. A similar analysis (Kornhauser and Revesz, 1994b) establishes that, when the plaintiff’s probabilities of success are perfectly correlated, joint and several liability promotes settlements over a range of solvencies. For solvencies below a given threshold, however, joint and several liability has the same settling- inducing properties as non-joint liability. The relevant results are summarized in Table 2. Table 2 Effects of Joint and Several Liability on Settlements Under Different Levels of Solvency Relative to Non-Joint Liability High Solvency

Low solvency

Independent probabilities

Discourages settlement

Neutral effect

Perfectly correlated probabilities

Encourages settlement

Neutral effect

D. Fairness 10. Fairness: Several Remarks The comparison of the relative fairness of joint and several liability and non-joint liability raises four principal issues (Kornhauser and Revesz, 1995). Three of these issues arise when the defendants are fully solvent: (1) the size of the plaintiff’s expected recovery when she litigates against the defendants; (2) the division of the plaintiff’s recovery among litigating defendants; and (3) the effects of settlements. A fourth issue arises when the defendants have limited solvency: the division of the burden of insolvency between the plaintiff and the solvent defendant (Wright, 1992). A question relevant to all four issues is whether one should assess fairness ex ante (in terms of the parties’ expected payments) or ex post (in terms of the actual payments in particular cases). We largely confine our remarks here to ex ante assessments.

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11. Size of the Plaintiff’s Recovery First, as indicated in Part C, except when the plaintiff’s probabilities of success against the defendants are perfectly correlated, joint and several liability leads to a higher expected recovery than non-joint liability. Recall the example in which the plaintiff’s damages are $100 and her probabilities of success against each of the defendants are 50 percent, and the defendants are equally at fault and fully solvent. The plaintiff’s expected recovery is $50 under non-joint liability, $50 under joint and several liability when the plaintiff’s probabilities of success are perfectly correlated, and $75 under joint and several liability when the plaintiff’s probabilities of success are independent. (In the range between independence and perfect correlation, the plaintiff’s recovery is between $50 and $75.) Thus, except when the plaintiff’s probabilities of success are perfectly correlated, an effect of joint and several liability is to transfer resources from the defendants to the plaintiff. The fairness consequence of this transfer depends upon why the plaintiff’s probability of success against each of the defendants is only 50 percent. It could be that the defendants are in fact liable but that the plaintiff has difficulty in proving their liability. In this case, joint and several liability is attractive on fairness grounds because it brings a defendant’s expected liability closer into line with the harm that it caused. Alternatively, it could be that there is true uncertainty about whether the defendants are liable, and that this uncertainty is captured by the 50 percent probability. Then, joint and several liability is undesirable because it increases a defendant’s expected liability beyond the level of the harm the defendant caused.

12. Division of the Plaintiff’s Recovery The second issue concerns the allocation of expected liability among litigating defendants. From this perspective, joint and several liability performs badly: it places a disproportionate burden on the defendant with the smaller share of the liability, except when the plaintiff’s probabilities of success are perfectly correlated. Consider an example in which, instead of being equally at fault, Row and Column are 25 percent and 75 percent at fault, respectively; the plaintiff’s probabilities of prevailing against each of the defendants remains at 50 percent and these probabilities are independent. There are then four possible scenarios, each carrying a probability of 25 percent: 1. the plaintiff prevails against both defendants and collects $25 from Row and $75 from Column; 2. the plaintiff prevails against Row and loses to Column, and collects $100 from Row;

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3. the plaintiff loses to Row and prevails against Column, and collects $100 from Column; and 4. the plaintiff loses to both defendants and does not recover anything. Thus, Row pays $25 with probability 25 percent and $100 with probability 25 percent; her expected liability is then $31.25. In turn, Column pays $75 with probability 25 percent and $100 with probability 25 percent, and her expected liability is $42.75. Thus, while Row’s contribution to the harm is only one-third that of Column’s, her expected liability is about three-quarters that of Column’s. The preceding example shows that this disproportionate effect stems exclusively from the fact that under joint and several liability the plaintiff might prevail against the defendant with the lower responsibility for the harm but lose against the other defendant, and that the defendant with the lower responsibility is then required to pay the plaintiff’s full damages. In contrast, under non-joint liability (and under joint and several liability when the plaintiff’s probabilities of success are perfectly correlated), each defendant’s expected liability is proportional to its responsibility for the harm.

13. The Effects of Settlements The possibility of settlements introduces a third fairness issue, also by placing a disproportionate burden on the defendant with the smaller share of the liability. Indeed, for the legal regime analyzed in Part C, which employs a pro tanto set-off rule, each defendant settles for the same amount, even when their shares of the harm are different. Consider the example in which the litigation costs are sufficiently high that they induce the parties to settle, and in which the plaintiff makes take-it-or-leave-it offers to the defendants. The largest settlement that Row will accept, SR, conditional on Column settling for SC (which is less than the plaintiff’s damages D) is given by SR = p(D − SC) + t (1) where p is the plaintiff’s probability of success against each defendant, t is each defendant’s litigation costs, and D are the plaintiff’s damages. Similarly, the largest settlement that Row will accept, SC, conditional on Column settling for SR (which is less than the plaintiff’s damages D) is given by SC = p(D − SR) + t (2) Thus, SR = SC = (Dp + t)/(1 + p)

(3)

As a result, when litigation costs are sufficiently high that the parties settle despite the independence of the plaintiff’s probabilities of success, the plaintiff

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extracts from each defendant an equal settlement, regardless of the differences in the defendants’ shares of the harm. In contrast, recall that under non-joint liability, each defendant’s expected liability is proportional to its responsibility for the harm. The plaintiff, if she made take-it-or-leave-it offers, could extract from each defendant in settlement this amount plus the defendant’s litigation costs. If each defendant’s litigation costs are independent of their share of the liability, the defendant with the smaller share will pay a disproportionate amount, but it will be less disproportionate than what she would have paid under joint and several liability.

14. Division of the Burden of Insolvency The fourth fairness issue arises if one of the defendants has limited solvency. Our assessment of fairness here is neither fully ex ante nor fully ex post. A fully ex ante perspective would consider the likelihood that each defendant would become insolvent; instead our discussion assumes that one defendant is already insolvent. On the other hand, our discussion is not fully ex post because we assess fairness in terms of expected litigation (and settlement) outcomes. We have studied elsewhere how the shortfall caused by the limited solvency of one defendant is allocated between the plaintiff and the remaining solvent defendant under joint and several liability (Kornhauser and Revesz, 1994b). That study revealed that, over a broad range of solvencies, the plaintiff bears the full shortfall, and it is never the case that the full shortfall is borne by the solvent defendant. This conclusion challenges the accepted wisdom that, under joint and several liability, the burden of one defendant’s insolvency falls exclusively on its co-defendants (Sugarman, 1992). The reason for the entrenchment of this erroneous view may be that judges and commentators implicitly consider only the situation in which the plaintiff’s probabilities of success are perfectly correlated and the plaintiff litigates against both defendants. Then, any shortfall caused by one defendant’s limited solvency is borne by the other defendant. If, however, the correlation of the probabilities is less than perfect, the plaintiff’s expected recovery is reduced because it might prevail only against the defendant with limited solvency. Moreover, the focus on litigation overlooks the fact that settlement might occur. Thus, under joint and several liability the shortfall caused by one defendant’s limited solvency is generally shared between the solvent defendant and the plaintiff. In contrast, as shown in Part C, under non-joint liability, the full shortfall is borne by the plaintiff. In summary, joint and several liability performs worse in terms of fairly allocating liability among defendants but does not necessarily perform worse in terms of fairly allocating liability between the plaintiff on the one hand, and the defendants on the other.

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15. Conclusions In sum, from the perspectives of inducing deterrence and inducing settlements, and promoting fairness, there is no dominant relationship between joint and several liability and non-joint liability. From a deterrence perspective, the comparison between the two rules turns on the levels of solvency of the defendants. In contrast, from settlement and fairness perspectives, the comparison turns on the correlation of the plaintiff’s probabilities of success against the defendants.

Acknowledgements Parts A, B, and C appear in the entry on ‘Joint and Several Liability’ of The New Palgrave Dictionary of Economics and the Law (1998) published by Macmillan Reference Ltd./Stockton Press and appear with the permission of the publisher.

Bibliography on Joint Tortfeasors (3200) Barnes, David W. and Baerverstad, Mark (1982), ‘Social Choices and Comparative Negligence’, 31 DePaul Law Review, 273-306. Barnes, David W. and Stout, Lynn A. (1992), Economic Analysis of Tort Law, St Paul, MN, West Publishing. Ben-Shahar, Omri and Harel, Alon (1995), ‘“Blaming the Victim”: Optimal Incentives for Private Precautions Against Crime’, 11 Journal of Law, Economics, and Organization, 434-455. Bernstein, Lisa and Klerman, Daniel (1995), ‘An Economic Analysis of Mary Carter Settlement Agreements’, 83 Georgetown Law Journal, 2215-2270. Chung, Tai-Yeong (1993), ‘Efficiency of Comparative Negligence: A Game Theoretic Analysis’, 22 Journal of Legal Studies, 395-404. Cooter, Robert D. and Ulen, Thomas S. (1986), ‘An Economic Case for Comparative Negligence’, 81 New York University Law Review, 1067-1110. Curran, Christopher (1992), ‘The Spread of Comparative Negligence in the United States’, 12 International Review of Law and Economics, 317-332. Curran, Christopher and Haddock, David D. (1985), ‘An Economic Theory of Comparative Negligence’, 14 Journal of Legal Studies, 49-72. Donohue, John J. III (1994), ‘The Effect of Joint and Several Liability on the Settlement Rate Mathematical Symmetries and Metaissues about Rational Litigant Behavior: Comment’, 23 Journal of Legal Studies, 543-558. Dopuch, N., Ingberman, Daniel E. and King, R. (1997), ‘An Experimental Investigation of Multi-defendant Bargaining in Joint and Several and Proportional Liability Regimes’, 23 Journal of Accounting and Economics, 189-221. Easterbrook, Frank H., Landes, William M. and Posner Richard A. (1980), ‘Contribution Among Antitrust Defendants: A Legal and Economic Analysis’, 23 Journal of Law and Economics, 331-367.

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Edlin, Aaron S. (1994), ‘Efficient Standards of Due Care: Should Courts Find More Parties Negligent under Comparative Negligence?’, 14 International Review of Law and Economics, 21-34. Flanigan, George B. et al. (1989), ‘Experience from Early Tort Reforms: Comparative Negligence Since 1974', 56 Journal of Risk and Insurance, 525-534. Grady, Mark F. (1988), ‘Common Law Control of Strategic Behavior: The Railroad and the Farmer’, 17 Journal of Legal Studies, 15-42. Grady, Mark F. (1990), ‘Multiple Tortfeasors and the Economy Prevention’, 19 Journal of Legal Studies, 653-678. Haddock, David and Curran, Christopher (1985), ‘An Economic Theory of Comparative Negligence’, 14 Journal of Legal Studies, 49-72. Kahan, Marcel (1996), ‘The Incentive Effects of Settlement under Joint and Several Liability’, 16 International Review of Law and Economics, 389-395. Klerman, Daniel (1996), ‘Settling Multidefendant Lawsuits: The Advantage of Conditional Setoff Rules’, 25 Journal of Legal Studies, 445-462. Kornhauser, Lewis A. and Revesz, Richard L. (1989), ‘Sharing Damages Among Multiple Tortfeasors’, 98 Yale Law Journal, 831-884. Kornhauser, Lewis A. and Revesz, Richard L. (1990), ‘Apportioning Damages among Potentially Insolvent Actors’, 19 Journal of Legal Studies, 617-651. Kornhauser, Lewis A. and Revesz, Richard L. (1993), ‘Settlements under Joint and Several Liability’, 68 New York University Law Review, 427-493. Kornhauser, Lewis A. and Revesz, Richard L. (1994a), ‘Multidefendant Settlements: The Impact of Joint and Several Liability’, 23 Journal of Legal Studies, 41-76. Kornhauser, Lewis A. and Revesz, Richard L. (1994b), ‘Multidefendant Settlements under Joint and Several Liability: The Problem of Insolvency’, 23 Journal of Legal Studies, 517-542. Kornhauser, Lewis A. and Revesz, Richard L. (1995), ‘Evaluating the Effects of Alternative Superfund Liability Rules’, in Revesz, Richard L. and Stewart, R. (eds), Analyzing Superfund: Economics, Science, and Law. Kraakman, Reinier H. (1988), ‘Auditor Liability and Information Disclosure: Discussion’, 3 Journal of Accounting Auditing, and Finance, 341-348. Landes, William M. (1990), ‘Insolvency and Joint Torts: A Comment’, 19 Journal of Legal Studies, 679-690. Landes, William M. and Posner, Richard A. (1980), ‘Joint and Multiple Tortfeasors: An Economic Analysis’, 9 Journal of Legal Studies, 517-555. Leong, A.K. (1989), ‘Liability Rules When Injurers as well as Victims Suffer Losses’, 9 International Review of Law and Economics, 105-111. Low, Stuart and Smith, Janet Kiholm (1992), ‘The Relationship of Alternative Negligence Defense Rules to Ligitation Behavior and Tort Claim Disposition’, 17 Law and Social Inquiry, 63-87. Low, Stuart and Smith, Janet Kiholm (1995), ‘Decisions to Retain Attorneys and File Lawsuits: An Examination of the Comparative Negligence Rule in Accident Law’, 24 Journal of Legal Studies, 535-557. Miceli, Thomas J. and Segerson, Kathleen (1991), ‘Joint Liability in Torts: Marginal and Infra-Marginal Efficiency’, 11 International Review of Law and Economics, 235-249. Miceli, Thomas J. and Segerson, Kathleen (1995), ‘Defining Efficient Care: The Role of Income Distribution’, 24 Journal of Legal Studies, 189-208. Miceli, Thomas J., Pancak, Katherine A. and Sirmans, C.F. (1996), ‘An Economic Analysis of Lead Paint Laws’, 12 Journal of Real Estate Finance and Economics, 59-75.

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Orr, Daniel (1991), ‘The Superiority of Comparative Negligence: Another Vote’, 20 Journal of Legal Studies, 119-129. Polinsky, A. Mitchell and Shavell, Steven (1981), ‘Contribution and Claim Reduction Among Antitrust Defendants: An Economic Analysis’, 33 Stanford Law Review, 447-471. Rea, Samuel A., Jr (1987), ‘The Economics of Comparative Negligence’, 7 International Review of Law and Economics, 149-162. Rubinfeld, Daniel L. (1987), ‘The Efficiency of Comparative Negligence’, 16 Journal of Legal Studies, 375-394. Schwartz, Gary T. (1978), ‘Contributory and Comparative Negligence: A Reappraisal’, 87 Yale Law Journal, 697-727. Shavell, Steven (1983), ‘Torts in Which Victim and Injurer Act Sequentially’, 26 Journal of Law and Economics, 589-612. Spier, Kathryn E. (1994), ‘A Note on Joint and Several Liability: Insolvency, Settlement, and Incentives’, 23 Journal of Legal Studies, 559-568. Stanley, Tom D. (1994), ‘An Analysis of the Rules of Contribution and No Contribution for Joint and Several Liability in Conspiracy Cases’, 35 Santa Clara Law Review, 1-122. Stout, Lynn A. and Barnes, David D. (1992), Economic Analysis of Tort Law, St Paul, MN, West Publishing. Sugarman, Stephen D. (1992), ‘A Restatement of Torts’, 44 Stanford Law Review, 1163-1208. Sullivan, Arthur M. (1990), ‘Victim Compensation Revisited: Efficiency versus Equity in the Siting of Noxious Facilities’, 41 Journal of Public Economics, 211-225. Thomas, Ewart A.C. (1985), ‘On Calculating Optimal Contributory Negligence Rules’, 2 Social Choice and Welfare, 65-85. Tietenberg, Tom H. (1989), ‘Indivisible Toxic Torts: The Economics of Joint and Several Liability’, 65 Land Economics, 305-319. Watts, Alison (1998), ‘Insolvency and Division of Cleanup Costs’, 18 International Review of Law and Economics, 61-76. White, Michelle J. (1989), ‘An Empirical Test of the Comparative and Contributory Negligence Rules in Accident Law’, 20 Rand Journal of Economics, 308-330. Winter, Harold (1994), ‘Sequential Torts with Imperfect Information’, 14 International Review of Law and Economics, 35-40. Wittman, Donald A., Friedman, Daniel, Crevier, Stephanie and Braskin Aaron (1997), ‘Learning Liability Rules’, 16 Journal of Legal Studies,145-164 . Wright, Richard W. (1988), ‘Allocating Liability Among Multiple Responsible Causes: A Principled Defense of Joint and Several Liability for Actual Harm and Joint Exposure’, 21 University of California at Davis Law Review, 1141-1211. Wright, Richard W. (1992), ‘The Logic and Fairness of Joint and Several Liability’, 23 Memphis State University Law Review, 45-84.

3300 CAUSATION AND FORSEEABILITY Omri Ben-Shahar Tel Aviv University © Copyright 1999 Omri Ben-Shahar

Abstract This chapter begins with a survey of the implicit role of causation in the writings of the early, pathbreaking economic analysts of tort law. It then clarifies the basic distinction between retrospective (ex post) causation and prospective (ex ante) causation, a distinction that forms the core of many subsequent economic discussions of causation. Next, the explicit role of causation doctrines in inducing optimal care and activity levels is examined under the strict liability and the negligence regimes. The analysis is then extended to cover several complications often plaguing the determination of causation: uncertainty over causation, joint actions among tortfeasors and unforeseeability of harm. JEL classification: K13 Keywords: Foreseeability, Retrospective and Prospective Causation, Optimal Care, Strict Liability, Joint Actions

1. Introduction The contribution of economic analysis to the clearer understanding of the function of law is particularly evident in the law of causation. The vast juristic literature deliberating the proper meaning of causation has left a trail of doubt and uncertainty. Prominent traditional tort scholars have conceded that ‘there is perhaps nothing in the entire field of law which has called for more disagreement, or upon which the opinions are in such a welter of confusion’ (Keeton et al., 1984, p. 263), and that ‘both courts and textbook writers still fall back when deciding issues in causal terminology’ (Hart and Honoré, 1985, p. 1). Economic analysis helps distinguish the different problems that are involved and offers a unified approach to their resolution. The attempts of traditional tort scholarship to make sense of the law of causation have led to the classification of the debates into two separate doctrines, cause-in-fact and proximate cause. The cause-in-fact doctrine incorporates the law’s endeavor to define and to conceptualize the criteria that would determine when an act is part of a causal chain that ends with the injury. Here, the but-for test is the most common intuitive criterion for inferring such a factual causality relation. Of all the acts that pass any of the cause-in-fact 644

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tests, the law narrows down the responsibility to those satisfying additional, ‘legal’, tests, which are mostly embodied in the proximate cause doctrine. Liability is imposed only upon a sub-set of the acts that are causally linked to the injury, those that survive the scrutiny of a variety of normative judgments regarding their proximity to the harmful event. As Cooter (1987) nicely labeled it, the proximity doctrine portrays causation as a ‘decaying transitive relation’: as the chain of causal inference extends (‘a caused b, b caused c, ...’), the relationship between removed links weakens without being destroyed. The economic analysis of the law of causation illuminates both the cause-in-fact and the proximate cause doctrines. Economic analysis applies positive tools from decision theory and statistics to clarify the definition of a cause-in-fact, and to resolve some of the confusion regarding the relative contribution of a given factor to the harmful consequence. Under the normative economic analysis, the proximate cause doctrine’s designated role is to expand or shrink the scope of liability, in order to achieve efficient deterrence. This chapter is structured as follows: it begins with a survey of the implicit role of causation in the writings of the early, pathbreaking economic analysts of tort law. It then clarifies the basic distinction between retrospective (ex post) causation and prospective (ex ante) causation, a distinction that forms the core of many subsequent economic discussions of causation. Next, the explicit role of causation doctrines in inducing optimal care and activity levels is examined under the strict liability and the negligence regimes. The analysis is then extended to cover several complications often plaguing the determination of causation: uncertainty over causation, joint actions among tortfeasors and unforeseeability of harm.

2. Causation in Early Economic Analysis of Law The original economic theory of tort law deliberately rejected an explicit role for a causation doctrine in determining liability. Coase’s (1960) view was particularly resolute in its exclusion of a formal causation element. Coase describes an injury as a result of mutual and symmetric interaction among parties. Like particles that randomly collide with each other in space, actions of individuals may conflict and cause one-sided or mutual harm. Thus, the phrase ‘the injurer acted and, when coming across the victim, caused an injury’ is interchangeable with the phrase ‘the victim acted and, when coming across the injurer, caused an injury’. Both passive and active factors are equally necessary in making the harm occur. Since liability cannot be placed solely on the basis of causation, as both the injurer and the victim are necessary causes, it ought to be decided according to a cost-benefit analysis, which will determine the identity of the party that can alter its actions more cheaply and avoid the injury. As Calabresi (1970)

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explained, for instrumental reasons the least-cost avoider should be singled out as the cause of an injury. The forward looking social objective - minimization of accidents’ costs - will be furthered if a party that can prevent an accident with a lower cost than the harm arising from the accident will be regarded as the sole legal cause of the accident and be held liable. Hence, under this view, causation is not a preliminary condition for evaluating liability, but it is the conclusion of the evaluation (see Cooter, 1987). Landes and Posner (1983, 1987, pp. 228-255) have reinforced this view and argued explicitly that causation has no role in determining liability. Inasmuch as the purpose of tort law is to promote economic efficiency, the injurer should be regarded as the cause of an injury when he is the lower-cost avoider of it, and not otherwise. Therefore, they claimed, ‘the idea of causation can largely be dispensed with in an economic analysis of torts’. When efficiency analysis is conducted to determine liability, it can be fully pursued without reference to causation. Inefficient behavior is synonymous with causing an expected harm. The symmetry among the roles of the injurer and the victim, as well as the absence of any independent requirement of causation, became well evident when Brown (1973) formulated his rigorous model of accidents. This model the benchmark for subsequent economic analysis of tort law - assigned symmetric roles to the injurer and the victim, by making the expected harm a function of care levels taken by both. A party’s action can raise the probability of harm and, thus, can only be a cause of an expected harm. Thus, in early economic analysis of tort law, cause is reduced to efficient prevention: the assignment of legal cause is dependent solely upon the judgment about the economic efficiency of preventive measures. The inquiry into causation carries no additional message once a cost-benefit analysis of the care choices has been completed. This characterization of causation, which prominent scholars have labeled ‘causal minimalism’ (see Hart and Honoré, 1985, pp. lxvii-lxxvii), has led authors to argue that causation serves goals other than efficiency (Epstein, 1973, 1979, 1987; Borgo, 1979; Cooter, 1987) or that it merely represents an older method of conducting efficiency analysis (Grady, 1989; Miceli, 1996).

3. Prospective Causation Building on the analytical framework of Calabresi (1970) and Brown (1973), subsequent treatments of causation distinguished among two concepts of factual linkage between acts and harms. Calabresi (1975) classified the empirical tests of causality into two types, which he labeled causal link and but-for cause. Both describe effects of actions on outcomes. An act is a but-for cause if, without it, the injury would not have taken place. In contrast, an act has a

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causal link to an injury if it increases the probability of its occurrence. As Shavell (1980) later rephrased the distinction, causation can be either retrospective or prospective. Retrospective causation exists if, all else held fixed, but for the action the harmful consequence would not have occurred. Prospective causation exists when an action raises the probability of the harmful consequence. Thus, the distinguishing factor between the two types of causation is the time perspective of the evaluation. Retrospective causation is backward-looking, answering the counterfactual inquiry of whether the action was a necessary condition for the outcome. Prospective causation, in contrast, is forward-looking, answering the ex ante inquiry of whether the action increased the likelihood of injury (see also Rizzo, 1981; Miceli, 1996). This distinction, and in particular the development of analytical tools to focus on prospective-probabilistic causation, has helped the economic literature advance both in its normative and positive study of the law. In the normative dimension, probabilistic causation became a building block of economic models of tort law. As Shavell (1980, p. 475) has explicitly phrased it, ‘the first-best level of care is determined by the cost of taking care and the degree to which lack of care is a cause of expected losses’. For an action (‘low care’) to raise the probability of a consequence (‘harm’) relative to another action (‘high care’), there must be states of the world in which harm occurs only if that action is taken, and not if the other action is taken. The prospective causation concept has also advanced the positive analysis of tort law. Perhaps the sharpest example of the contrast between retrospective and prospective causation theories, and the clearest application of prospective causation analysis, arises within the family of ‘coincidental’ accidents cases. In the famous case of Berry v. Borough of Sugar Notch, 43 A. 240 (1899), an excessively speeding streetcar happened to arrive at a point along its route just when a tree fell above that point, and struck it. A strict retrospective causation inquiry would have identified the action of speeding as a but-for cause, since the accident would not have occurred had the streetcar travelled more slowly. Applying the traditional retrospective approach, the court sensed the illogic of assigning liability for such an arbitrary episode, thus had to resort to elusive concepts such as ‘coincidental harm’ or ‘abnormal risk’ in order to screen such results and derive a general principle that will restrict the scope of liability. In contrast, under prospective causation inquiry the action of speeding is recognized to have not affected the likelihood of harm of the type that occurred. Ex ante, a tree can fall at any point along the route, and the speed at which the vehicle is moving does not increase its probability of being hit. The result that the court reached can be easily aligned with the logic of prospective causation. (See Honoré, 1983, pp. 50-55, for early applications of the prospective causation concept.)

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4. Causation and Socially Optimal Care The causation requirement, although not an explicit element in the ordinary economic model of tort law, can be isolated and characterized in economic terms. The basic proposition made by Shavell (1980, 1987, pp. 105-126), and reiterated by Rizzo (1981), Landes and Posner (1983, 1987) and Cooter (1987), claims that the desirability of any precautionary action should be determined only with reference to states of the world in which failure to take the action would lead to greater expected losses. In determining the level of care that is optimal, the benefits of care should be balanced against its costs. But whereas the costs of care accrue before the ensuing state of the world materializes and regardless of the actual state of the world that will materialize, the benefits of care arise only in those states in which taking care reduces harm. For example, in the case of City of Piqua v. Morris, 120 N.E. 300 (1918) the defendant failed to take sufficient measures against floods. However, a particularly severe flood occurred, one that even appropriate precautions would not have withstood. Thus, in evaluating the desirability of anti-flood measures, only the chance for moderate floods should be counted. The idea that care can be cost-justified only with reference to states of the world in which it can reduce the harmful consequence was formulated by Shavell (1987, pp. 118-121) in causation terminology. Shavell defined care (or lack thereof) to be a necessary cause of harm if, given some state of the world, a different level of care would have led to a different level of expected harm. He then proceeded to show that the socially optimal level of care depends only on states of the world in which the injurer’s care would be the necessary cause of any losses that occur. In order to examine the extent to which liability rules can implement optimal care, a causation restriction was formally introduced to the structure of liability rules. Shavell’s (1980) concept of the scope of liability incorporates the causation restriction. The scope of liability is defined as the set of states of the world under which liability can be applied. The scope of liability is said to be restricted if, given a harmful consequence, there are some states of the world in which the injurer is not held liable. The scope of liability will be unrestricted if, anytime there is a harmful consequence, and no matter what state of the world surrounded it, the injurer will be held liable. The design of a liability regime includes, in addition to the determination of due care (in negligence) and the magnitude of liability (both in strict liability and in negligence), the determination of the scope of liability. If an act is not a necessary cause of the injury, the injury may be left outside the actor’s scope of liability. Adding the determination of a scope of liability into the analysis nicely extends the early economic models, by capturing the effects of conditions beyond the control of the human actors. When the probability or magnitude of

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injuries depend upon external conditions, analyzing such conditions within the formal structure of liability rules is necessary.

5. Causation Under Strict Liability Under strict liability, courts have to determine the magnitude of liability and its scope. Assuming the magnitude of liability equals the victim’s actual harm, what remains to be determined is whether the accident is to be included within the scope of liability. Two principal propositions can be made regarding the incentive effects of the determination of the scope of liability: 5.1 The Effect of the Scope of Liability on the Level of Care The injurer will have optimal incentives to take care as long as the scope of liability includes at least all the states of the world in which the injurer’s care is a necessary cause of the harm. If the scope of liability is too restricted, and does not include all the states in which the injurer could alter the harmful consequence with its care, then the injurer will have insufficient incentives to take care. In this case, the injurer will ignore some of the social benefits of its care - the reduction in expected harm occurring in states of the world outside the scope of liability - and will underinvest in care. If, in contrast, the scope of liability is optimally restricted, and includes only states of the world in which the injurer’s care is a necessary cause, the injurer will bear only the increment in expected losses due to its actions, and will have optimal incentives to take care. Similarly, if the scope of liability is unrestricted, so that whenever harm occurs, and regardless of the state of the world, the injurer is held liable, the injurer will engage in optimal care. Notice that an unrestricted scope of liability does not, in itself, distort the injurer’s incentives to take care. Even if the injurer is liable for harms which its care could not have prevented, it will not exercise excessive care. Taking more care will not prevent the harm in the states of the world in which care is not a necessary cause, and thus will not reduce its expected liability. Hence, the injurer’s incentives to take care can be distorted only by an overly-restricted scope of liability, not by an unrestricted one (see Shavell, 1980, 1987, pp. 105-110; Landes and Posner, 1987, p. 236). 5.2 The Effect of the Scope of Liability on the Level of Activity If the scope of liability is too restricted, and does not include all the states in which the injurer’s care is a necessary cause, it was already established above that underinvestment in care will arise. This underinvestment can also lead to excessive incentives to engage in the activity, as the injurer will not bear the full ‘externality’ of its activity. The cost of engaging in the activity is reduced by the incremental reduction in the investment in care and by the incremental

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reduction in the expected liability and, thus, an injurer may engage in an activity even when it is undesirable from a social point of view. Similarly, if the scope of liability is too broad or unrestricted, it may discourage an injurer from engaging in a socially desirable activity. Although the injurer who faces an unrestricted scope of liability will not take excessive care, the injurer will face an inflated expected liability. As Shavell (1980, 1987, p. 108) has termed it, the injurer may find the unrestricted scope of liability to be ‘crushing’. An activity that is worthwhile may be deterred by imposing upon the actor costs of losses that would have been occasioned regardless of this activity. For example, if a car manufacturer is held liable for accidents arising from bad conditions of roads, such that cannot be avoided by extra prevention devices in the car’s design, it may be led to reduce the volume of production. Hence, for injurers to engage in optimal levels of activity, courts have to restrict the scope of liability appropriately, which, according to some (for example, Burrows, 1984), may demand too much sophistication from the legal system, and, according to others (for example, Wright, 1985) does not reflect prevalent causation doctrines.

6. Causation Under the Negligence Rule Under the negligence rule, courts have to determine the level of due care, the magnitude of liability and the scope of liability. Assuming that the magnitude of liability equals the victim’s actual harm, what remains to be determined is which harms should be factored into the determination of the standard of due care, and under what states of the world the accident is to be included within the scope of liability. Shavell (1980, 1987, pp. 105-121) has made the following propositions concerning the incentive effects of causal determinations: 6.1 The Determination of the Optimal Standard of Care The due level of care should equal the optimal level of care, as determined by considering the effect of care only in circumstances in which care is a necessary cause - that is, only in states of the world in which taking care would reduce harm. Care that has no bearing on the occurrence of harm should be excluded from the negligence standard. 6.2 The Effect of the Scope of Liability on the Actual Level of Care Once a standard of due care is set, the scope of liability has only limited incentive effects. Whether the scope of liability is optimally restricted (to include only states of the world in which the injurer is the necessary cause), or whether the scope of liability is too broad or unrestricted, the injurer will take the due level of care (assumed to be set optimally). Further, unlike the activity-crushing effect of strict liability, under the negligence rule an

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unrestricted scope of liability does not necessarily deter the injurer from engaging in the activity. The injurer is induced to take due care and thereby avoid liability, and thus becomes indifferent as to the actual scope of liability (Landes and Posner, 1983, 1987, p. 236). As long as the exaggerated scope of liability does not boost the level of due care, it has no adverse incentive effects per se. In contrast, if the scope of liability is too restricted, and does not include all the states in which the injurer’s care could have reduced harm, the injurer may (but not necessarily) be led to take too little care. The injurer will compare the cost of due care to the cost of liability in its inefficiently restricted scope. If the cost of liability is smaller, the injurer’s incentives to take due care will be distorted. 6.3 The Scope of Liability in an Imperfectly Operating Negligence System Inasmuch as the application of the negligence rule is plagued with error and uncertainties, it contains an element of strict liability (the injurer may bear liability even if he were not negligent). In this case, the unrestricted scope of liability can have the crushing effect that is associated with the operation of a strict liability rule (Shavell, 1980, 1987, p. 108), Landes and Posner, 1983, 1987, p. 236). Even after Shavell’s (1980) analysis of the optimal scope of liability, showing that liability should be restricted only to accidents that would not have occurred had the injurer employed due care, most economic models of negligence, including part of Shavell’s (1987) book, continued to implicitly assume that the scope of liability is unrestricted, and that liability turns solely upon the injurer’s negligence. That is, if the injurer were negligent, no matter how slight its deviation from due care, it is liable for any accident that arises, including accidents that additional care would not have prevented. Grady (1983, 1984, 1989), Kahan (1989) and Marks (1994) have shown that the analytical framework which assumes unrestricted scope of liability is not in line with either tort doctrine or optimal incentive design. To adhere to Shavell’s analysis and restrict the scope of liability so that it includes only accidents that were caused by the injurer’s negligence, would imply that an injurer who takes less than due care is not liable for every harm that arises, but only for those harms which would not have arisen had the injurer taken due care. Thus, if the injurer takes slightly less than due care, the proper scope of its liability would include only the (slight) incremental harm that occurred due to this deviation, and will not include all harms that would have occurred anyway. In the ordinary case in which care reduces the probability of an accident but not its magnitude, if the accident occurs the negligent injurer will have to pay damages with a probability less than one. Using Kahan’s (1989) illustration, suppose the proper height of a fence surrounding a stadium is 10 feet, and the field owner erects a fence of 9 feet. If a ball flies over the fence and causes harm, the scope of liability should be

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(and, as a matter of common law, is) restricted to those accidents caused by balls flying over the fence at heights between 9 and 10 feet. Only those accidents are caused by the field owner’s negligence. Making the field owner liable for all harms caused by flying balls, including those that fly at heights exceeding 10 feet, would mean imposing an unrestricted scope of liability. Until Kahan (1989) exposed it, most economic models managed to conceal their incorrect characterization of the scope of liability. The reason these models successfully overlooked this restriction relates to the discussion above, which suggested that in the case of a perfectly operating negligence system an exaggerated scope of liability does not have a distorting effect. Since the perfect-information models of negligence find that the injurer will have the proper incentives to take optimal care even under the exaggerated scope of liability regimes, and since there is no crushing of activity effect, they suppress the significance of the exaggerated scope of liability. But, as Kahan clearly demonstrated, an unrestricted scope of liability will have different incentive effects from an optimally restricted scope of liability in cases in which the application of the negligence rule is plagued with information imperfections. Grady and Kahan’s analyses also suggest that the proper characterization of causation should eliminate what is otherwise considered a prominent feature of the negligence rule: the discontinuity of the injurer’s cost function at the point of due care. This feature of discontinuity plays an important role in models analyzing injurers’ behavior under uncertainty (see, for example, Craswell and Calfee, 1986; Shavell, 1992; Ben-Shahar, 1995). If the injurers’ cost function is continuous, as Grady (1989), Kahan (1989), and Cooter (1989b) have demonstrated it to be, the incentive to deliberately engage in excessive care, to ensure compliance with the uncertain legal standard, is significantly diminished.

7. Uncertainty over Causation When an injury occurs, its origin may be ambiguous. Several reasons may account for the uncertainty. First, it may be that separate factors created similar risks simultaneously, and the actual injury cannot be clearly traced to any one of them. Second, it may be that the injury manifested itself a long period after the risk was created or the accident occurred, in which case the cause is difficult to identify. The principal question that needs to be addressed in the face of causal uncertainty is under what conditions should a party be liable for injuries that are uncertain to have been caused by its actions? Two basic approaches to liability in the face of uncertainty over causation can be proposed. The first approach applies an all-or-nothing criterion to determining liability. An all-or-nothing criterion holds that either there is no liability or, if liability is imposed, then it equals the full losses of the victim.

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The most common all-or-nothing criterion is the threshold probability rule, under which full liability is imposed upon the defendant if the probability that it caused the accident exceeds a threshold level. Potentially, any threshold can be set, including one that would require proof of causation exceeding any reasonable doubt. However, the prevalent doctrine applying the threshold probability rule is the ‘preponderance of the evidence’ standard of many common law jurisdictions, which incorporates a threshold probability of 50 percent. (In some cases the law reverses the burden of proof and presumes that the defendant is the cause of the injury. Then, the defendant needs to satisfy the 50 percent threshold in proving that he is not the cause of the injury.) The second approach to resolving uncertainty over causation incorporates a proportional liability criterion. Under this approach, whenever there is a positive probability that the defendant caused the injury, liability will be imposed, but its magnitude will be reduced proportionally to account for the uncertainty. The most common proportional rule, known as the ‘market share’ approach, sets the defendant’s liability equal to the actual harm multiplied by the probability that the defendant caused the injury. Traditionally, the law of torts has been governed by the first approach of all-or-nothing. Full liability is assigned to a party whose acts are assessed to be a substantial factor in bringing about the harm. A ‘preponderance of probabilities’ - a threshold of 50 percent - is required for imposition of liability, and without it no liability is inflicted. However, beginning in the 1980s, and coming as a response to the onslaught of mass exposure or catastrophic injury torts, American courts have been more willing to apply the second approach. In the case of Sindell v. Abbott Laboratories 607 P.2d 924 (1980), which involved the mass disaster of the DES drug, the court determined each manufacturer to be liable for a fraction of every victim’s harm, with liability determined in proportion to the manufacturer’s market share. The debate over the market share doctrine has since occupied many branches of tort scholarship, including law and economics. The next two sections examine the economic justifications for the two approaches.

8. The Case for Threshold Probability Rules The first systematic analysis applying economic methods to compare the two liability approaches was presented by Kaye (1982), who proposed to show the superiority of the 50 percent threshold probability rule over any other threshold probability rule as well as over the proportional approach. Kaye’s argument is based on the assumption that in situations of uncertainty over causation the social objective of tort adjudication is to minimize the ex post costs of erroneous liability decisions. Ignoring any ex ante incentive effects that the rules may

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have, and assuming that the two types of potential errors courts could make false positives and false negatives - are just as costly, Kaye shows that the 50 percent threshold rule is the error-minimizing one. To illustrate the essence of Kaye’s argument, consider a case in which the harm is $100 and the probability that the defendant caused it is 40 percent. Under the ‘preponderance of the evidence’ rule, the defendant will not be liable, and the expected error costs will equal $40 (there is a 40 percent chance that the defendant is truly the tortfeasor, in which case it underpays by $100, for an expected error cost of 0.4×$100 = $40). In contrast, if the court applies the proportional liability rule and sets the defendant’s liability at $40, the expected error costs will be $48 (there is a 40 percent chance that the defendant is truly the tortfeasor, in which case it underpays by $60, for an expected error cost of 0.4×$60 = $24; and there is a 60 percent chance that the defendant is not the tortfeasor, in which case it overpays by $40, for an expected error cost of 0.6×$40 = $24; the sum of the expected costs of the two possible errors is $24 + $24 = $48). The all-or-nothing feature embodied in the threshold liability rule has an additional potential advantage, suggested by Levmore (1990), of reducing the degree of uncertainty. If uncertainty is assumed to be endogenous, and to vary according to the incentives of the parties to bring evidence to court, then the liability approaches can be compared with respect to the degree of uncertainty they generate. Here, Levmore claims, a high threshold probability will produce the most evidence and lead to the least uncertainty. When uncertainty is great and tortfeasors are difficult to identify, plaintiffs face a complete denial of recovery under a threshold rule that sets a sufficiently high threshold probability. This will induce plaintiffs to invest more in developing evidence and identifying the true injurers. In contrast, under a market share regime plaintiffs need not invest in identifying the true injurers, since they are fully compensated regardless of the degree of uncertainty. (Of course, if the defendant, rather than the plaintiff, were assumed to be the party that can develop superior evidence, then a market share rule will give the defendant the greatest incentives to bring evidence.) Again, ignoring the ex ante incentive effects of the rules and focusing on the ex post characteristics of the adjudicatory regime, a case is made for the threshold probability rule. Apart from minimizing uncertainty and the ex post costs of uncertainty, the threshold probability approach may offer the additional advantage of reducing administrative costs. As Shavell (1987, p. 117) suggests, there are three distinct reasons that the administrative costs will likely be higher under the proportional liability approach. First, the volume of cases is likely to be higher under the proportional liability approach, because actions in which the probability of causation is less than the threshold could be brought. Second, more defendants could be sued in a typical case under the proportional approach, raising the costs of litigating the case. And third, litigation under the

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proportional approach requires the added judicial determination of the precise probability of the defendant being the cause of the injury, whereas under the threshold probability approach the only thing that matters is whether the probability of causation exceeds the threshold. Some of these excess costs may be diminished under the enforcement regime that Rosenberg (1984) has proposed, which borrows features from ‘public law’, such as class actions, damage scheduling, and insurance fund judgments.

9. The Case for the Proportional Liability Rule An economic analysis purporting to show the potential superiority of the proportional rule was presented by Shavell (1985, 1987, pp. 115-118, 123-126). Shavell evaluated the effects of the two approaches with respect to a different social objective from the ex post error-costs minimization criterion. Adopting an ex ante focus, Shavell took the objective of liability regimes to create optimal deterrence, that is, the minimization of accident losses. In this perspective, legal errors do not involve a welfare cost per se, and their minimization could perhaps be taken as a measure of fairness but not as a proxy for optimal deterrence (see also Kaplow, 1994). Once embracing the social objective of optimal deterrence, Shavell has managed to demonstrate that the proportional liability approach is the superior method of inducing socially desirable behavior. The main propositions made by Shavell are as follows. First, the threshold probability criterion distorts the incentives of parties to take care. If the probability of causation is systematically below the threshold probability, the party will face too little liability and will take less than optimal care. This problem of underdeterrence under the conventional threshold probability rule was labeled by Levmore (1990) and Farber (1990) as the problem of recurring misses. For example, if the probability of a party being the cause of a typical injury is systematically 40 percent (as in the case of a manufacturer holding a 40 percent share of the market for a harm-causing product), the party will always escape liability under the 50 percent threshold rule. The net of liability will miss this party repeatedly. Thus, the party will have no incentives to take care. The underinvestment result arises both under the negligence rule and under strict liability (see also Landes and Posner, 1987, pp. 263-269; Robinson, 1985). Similarly, if the probability of causation is systematically assessed above the threshold, the injurer may have excessive incentives to take care. This distortion will arise under a strict liability regime, since the injurer will pay for all losses, more than it actually causes. The injurer may take excessive care for a subtle reason. Since the injurer pays for all losses only if he is determined to by the likely cause, the injurer will have the incentive to reduce the chance that this determination would be made. By taking excessive care, the injurer may

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be able to reduce the posterior probability that he will be designated as the likely cause of the injury. That is, extra care may shift the preponderance of probabilities, and clear the injurer from liability altogether. Notice that this overinvestment result will not arise under a negligence regime, since the injurer will take due care and will avoid the excessive liability (unless, of course, the level of due care is ill-defined). This is another illustration of the general proposition discussed in Section 6 above, which claimed that an unrestricted scope of liability - that is, liability for consequences that a party did not cause does not in itself lead to distorted incentives, and only enhances the motive to take due care under a negligence regime. In contrast to the distorted outcome under the threshold probability rule, the proportional liability approach leads to socially optimal levels of care (see Delgado, 1982; Rosenberg, 1984; Shavell, 1985, 1987, pp. 115-118; Levmore, 1990). The injurer faces expected liability equal to the expected loss associated with its behavior, and will behave as it would in the absence of uncertainty over causation. For example, a manufacturer who causes 40 percent of the harms of a particular type will pay for losses in every case, including the 60 percent of the cases which it did not cause. But in every case its liability will equal 40 percent of the individual harm, thus it ends up bearing liability of 40 percent of the total harm, equal to the fraction it caused. Another important proposition made by Shavell concerns the incentives of parties to engage in the activity that produces the harm. Again, the threshold probability rule distorts ex ante incentives. When the probability of causation is systematically above the threshold, the injurer will be overdeterred from engaging in activity under the strict liability regime. (Under the negligence rule the injurer takes due care and escapes liability, thus engages in the same level of excessive activity as it does in the absence of uncertainty over causation, see Shavell, 1987, pp. 21-32). Likewise, when the probability of causation is systematically below the threshold, the injurer escapes liability and, as a result, engages in excessive levels of activity, both under negligence and under strict liability. In contrast, under the proportional liability rule, the injurer’s incentives to engage in the activity are the same as they would be in the absence of any uncertainty over causation. Several authors have argued that the market share approach may lead a free-rider problem which will cause underinvestment in care. Marino (1991) demonstrated that care practiced by one firm produces benefits to other firms. By reducing the probability of harm associated with its products, a firm produces a positive externality captured by the other firms in the form of reduced expected liability. That is, each firm will underinvest in care because it bears the cost of care in full but can appropriate only a share of its benefits. The magnitude of this underinvestment will diminish as the firm’s market share increases, and the underinvestment problem will disappear if the firm is

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a monopoly. In similar spirit, other authors have argued that proportional liability will not generate optimal incentives for safety research. Delgado (1982) and Rose-Ackerman (1990) have pointed out the public good characteristics of safety improvements, and speculated that the infliction of full liability on an injurer who has the greatest opportunity to conduct safety research may be superior to the division of liability according to proportional causation. The dichotomy between the proportional liability approach and the all-or-nothing threshold probability approach reflects the tension between ex ante and ex post goals of the tort system. A framework that seeks to unite the two approaches has been offered recently by Porat and Stein (1997). Under this framework, a liability rule should be designed to give incentives to parties who are the cheapest evidence providers, to reduce the ex post uncertainty in assessing liability. The ingenious mechanism these authors examine is titled ‘liability for uncertainty’ - imposing liability for an injury whose cause is uncertain on the party that created or had the best opportunity to prevent that uncertainty. This will lead the parties to invest optimally in removing uncertainties, and when ex post uncertainty is eliminated, the ordinary liability mechanisms can operate to generate optimal incentives to reduce the primary damage. Thus, for example, DES manufacturers can either eliminate the uncertainty over causation (thus avoid liability for uncertainty), in which case the all-or-nothing approach will apply and will generate optimal care incentives, or the manufacturers can choose not to eliminate the uncertainty over causation, in which case they will be liable for the injuries based on their proportional contribution to the creation of uncertainty.

10. Risk-Based Liability and Safety Regulation The market share approach is a doctrinal step away from the strict fundamentals of causation. But it is not the most radical step. With the growth of mass exposure torts, and due to the large degree of uncertainty over causation in these torts, authors have advocated an even more unorthodox legal mechanism which will practically abandon any causality requirement between the injurer’s action and actual harm. The idea is to structure a liability regime based solely on ‘probabilistic causation’. Under this regime, liability is proportional not to the harm itself, but rather to the risk of harm which the actor produces; it is applied regardless of whether this risk actually materializes. For example, an individual who uses a product and later discovers that she is under a particular risk, that may or may not develop into actual harm, may recover damages equal to her expected harm. Thus, liability is assigned strictly on the basis of the creation of unreasonable risk, independent of any injury. Contrary to the dominant role that the causation requirement was

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given in other influential theories (as in Epstein, 1973), here the causation element is essentially eliminated. Robinson (1985) and Landes and Posner (1984, 1987, pp. 263-269) have argued that awarding its expected losses to each potential victim exposed to the risk of harm will create the proper incentives for injurers to take care and to select the correct activity levels. In the context of mass exposure accidents, and in light of the severity of risk-spreading and bankruptcy concerns, this view has triggered serious attention (see, for example, Roe, 1984; Celli, 1990). Viewed ex post, this approach gives many potential victims a windfall, as they are going to be compensated without actually bearing any risk; at the same time, actual victims will be undercompensated. But viewed ex ante, this approach can provide superior incentives for care relative to other approaches that have to await the actual, oftentimes lagged, harm and, thus, dilute the deterrent force of liability. Obviously, a troubling aspect of a risk-based liability regime is its administrative costs. Litigation need not be conditional on occurrence of harm and thus could be more frequent, let alone more complicated (see Celli, 1990). At the same time, each victim is awarded only a fraction of the actual harm, which may reduce the incentives to take legal action and, consequently, will lead to underdeterrence. A different approach to monitoring incentives in cases that pose inherent difficulties in ascertaining causation is a centralized approach, relying on administrative regulation to enforce optimal risk reduction. Several authors (Shavell, 1984, 1993; Cooter and Ulen, 1989, p. 420) have examined the advantages of relying on regulatory authorities to monitor and deter risk creation in the period before harm manifests itself. These authors have suggested that regulation of safety may perform better than a risk-based liability system in preventing mass torts. The main justifications for the superiority of a regulatory regime are: (1) the government may be a better information-gatherer than the injurer; (2) injurers may be judgment-proof in catastrophic harms, thus liability will not generate sufficient deterrence; (3) suits may not be brought in all cases, due to their costs and to victims’ lack of information, thereby diluting the deterrent effect of liability; (4) administrative costs of decentralized liability regimes may be higher.

11. Causal Apportionment among Joint Tortfeasors Uncertainty over causation may involve another dimension. Apart from the difficulty of identifying the actual cause-in-fact - the party whose act caused the particular accident - courts may face the difficulty of determining the relative causal share of each of several tortfeasors. There may be information as to the probabilistic contribution of each act - what ex ante risk each act imposes - and

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how the risks change when acts occur simultaneously. However, when two acts operate simultaneously to cause harm, the contribution of each act to the combined risk has to be determined before courts can apply either the threshold probability approach or the proportional liability approach. This determination involves a ‘disentanglement’ of the harm-production process, a logical exercise which has proven to be problematic. To illustrate the problem, imagine two fires that are set simultaneously and independently and combine to destroy a field. It is estimated that, ex ante, the first fire alone had a 10 percent chance of destroying the field, the second fire alone had a 20 percent chance, and together they had a 50 percent chance of destruction. That is, their joint operation creates a synergistic effect. If both fires were set and the destruction occurred, how should liability be divided across the two ‘causes’? Or, suppose a particular illness can be contracted either by use of a product (1 percent) or, independently, by smoking (4 percent). However, if an individual both uses the product and smokes, the risk increases to 15 percent. Again, a significant synergistic effect exists. What fraction of the harm can a smoker that has used the product recover from the manufacturer? In both examples, how should the synergistic effect arising from the multiple causes joined together be divided across the causal contributors? The problem of allocating the shares of liability in accidents that have multiple causes is said to have ‘generated a bewildering variety of legal rules and nomenclature’ (Kaye and Aickin, 1984), and have perplexed scholars who expressed ‘doubts that there exists a single factotum satisfactory formula for dividing damages’ (Kruskal, 1986). The first systematic treatment of the causal apportionment problem was offered by Rizzo and Arnold (1980) (see also Rizzo and Arnold, 1986). These authors proposed an apportionment scheme that assigns to each act a share of liability that consists of two elements. The first element is proportional to the act’s ‘marginal product’, which Rizzo and Arnold defined to be the probability of harm given this act operating alone. The second element is a fraction of the synergistic effect, which Rizzo and Arnold arbitrarily selected to be one half. In the literature that followed, Rizzo and Arnold’s allocation scheme was generally rejected. Kaye and Aickin (1984) found flaws with the statistical framework applied by Rizzo and Arnold, as well as with the material justifications for the apportionment scheme. In particular, Kaye and Aickin suggested that Rizzo and Arnold’s definition of an act’s marginal product - the increase in the probability of harm, given this act operating alone - is no more appropriate than many other possible definitions, such as the incremental increase in the probability of harm, given that the other act is also operating. Kaye and Aickin argued also that there is no one logical way to divide the synergistic effect across the acts, and thus logic alone cannot provide a

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guideline for resolving the causal apportionment problem. Hence, any apportionment scheme should be evaluated mainly according to the incentive effects it generates. Further criticism of Rizzo and Arnold was voiced by Kruskal (1986), Kelman (1987) and Rose-Ackerman (1990), who again claimed that there is no one principled way to apportion damages that will not be arbitrary and that will make economic sense. An alternative to the Rizzo and Arnold method of defining an act’s marginal product can be derived from the cooperative game-theory concept of the Shapley value. This method offers a more structured way to define an act’s marginal product, based on its expected marginal contribution to the probability of harm, averaged over all possible combinations of acts (see Ben-Shahar, 1996). While this approach enjoys some intuitive appeal that the previous method did not have, it has the similar shortcoming in its reluctance to consider the ex ante effects of the apportionment rule on the incentives for care among multiple tortfeasors. When multiparties are responsible for an injury, there may not exist an apportionment rule that leads to efficient incentives and keeps total liability equal to harm. To provide the right incentives to all parties, damages exceeding full harm may need to be assigned. For example, Landes and Posner (1980, 1987, pp. 193-201) have focused on the effects of liability apportionment on incentives for care under the negligence regime. They have argued that joint tortfeasors can be led to take due care under a no-contribution rule - that is, a rule that makes each party liable for the entire damage and allows the victim to determine each tortfeasor’s liability share. If the total cost of care is less than the expected harm, at least one of the injurers will have the incentives to take due care (his cost of care is less than half the expected harm), thereby placing the entire liability on the other and leading the other to take due care as well (see also Wittman, 1981, for a related argument in a joint but sequential care setting). Thus, in the celebrated case of Summers v. Tice, 199 P.2d 1 (1948), where two hunters independently and simultaneously fired in the direction of a victim but only one - unidentified - hit, joint liability with no contribution will lead both to take optimal care. Notice that a doctrinal justification for making each hunter fully liable can be obtained through Porat and Stein’s (1997) idea of liability for uncertainty. Each hunter is liable since, but for his action, the apportionment difficulty would not have existed: either the fatal bullet was shot by him, in which case but for his action there would have been no injury, or the fatal bullet was shot by the other, in which case but for his action there would have been no uncertainty. The problem with the negligence-based no contribution rule is that it may lead injurers to engage in excessive levels of activity. Miceli and Segerson (1991) study a different apportionment rule, one that would potentially lead joint tortfeasors to take efficient care and make efficient activity decisions. They propose a ‘decoupled’ strict liability regime, under which each tortfeasor pays

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a sum equal to the difference between actual damages and the damages that would have resulted were he inactive. That is, all tortfeasors are held strictly liable simultaneously, but each receives a ‘credit’ for the expected damages that would have occurred in his absence. Since this rule may lead to payment exceeding actual harm, the excess can be paid as a fine to the state.

12. Unforeseeability Whether the objective probability of an accident is low or high should not in itself affect its inclusion or exclusion from the scope of liability. As Shavell (1980) explained, even if the probability of the harmful consequence is very small, the act that is the cause of the increase in probability should carry liability. The effects on incentives to take care and on the level of activity will be correspondingly small, as they ought to be. In addition, the added expected administrative costs of adjudicating a low-probability event are small, since these costs will be incurred only with a small probability. Thus, the benchmark claim is that whenever an act is a necessary cause of the harm, liability should follow (see also Rizzo, 1981). However, to determine the incentive effects that any scope of liability generates, it is not the objective probability of harm that matters, but the subjective probability - the ex ante assessment of the possible consequences as it is made by the injurer. Calabresi (1975) was the first to state explicitly that there is no sense in trying to deter an act which is a necessary cause of the injury by threatening to impose liability on an injurer who assigns a subjective probability of zero to the injury. An injurer who does not foresee a harmful consequence cannot be meaningfully labeled the least-cost avoider. As Shavell (1980) clarified and generalized, whenever the subjective probability is very low in absolute terms, and lower than the objective probability in relative terms, liability will not produce sufficient ex ante behavioral effects to justify the increase in the costs of dispute resolutions. Thus, under the doctrine of unforeseeability, accidents whose probabilities are likely to be underestimated by injurers should be excluded from the scope of liability. (But see Rizzo, 1981, for an alternative view, advocating the use of objective probabilities in determining the abnormality of events.) It may be that an injurer does not foresee some specific low-probability consequences that subsequently materialize. However, the same injurer may still be in a position to associate an activity with unforeseen risks. The injurer may recognize a large variance of outcomes even if it does not recognize the nature of each outcome in the distribution. In this case, assigning liability for unforeseen harms will have the desirable effect of reducing the level of an activity that is known, ex ante, to cluster many unforeseen risks (see Shavell,

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1980; Landes and Posner, 1987, p. 250). For example, handing a loaded gun to a child leads to many unforeseeable risks (apart from the obvious ones), and can be deterred by imposing liability on this action. Of course, when injurers systematically fail to recognize the unforeseeable consequences of their actions, other forms of deterrence may be required, such as criminalizing the actions (see Calabresi, 1975). The scope of liability for low probability events has another important effect, in determining the incentives of potential injurers to investigate and contemplate the potential consequences of their actions. That is, the amount of information individuals have regarding risk and risk avoidance can be thought of as endogenous, influenced in part by liability rules. The effects of liability rules on the incentives to acquire accurate information ex ante have been studied in more general contexts by several authors (see, for example, Kaplow and Shavell, 1992, 1996; Shavell; 1992; Ben-Shahar, 1995). Specifically, as the scope of liability for low-probability harms expands, individuals will have greater incentives to learn and anticipate these harms, and to take proper measures to avoid them (or liability for them). Thus, the unforeseeability doctrine should be replaced by a doctrine of ‘expensive foreseeability’: only risks that are too costly to anticipate and foresee will be excluded from the scope of liability. Therefore, in operating the hand formula to determine whether lack of care should be considered negligent, courts have to account not only for the direct costs of care, but also for the costs of foresight (Calabresi, 1975; Grady, 1984; Landes and Posner, 1987, pp. 239-247). The concept of unforeseeability in tort law differs from the concept of unforeseeable damage in contract law. The tort doctrine excludes only ‘freak’ accidents from the scope of liability and serves to avoid unnecessary dispute resolution costs. The contract doctrine serves only to limit damages to the average, reasonable, level. However, in economic terms, both tort and contract doctrines can be justified by their effects on ex ante information acquisition. The limited scope of liability in tort should apply only when the risk is too costly for the injurer to anticipate, thus it creates incentives to foresee. The limited scope of liability in contract has the important effect of inducing high-risk contractual parties to reveal their idiosyncratic traits ex ante, so as to secure full compensation and to reduce the chance of breach (see Bebchuk and Shavell, 1991). Two prominent tort doctrines can further illustrate the role of foreseeability in monitoring incentives. The first doctrine distinguishes between categories of harms and can be illustrated by the well-known case of Palsgraff v. Long Island R.R. (162 N.E. 99 (1928)). In that case, as the result of a railroad employee’s negligence, a parcel containing fireworks fell from the train, exploded and caused the crowd to panic and to knock down scales that were standing on the other platform, in a manner that injured a passenger. Since the

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employees did not know of the parcel’s content, the court found the harm to be unforeseeable and outside the scope of negligence. This result is found by most economic writers to be justified (see Calabresi, 1975; Shavell, 1980; Landes and Posner, 1983, 1987, pp. 246-247). Since the injurer discounted the probability of that type of accident, liability would not have generated better incentives and would not have led to prevention of the accident. The injurer may be the least-cost avoider with respect to losses from injuries to passengers and, at the same time, not the least-cost avoider with respect to non-passengers. Making the railroad liable for injuries to non-passengers from acts that were negligent due to the risk they posed to passengers will either have no effect in reducing risks to non-passengers, or may lead the railroad to engage in socially excessive investments to identify freak accidents. Another well-known tort law doctrine is the eggshell skull doctrine, according to which courts impose liability for bodily harm equal to the full severity of the injury, even if the extent of the injury was unforeseeable due to a pre-existing condition of the victim. This may seem to contradict the basic economic insight, which established that when the probability of a high loss is systematically underestimated, holding the injurer liable for the total loss does not increase the incentive to take care (Shavell, 1980). However, as Landes and Posner (1983, 1987, pp. 249-250) have explained, there is economic sense in holding liability for an unforeseeable extent of injury. First, allowing only average damages could potentially generate optimal care incentives, but only if carried out in all cases, including in cases in which victims have ‘thick skulls’ (that is, awarding these victims average damages despite the fact such damages are known to overcompensate them). Put differently, if at the high end of the distribution of harms liability is capped, but at the low end of the distribution liability equals actual harm, average liability will fall short of average harm and the incentives for care will be diluted. As long as victims with low harms get their actual damages, victims with eggshell skulls should also get their full damages, to maintain the correct level of average liability ex ante (see also Kaplow, 1994; Kaplow and Shavell, 1996). In addition, liability for an unlimited extent of injury may have a desirable activity-reducing effect, resulting from the injurer’s de facto strict liability.

13. Causation and Litigation Costs The restriction on the scope of liability that the causation requirement embodies has, in itself, an ambiguous effect on the administrative costs of the legal system. A restricted scope leads to a lower volume of suits that are filed, saving the litigation costs in cases that are clearly outside the scope of liability. On the other hand, if the scope is unrestricted there may be less harms (through a

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reduction in the level of activity) and thus less suits, and each suit that is filed may be less costly to litigate, as there is no causation issue to resolve (see Shavell, 1980, 1987, p. 109; Landes and Posner, 1983). Informational imperfections and their legal treatment have important effects on the costs of resolving disputes. When courts are uncertain about causation, a significant portion of the trial effort may be devoted to disentangling the causation process. Applying simple standards such as the ‘preponderance of the evidence’ rule may reduce administrative costs, sufficiently so to overshadow its inferior incentive effects. Similarly, when the court’s ex post assessment of the probability of harm exceeds the injurer’s ex ante assessment, administrative costs of determining liability may tip the scale towards categorizing the harm as unforeseeable. Lastly, when causation is difficult to verify ex post, but probabilitic linkage is known to exist ex ante, the costs of decentralized dispute resolutions may exceed the costs of a centralized regulatory scheme, outlining the proper bounds of the civil liability system.

Bibliography on Causation and Foreseeability (3300) Abel, Richard L. (1986), ‘Should Tort Law Protect Property Against Accidental Loss?’, 23 San Diego Law Review, 79-123. Assmann, Heinz-Dieter (1988), ‘Multikausale Schäden im deutschen Haftungsrecht (Multicausal Injuries in German Tort Law)’, in Fenyves, Attila and Weyers, Hans-Leo (eds), Multikausale Schäden im Modernen Haftungsrechten, Frankfurt a.M., Metzner, 99-151. Barnes, David W. and Stout, Lynn A. (1992), Economic Analysis of Tort Law, St Paul, MN, West Publishing Company. Bebchuk, Luci an Arye and Shavell, Steven (1991), ‘Information and the Scope of Liability for Breach of Contract: The Rule of Hadley vs. Baxendale’, 7 Journal of Law, Economics, and Organisation, 284-312. Ben-Shahar, Omri (1996), ‘Multiple Causation and the Shapley Value: A Note on Apportionment of Damages’, Unpublished Manuscript, Tel-Aviv University. Borgo, John (1979), ‘Causal Paradigms in Tort Law’, 8 Journal of Legal Studies, 419-455. Burrows, Paul (1984), ‘Tort and Tautology: The Logic of Restricting the scope of Liability’, 13 Journal of Legal Studies, 399-414. Calabresi, Guido (1975), ‘Concerning Cause and the Law of Torts: An Essay for Harry Kalven’, 43 University of Chicago Law Review, 69-100. Celli, Andrew G., Jr (1990), ‘Toward a Risk Contribution Approach to Tortfeasor Identification and Multiple Causation Cases’, 65 New York University Law Review, 635-692. Cooter, Robert D. (1987), ‘Torts as the Union of Liberty and Efficiency: An Essay on Causation’, 63 Chicago-Kent Law Review, 522-551. Cooter, Robert D. and Ulen, Thomas S. (1986), ‘An Economic Case for Comparative Negligence’, 61 New York University Law Review, 1067-1110.

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Cooter, Robert D. (1989a),‘Towards A Market in Unmatured Tort Claims’, 75 University of Virginia Law Review, 383-411. Cooter, Robert D. (1989b), ‘Punitive Damages for Deterrence: When and How Much?’, 40 Alabama Law Review, 1143-1196. Crasswell, Richard and Calfee, John E. (1986), ‘Deterrence and Uncertain Legal Standards’, 2 Journal of Law, Economics, and Organisation, 279-303. Culp, Jerome M. (1986), ‘Causation, Economists, and the Dinosaur: A Response to [Causal Judgment in Attributive and Explanatory Contexts]’, 49(3) Law and Contemporary Problems, 23-46. Delgado, Richard (1982), ‘Beyond Sindell: Relaxation of Cause-in-Fact Rules for Indeterminate Plaintiffs’, 70 California Law Review, 881-908. Epstein, Richard A. (1979), ‘Causation and Corrective Justice: A Reply to Two Critics’, 8 Journal of Legal Studies, 477-504. Epstein, Richard A. (1987), ‘Causation - in Context: An Afterword’, 63 Chicago-Kent Law Review, 653-680. Farber, Daniel A. (1990), ‘Recurring Misses’, 19 Journal of Legal Studies, 727-737. Faure, Michael G. (1993), (G)een Schijn van Kans. Beschouwingen over het Statistisch Causaliteitsbewijs bij Milieugezondheidsschade (No chance. Reflections on Statistical Causation and Environmental Health Damage), Antwerpen, Maklu, 68 p. Grady, Mark F. (1983), ‘A New Positive Theory of Negligence’, 92 Yale Law Journal, 799-829. Grady, Mark F. (1984), ‘Proximate Cause and the Law of Negligence’, 69 Iowa Law Review, 537-573. Grady, Mark F. (1988), ‘Discontinuities and Information Burdens: Review of the Economic Structure or Tort Law by William M. Landes and Richard A. Posner’, 56 George Washington Law Review, 658ff. Grady, Mark F. (1989), ‘Untaken Precautions’, 18 Journal of Legal Studies, 139-156. Kahan, Marcel (1989), ‘Causation and Incentives to Take Care under the Negligence Rule’,18 Journal of Legal Studies, 427-447. Kaye, David (1982), ‘The Limits of the Preponderance of the Evidence Standard: Justifiably Naked Statistical Evidence and Multiple Causation’, American Bar Foundation Research Journal, 487-516. Kaye, David and Aickin, Mikel (1984), ‘A Comment on Causal Apportionment’, 13 Journal of Legal Studies, 191-208. Kelman, Mark G. (1987), ‘The Necessary Myth of Objective Causation Judgments in Liberal Political Theory’, 63 Chicago-Kent Law Review, 579-637. Kruskal, William (1986), ‘Terms of Reference: Singular Confusion about Multiple Causation’, 15 Journal of Legal Studies, 427-436. Landes, William M. and Posner, Richard A. (1983), ‘Causation in Tort Law: An Economic Approach’, 12 Journal of Legal Studies, 109-134. Landes, William M. and Posner, Richard A. (1984), ‘Tort Law as a Regulatory Regime for Catastrophic Personal Injuries’, 13 Journal of Legal Studies, 417-434. Levmore, Saul (1990), ‘Probabilistic Recoveries, Restitution, and Recurring Wrongs’, 19 Journal of Legal Studies, 691-726. Marino, Anthony M. (1991), ‘Market Share Liability and Economic Efficiency’, 57 Southern Economic Journal, 667-675.

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Marks, Stephen V. (1994), ‘Discontinuities, Causation, and Grady’s Uncertainty Theorem’, 23 Journal of Legal Studies, 287-301. Miceli, Thomas J. (1996), ‘Cause in Fact, Proximate Cause, and the Hand Rule: Extending Grady’s Positive Economic Theory of Negligence’, 16 International Review of Law and Economics, 473-482. Miceli, Thomas J. and Segerson, Kathleen (1991), ‘Joint Liability in Torts: Marginal and Infra-Marginal Efficiency’, 11 International Review of Law and Economics, 235-249. Moore, Michael S. (1987), ‘Thomson’s Preliminaries about Causation and Rights’, 63 Chicago-Kent Law Review, 497-521. Polinsky, A. Mitchell (1972), ‘Probabilistic Compensation Criteria’, 86 Quarterly Journal of Economics, 407-425. Porat, Ariel and Stein, Alex (1997), ‘Liability for Uncertainty: Making Evidential Damage Actionable’, 18 Cardozo Law Review, forthcoming. Posner, Richard A. (1979), ‘Epstein’s Tort Theory: A Critique’, 8 Journal of Legal Studies, 457-475. Rizzo, Mario J. (1981), ‘The Imputation Theory of Proximate Cause: An Economic Framework’, 15 Georgia Law Review, 1007-1038. Rizzo, Mario J. (ed) (1987a), ‘Symposium on Causation in the Law of Torts’, 63 Chicago-Kent Law Review, 397-680. Rizzo, Mario J. (1987b), ‘Foreword: Fundamentals of Causation’, 63 Chicago-Kent Law Review, 397-406. Rizzo, Mario J. and Arnold, Frank S. (1980), ‘Causal Apportionment in Tort Law: An Economic Theory’, 85 Columbia Law Review, 1399-1429. Rizzo, Mario J. and Arnold, Frank S. (1986), ‘Causal Apportionment: Reply to the Critics’, 15 Journal of Legal Studies, 219-226. Robinson, Glen O. (1985), ‘Probabilistic Causation and Compensation for Tortious Risk’, 14 Journal of Legal Studies, 779-798. Rose-Ackerman, Susan (1990), ‘Market-Share Allocations in Tort Law: Strengths and Weaknesses’, 19 Journal of Legal Studies, 739-746. Rosenberg, David M. (1984), ‘The Causal Connection in Mass Exposure Cases: ‘Public Law’ Vision of the Tort System’, 97 Harvard Law Review, 849-929. Rossello, Carlo (1990), Il danno Evitabile. La Misura della Responsabilità tra Diligenza ed Efficienza (Avoidable Damage: The Measure of Liability Between Due Care and Efficiency), Padova, CEDAM, 320 p. Schwartz, Alan (1987), ‘Causation in Private Tort Law: A Comment on Kelman’, 63 Chicago-Kent Law Review, 639-651. Shavell, Steven (1980), ‘An Analysis of Causation and the Scope of Liability in the Law of Torts’, 9 Journal of Legal Studies, 463-516. Shavell, Steven (1985), ‘Uncertainty over Causation and the Determination of Civil Liability’, 28 Journal of Law and Economics, 587-609. Thomson, Judith Jarvis (1987), ‘Causality and Rights: Some Preliminaries’, 63 Chicago-Kent Law Review, 471-496. Weinrib, Ernest J. (1987), ‘Causation and Wrongdoing’, 63 Chicago-Kent Law Review, 407-450. Wittman, Donald A. (1981), ‘Optimal Pricing of Sequential Inputs: Last Clear Chance, Mitigation of Damages and Related Doctrines in the Law’, 10 Journal of Legal Studies, 65-91.

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Wright, Richard W. (1985), ‘Actual Causation vs. Probabilistic Linkage: The Bane of Economic Analysis’, 14 Journal of Legal Studies, 435-456. Wright, Richard W. (1987), ‘The Efficiency Theory of Causation and Responsibility: Unscientific Formalism and False Semantics’, 63 Chicago-Kent Law Review, 553-578.

Other References Ben-Shahar, Omri (1995), ‘Informed Courts, Uninformed Individuals, and the Economics of Judicial Hindsight’, 151 Journal of Institutional and Theoretical Economics, 613-630. Brown, John P. (1973), ‘Toward an Economic Theory of Liability’, 2 Journal of Legal Studies, 323-350. Calabresi, Guido (1970), The Costs of Accidents, New Haven: Yale University Press. Coase, Ronald C. (1960), ‘The Problem of Social Costs’, 3 Journal of Law and Economics, 1-44. Cooter, Robert C. (1989), ‘Punitive Damages for Deterrence: When and How Much?’, 40 Alabama Law Review, 1143-1196. Cooter, Robert D. and Ulen, Thomas (1989), Law and Economics, New York, Harper Collins. Epstein, Richard (1973), ‘A Theory of Strict Liability’, 2 Journal of Legal Studies, 151-204. Hart, H.L.A. and Honoré, Tony (1985), Causation in the Law (2nd edn), Oxford, Oxford University Press. Honoré, Tony (1983), ‘Causation and Remoteness of Damages’, XI(1) International Encyclopedia of Comparative Law. Kaplow, Louis (1994), ‘The Value of Accuracy in Adjudication: An Economic Analysis’, 23 Journal of Legal Studies, 307-401. Kaplow, Louis and Shavell, Steven (1992), ‘Private versus Socially Optimal Provision of Ex Ante Legal Advice, 8 Journal of Law, Economics, and Organization, 317-320. Kaplow, Louis and Shavell, Steven (1996), ‘Accuracy in the Assessment of Damages’, 39 Journal of Law and Economics, 191-209. Keeton, W. Page, Dobb, Dan, Keeton, Robert and Owen, David (1984), Prosser and Keeton on Torts (5th edn), St Paul, MN, West Publishers. Landes, William M. and Posner, Richard A. (1980), ‘Joint and Multiple Tortfeasors: An Economic Analysis’, 9 Journal of Legal Studies, 517-555. Landes, William M. and Posner, Richard A. (1987), The Economic Structure of Tort Law, Cambridge, MA, Harvard University Press. Roe, Mark (1984), ‘Bankruptcy and Mass Tort’, 84 Columbia Law Review, 846-922 . Shavell, Steven (1984), ‘Liability for Harm versus Regulation of Safety’, 13 Journal of Legal Studies, 357-374. Shavell, Steven (1987), Economic Analysis of Accident Law, Cambridge, MA, Harvard University Press. Shavell, Steven (1992), ‘Liability and the Incentives to Obtain Information about Risk’, 21 Journal of Legal Studies, 257-270. Shavell, Steven (1993), ‘The Optimal Structure of Law Enforcement’, 36 Journal of Law and Economics, 355-388.

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Cases Berry v. Borough of Sugar Notch, 43 A. 240 (1899). City of Piqua v. Morris, 120 N.e. 300 (1918). Sindell v. Abbott Laboratories 607 P.2d 924 (1980). Palsgraff v. Long Island R.r. 162 N.e. 99 (1928). Summers v. Tice, 199 P.2d 1 (1948).

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3400 VICARIOUS AND CORPORATE CIVIL LIABILITY Reinier H. Kraakman Professor of Law, Harvard Law School © Copyright 1999 Reinier H. Kraakman

Abstract Vicarious liability is the strict liability of a principal for the misconduct of her agent. This chapter reviews six areas of commentary on vicarious and corporate civil liability. It begins by formulating the standard case for vicarious liability based on the likely insolvency of the firm’s culpable agents in the face of massive liability for business torts. Next, it addresses cost considerations that militate against imposing vicarious liability on the corporation in some circumstances, and the relationship between corporate liability the structure of liability imposed on corporate agents. Two additional sections of the article review alternatives to traditional vicarious liability regimes, including alternative liability rules for corporate principals (notably a negligence rule) and alternative targets for liability besides the firm (notably top corporate managers). Finally, the chapter reviews recent literature on the distinction between corporate civil and criminal liability. It concludes that the case made out thus for distinguishing between these too forms of corporate liability is weak. JEL classification: K13, K22, K42 Keywords: Vicarious Liability, Corporate Liability, Principal, Agent, Gatekeeper

1. Introduction ‘Vicarious liability’ is the absolute liability of one party - generally the legal ‘principal’ - for misconduct of another party - her ‘agent’ - the actor whose activities she directs. As such, traditional vicarious liability is a form of strict secondary liability, in contrast to secondary liability imposed on principals or other parties under a duty-based standard such as negligence. In the common law, the legal doctrine of respondent superior is the principal vehicle for holding principals liable for the torts and other delicts of their agents. Under this doctrine, principals are jointly and severally liable for the wrongs committed within the ‘scope of employment’ by agents whose behavior they have the legal right to control (‘servants’) (Restatement (Second) of Agency, 1958, §§2, 219, 220, 229). Most corporate liability for torts, and in the United States for crimes as well, is vicarious liability imposed under respondent superior or a similar doctrine. 669

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To be sure, corporate liability may also be direct, as when the independent actions of several corporate agents cumulatively result in a business tort, although no single agent is individually culpable. But even in this case, the liability of corporate principals is best conceptualized as vicarious liability for the failure of the firm’s management to supervise its employees. An overview of the literature on vicarious and corporate civil liability must address at least six areas of commentary: (a) the standard case for strict vicarious liability; (b) the factors militating against vicarious liability; (c) the interaction between vicarious liability and the structure of liability for agents; (d) alternatives to a strict vicarious liability standard; (e) alternative targets for vicarious liability; and (f) the choice between civil and criminal corporate liability.

2. The Standard Case for Vicarious Liability The initial issue raised by a regime of vicarious liability for torts is the Coasian question: why should an allocation of liability between principals and agents matter if these parties are able to reallocate liability among themselves by agreement? The fundamental analysis of vicarious liability, developed with the aid of principal-agent models by Kornhauser (1982) and Sykes (1981, 1984), looks to the insolvency of agents and to limitations on the ability of the parties to shift liability as the basic conditions favoring vicarious liability. As a general matter, Kornhauser (1982), Sykes (1984) and Shavell (1987) agree that vicarious liability for ordinary torts is more likely to increase social welfare as the disparity between agent assets and the magnitude of prospective tort liability increases. By contrast, where tort liability would leave both principals and agents solvent and the costs of negotiating between principals and agents are slight, vicarious liability is likely to have few efficiency consequences (for example, Kornhauser, 1982, pp. 1351-1352; Sykes, 1984, p. 1241). Given that principals can satisfy prospective tort liability but agents cannot, vicarious liability may or may not be efficient. Consider first the considerations that weigh in favor of vicarious liability when agents are insolvent but corporate principals are not. To begin, vicarious liability is increasingly likely to be efficient as principals have greater ability to monitor or otherwise control agent risk-taking. The analysis is straightforward. Absent vicarious liability, personal liability gives insolvent agents insufficient incentive to take care, since they lack the wealth to pay tort damages (Sykes, 1981, p. 168; Shavell, 1987, pp. 170-171). Moreover, their principals have no incentive to urge greater care, since the only liability cost faced by principals (in the absence of secondary liability) is the wage cost of offsetting the expected liability of their agents. Thus, insolvent

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agents under a regime of purely personal liability will lead firms to take too little care and to initiate too much risky activity or misconduct. By contrast, principals who are vicariously liable and face the full expected cost of tort damages will seek to control their agents to ensure optimal precautionary measures. The traditional doctrine of respondent superior is fully in accord with this analysis since it appears to tie vicarious liability explicitly to the principal’s costs of monitoring or otherwise controlling employee behavior (Landes and Posner, 1987, p. 208). For example, agency law determines the principal’s tort liability based not only on her capacity to monitor her agent’s actions but also on her ability to contractually alter her agent’s incentives, as when the scope of employment rules condition vicarious liability on whether the culpable agent acted, at least in part, to benefit his principal (Restatement (Second) of Agency, 1958, §228(1) (c)). Apart from inducing principals to control agent misconduct through monitoring and preventive measures, vicarious liability can also force principals to internalize the costs of misconduct when agents are judgmentproof. In the private sector, at least, forcing firms to internalize the costs of misconduct that accompany their productive activity leads, other things being equal, to an efficient scale of production by bringing the private costs of production into line with the social costs (for example, Shavell, 1980; Kramer and Sykes, 1987, p. 286). Thus, even if corporate principals cannot control caretaking by agents, vicarious liability can ensure that they at least face the full expected costs of accidents or wrongdoing, and thus do not undertake too much risky activity - providing, of course, that their agents are also strictly liable for the underlying harms at issue (Polinsky and Shavell, 1993). As Shavell (1987, pp. 173-174) notes, moreover, several other considerations favor a rule of corporate vicarious liability as well, especially when contracting between principals and agents is constrained and there are limitations such as solvency on the effective liability faced by agents. First, principals may be better informed than agents about accident risks, or better able to limit these risks by reorganizing the workplace. Second, principals - and particularly firms - may be better able to monitor and discipline agents than the courts. Thus, vicarious liability may be socially advantageous if principals are less likely than courts to err in reviewing agent conduct. Third, principals may be more attractive targets of liability as a consequence of what Kornhauser (1982, pp. 1370-1371) terms the problem of ‘multiple agents’. That is, an outside plaintiff may find the task of determining which of a firm’s many agents has caused a tort extremely costly, even when one of the firm’s agents is clearly responsible. But if the firm faces liability, it may be able to locate and discipline the culpable agent - or, even if it cannot, it may be able to reduce tort costs through other means such as training programs or screening measures. Fourth, as most commentators acknowledge, shifting liability to principals under a vicarious liability rule is likely to reduce risk bearing costs, at least in

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the paradigmatic case where agents are risk averse or insolvent, principals are firms, and victims are risk-averse individuals (for example, Kramer and Sykes, 1987, p. 278; Chapman, 1996). Finally, in addition to the justifications for vicarious liability resting on the assumption of rational, utility-maximizing actors, some commentators have proposed justifications based on limited or defective rationality, particularly on the part of corporate agents (for example, Croley, 1996; Schwartz, 1996a). In these accounts, defective rationality blunts the incentive effects of liability on wayward agents, much as insolvency, or external constraints on sanctions, limits the power of liability to deter agents in more conventional accounts of vicarious liability.

3. Factors Militating Against Strict Vicarious Liability Although the standard considerations favoring vicarious liability make a persuasive case in many circumstances, they also point to several factors that militate against vicarious liability. Agents who are well capitalized, especially in relationship to their putative principals, are better left to bear full personal liability for business torts on both incentive and risk bearing grounds. As Shavell (1987, p. 174) argues, outside the conventional context of large enterprises and their employees, ‘there is no natural presumption’ about the comparative capitalization of principals and agents - or about the ability of principals to observe the loss avoidance behavior of agents. Imposing liability on principals who cannot monitor their agents is unlikely to reduce accident costs and, as Sykes (1984, p. 1249) notes, may actually decrease safety by lowering the expected liability of agents for their own negligence. Finally, most commentators agree that whatever the advantages of vicarious liability, it clearly increases administrative costs by including additional defendants in tort actions. Even in the context of large firms, where the case for vicarious liability is generally strongest, it is arguably inappropriate under some circumstances. One example arises when senior managers intentionally release fraudulent information into the capital market in order to protect their jobs or secure personal benefits. As Arlen and Carney (1992) note, vicarious liability may have little deterrent effect when top managers charged with supervising the firm act on their own behalf in committing misconduct, particularly when these managers are in an end game because the firm faces likely bankruptcy. Further, the risk-bearing rationale for imposing liability on the firm rather than on its agents is weak for such self-conscious misconduct because managers can avoid risk of liability simply by refraining from making misleading statements. Finally, the firm liable for damages inflicted by its top managers on a subset of its own investors has perverse consequences. Absent strong evidence that such

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liability leads managers to monitor one another, its effect is simply to shift assets (net of litigation expenses) from one class of innocent investors to another. Arlen (1994) also identifies a second circumstance in which holding firms vicariously liable for the intentional wrongdoing of agents can generate perverse incentives and increase enforcement costs. In cases where misconduct is difficult to detect, the firm may enjoy a comparative advantage over outsiders in monitoring for it. Yet the firm will not monitor optimally under a vicarious liability regime - and may not monitor at all - if the information that the firm acquires can be used to increase its own probability of incurring liability. The reason is straightforward: increased monitoring lowers the firm’s expected liability costs by raising its ability to deter or prevent misconduct, but increased monitoring also raises the firm’s expected liability costs by increasing the probability that, should misconduct occur, the firm will be held liable for it. Although Arlen (1994) directs her analysis to corporate crimes, the ‘potentially perverse’ effect that she identifies clearly extends to vicarious civil liability for torts that may be difficult to detect without monitoring by the principal. A related observation, made in Arlen and Kraakman (1997, pp. 712-717), is that a credibility problem may arise where strict vicarious liability is used to induce firms to monitor or investigate misconduct. The nub of the problem is that, absent a commitment device such as reputation, firms may not have an incentive to actually monitor, or to investigate and report misconduct after it has occurred. While credible threats to implement these measures would deter misconduct, the measures themselves add nothing under a vicarious liability rule except enforcement costs and enhanced liability risks for firms. The danger, then, is that some firms may not be able to make credible enforcement threats - even if they intend to carry them out - because wayward agents rightly suspect that actually implementing these enforcement measures would be acting against interest. By contrast, an element of duty-based liability such as a negligence rule can assure the credibility of enforcement threats, just as it can overcome the perverse effects associated with traditional vicarious liability (Arlen and Kraakman, 1997, pp. 717-718). Lastly, a novel set of problems associated with strict vicarious liability arises in the context of government bodies and certain non-profits that are not subject to ordinary market constraints. While the aims of inducing optimal caretaking, self-policing, and efficient risk-bearing arguably support vicarious liability for such non-market entities just as they do for business corporations, the argument for this liability rule based on the need to regulate activity levels does not (see Kramer and Sykes, 1987, pp. 278-283). It is simply unclear how cost internalization affects the scale of the non-market enterprise - it might yield too much or too little activity (Kramer and Sykes, 1987, p. 286). For this reason, a duty-based or negligence-based liability regime might be preferred to strict vicarious liability for non-market entities such as cities (Kramer and Sykes,

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1987, p. 294) - just as it might sometimes be preferable for rival firms where perverse incentive and credibility problems are severe.

4. The Interaction between Principal and Agent Liability An important question in the literature concerns the relationship between vicarious liability and the regime under which the principal’s agent incurs personal liability. Vicarious liability is a form of strict liability: the principal is absolutely liable for the delicts of the agent as if the principal actually were the agent. Moreover, the agent and the principal share exactly the same liability: the principal simply steps into the shoes of the agent. Yet both of these dimensions of the traditional vicarious liability regime are open to challenge in many circumstances. Consider first whether the agent and the principal should face the same liability. In the standard case where the principal is an enterprise, the agent is an employee, and the agent’s actions trigger significant liability, a rule of vicarious liability generally makes the enterprise rather than the agent liable as a practical matter (Kraakman, 1984a; 1984b). At most, the culpable agent faces the loss of his job and the risk of losing limited assets in a civil lawsuit. Chapman (1996) argues that this shift from individual to enterprise liability protects firms from the agency problem of overcompliance that might otherwise arise as managers sought to reduce their risk of personal liability. As Polinsky and Shavell (1993) observe, however, the opposite problem may also arise: the firm may not be able to administer private sanctions severe enough to induce its employees to take optimal care where the social costs of torts are large. Thus, it may be appropriate to not only sanction employees but to administer criminal sanctions such as fines and imprisonment, even when the firm remains liable for only civil damages. Polinsky and Shavell (1993) propose criminal liability for employees, then, not because employees are inherently blameworthy, but rather because their limited assets may insulate them from the contractual sanctions and civil suits at the disposal of firms. Of course, if the firm’s agents become criminally liable, the firm must pay wages to compensate its employees for their greater liability costs and its own vicarious liability should be reduced accordingly. Failure to reduce the firm’s liability in this fashion would distort its activity level and undesirably discourage consumption (Polinsky and Shavell, 1993, p. 241). Next, consider whether firms and agents ought to face liability under precisely the same circumstances as they currently do under a traditional regime of vicarious liability. Polinsky and Shavell (1993, pp. 251-253) argue that vicarious liability may often be, in effect, underinclusive, because firms should be strictly liable for harms associated with their production processes

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while their employees ought to be liable only under a negligence standard. One argument offered by Polinsky and Shavell (1993) is that a negligence standard offers a stronger incentive for caretaking than strict liability does when agents are partially insulated from liability by limited assets. Other arguments for a negligence standard include its value in economizing on costly criminal sanctions such as imprisonment, and its potential value in limiting the risk-bearing costs of risk averse corporate agents. A different issue associated with holding agents and principals liable in precisely the same circumstances arises when principals are vicariously liable for the negligence of agents - as distinct from facing strict liability for the underlying misconduct (as Polinksy and Shavell, 1993, propose). Because a negligence standard governs much of tort law, firms are often strictly liable for employee negligence under the traditional vicarious liability regime. But establishing the negligence of corporate employees who act deep within the enterprise may be extremely difficult without the assistance of the corporate principal itself. As Chu and Qian (1995) point out, this juxtaposition of corporate liability and monitoring leads to a familiar problem: vicarious liability gives the principal a powerful incentive to withhold monitoring evidence from the court precisely because the principal cannot be vicariously liable unless its agent is found negligent in the first instance. This effect parallels Arlen’s (1994) analysis of possible perverse effects associated with vicarious corporate criminal liability insofar as it turns on the difficulty of detecting misconduct (here the agent’s negligence) without enlisting the cooperation of the principal. If the corporate principal is made strictly liable for the harm regardless of the agent’s negligence (as proposed by Polinsky and Shavell, 1993), the incentive of the corporate principal to withhold information about the negligence of its agents may be mitigated. Yet it will not be eliminated entirely as long as monitoring by the corporate principal increases the probability of corporate liability (Chu and Qian, 1995, p. 320).

5. Negligence and Composite Vicarious Liability Regimes As the preceding discussion indicates, a traditional regime of strict vicarious liability is a relatively rigid rule that, in some circumstances, may fail to satisfy one or both of the fundamental objectives of tort law: providing for the internalization of tort costs and for the optimal regulation of precautionary measures. In most cases strict vicarious liability is congruent with a policy of forcing firms to internalize tort costs. In fact, when principals cannot monitor their agents’ behavior, the only justification for vicarious liability is the internalization of tort costs and the concomitant regulation of activity levels. It is possible, however, that principals may be in a position to prevent some forms of misconduct that are not properly assigned to the marginal costs of

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enterprise production. In this case a negligence rule that imposes liability only when principals fail to take reasonable steps to prevent misconduct may dominate strict vicarious liability, precisely because such a rule does not charge the full cost of misconduct to the firm (Sykes, 1988, pp. 577-579). In the more conventional case where tort costs are appropriately assigned to the enterprise, a chief drawback of traditional strict liability is the perverse monitoring incentive analyzed by Arlen (1994) and Chu and Qian (1995): that is, the risk that principals will not monitor their agents optimally because doing so might increase their risk of incurring vicarious liability. Here too, as was suggested in Section 3 above, a negligence standard imposing liability only on principals who fail to take reasonable monitoring steps is a natural solution to the risk of inadequate monitoring under a strict liability regime. There are, however, important drawbacks to a regime of ‘negligence-based’ vicarious liability, as it is termed by Kramer and Sykes (1987, p. 283). For example, a negligence standard will not regulate activity levels efficiently by assuring that firms fully internalize the costs of their torts. In addition, a negligence regime is arguably poorly suited for inducing firms to undertake other kinds of measures to prevent misconduct - such as reorganizing production processes - that do not involve monitoring or affect the principal’s risk of incurring liability. In the case of intentional torts and crimes, Arlen and Kraakman (1997) discuss three types of ‘mixed’ liability regimes that are designed to induce corporate principals to undertake appropriate monitoring measures (and possibly to report agent misconduct as well) while simultaneously encouraging preventive measures and assuring that firms internalize the full costs of their agents’ misconduct. The first type includes regimes that, through use immunity or privilege doctrines, attempt to insulate corporate principals from any increase in their probability of prosecution arising from their internal monitoring and investigatory efforts. An example is coupling strict liability for environmental harms with an environmental audit privilege, to ensure that firms retain their incentives to undertake such audits. The second type is a regime of strict liability with a variable sanction that declines to offset any increase in the expected liability that a firm would otherwise from monitoring for employee misconduct. Finally, the third type includes ‘composite’ regimes that combine a negligence rule to regulate corporate monitoring and investigation of misconduct with a residual element of strict liability to ensure that corporate principals adopt preventive measures and internalize the costs of agent misconduct. Here an example is the liability regime created by the US Federal Sentencing Guidelines for corporate crimes (see Arlen and Kraakman, 1997, pp. 745-752). Arlen and Kraakman (1997) argue that the range of mixed vicarious liability regimes - extending from evidentiary privileges through adjusted sanction regimes to composite regimes - are increasingly costly to administer

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effectively but are also increasingly likely to satisfy the multiple enforcement objectives of a vicarious liability regime. To be sure, some commentators oppose any resort to a negligence standard to supplement strict liability (as is necessary in a composite regime) on the grounds that judicial error in administering the standard will inevitably create liability in excess of the social cost of misconduct (Fischel and Sykes, 1996, pp. 328-329). This effect, however, can be ameliorated by downwardly adjusting the composite liability regime’s residual liability level. It follows that the traditional American rule of strict vicarious liability is well-suited to the ordinary cast in which the costs of agent misconduct are appropriately charged to the principal and misconduct is unlikely to escape detection. Whenever one of these conditions fails, however, strict vicarious liability may be dominated by either negligence-based vicarious liability or a mixed regime that includes elements of both strict and negligence-based liability.

6. Reaching Beyond the Principal: Alternative Liability Targets Traditional vicarious liability makes the legal ‘principal’ liable for her agent’s torts. But other actors besides the principal may also be in a position to monitor safety precautions or thwart third-party misconduct: for example, senior managers within the firm who supervise lower-level employees; or the lawyers, accountants and underwriters who facilitate fraudulent public issues of securities. In fact, secondary liability (if not necessarily traditional strict vicarious liability) for the torts and delicts of primary wrongdoers is a common legal control strategy well outside the domain of principal-agent relationships. In some cases, the secondary liability of parties other than the organizational principal or enterprise serves as a backstop for traditional vicarious liability. For example, Kraakman (1984a, 1984b) argues that the personal liability of corporate managers for garden-variety torts protects against the possible inadequacy of corporate assets to satisfy the firm’s liability. Thus, in a reversal of the traditional justification for vicarious liability discussed above in Section 1, Kraakman (1984a, pp. 869-871; 1984b) suggests that most personal liability of managers for corporate torts should be understood as protecting tort victims against undercapitalized firms rather than agents, since well-capitalized firms invariably insulate their managers from liability through insurance or indemnification contracts. In some cases, however, the law blocks the indemnification of managers for their own misconduct or extends liability for corporate misconduct to a broader circle of influential actors beyond the group of top managers, such as outside directors and accountants associated with companies. Kraakman (1984a, 1984b) describes this as a ‘gatekeeper strategy’ that is designed to augment potentially inadequate levels of liability imposed on the firm itself. Thus, just

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as vicarious corporate liability can enhance legal controls over judgment-proof agents, so in extreme cases the personal liability of corporate managers, directors, and even outside directors can partially offset the inadequacy of corporate liability. In addition, the potential uses of secondary liability, whether civil or criminal, and the value of the gatekeeper strategy, extend well beyond the corporate enterprise. An important research agenda turns on identifying contexts where these liability strategies are or are not cost effective. Kraakman (1986) examines several considerations bearing on the costs and benefits of imposing secondary liability on a contracting party in order to deter or prevent the misconduct of the counter-party to the contractual relationship. The chief enforcement tool at the disposal of a private ‘gatekeeper’ is the power to withhold goods, services, or facilitation from a counter-party engaged in risky or suspect behavior, just as the principal’s chief incentive device in the traditional agency relationship is the threat to fire an agent who engages in risky behavior. Moreover, whether gatekeeper liability is likely to prevent misconduct depends in part on the same considerations that contribute to an effective regime of vicarious liability, such as the assets and the expertise of the gatekeeper relative to those of the potential tortfeasor. But especially in the case of intentional misconduct, the efficacy of gatekeeping turns in large part on how easily would-be wrongdoers can contract around honest gatekeepers who withhold their services from suspect endeavors (Kraakman, 1986, pp. 66-74). Several commentators have undertaken more particularized assessments of the costs and benefits of gatekeeper liability for individual classes of strategic gatekeepers. For example, Franzoni (1996) examines gatekeeper enforcement of tax laws through imposing liability on auditors. Choi (1998) offers a skeptical analysis of the costs and benefits of gatekeeper liability imposed on underwriters in the securities market. Jackson (1993) and Wilkins (1993) consider gatekeeper liability imposed on lawyers in the context of banking regulations.

7. Corporate Civil Liability versus Criminal Liability The vicarious liability regime that accounts for most corporate liability in the United States makes no distinction between civil and criminal liability. It is well-accepted that when corporate agents commit crimes within the scope of their employment, firms can be criminally prosecuted on a theory of vicarious liability - just as firms are vicariously liable for the civil torts of their agents. Recent literature on vicarious liability, however, questions the value of imposing specifically criminal liability on corporate principals, as distinct from imposing vicarious civil liability for the criminal acts of corporate agents. The critique of corporate criminal liability proceeds on several fronts. Fischel and Sykes (1996, pp. 322-324) point out that the specifically criminal

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sanction of incarceration is unavailable against corporations, and that the criminal law objective of incapacitating criminals though incarceration makes little sense in the context of corporate liability. Equally important, Fischel and Sykes (1996) argue, criminal sanctions are uncalibrated to the level of harm associated with crime, which may be appropriate to penalties imposed on individuals but is inappropriate to penalties operating on the corporate level. Criminal penalties imposed on individuals for intentional crimes such as murder create little risk of overdeterrence: less murder is always better. But penalties imposed on the corporate level lack this character, precisely because they are corporate penalties. Corporations are, in Fischel and Sykes’s (1996, p. 323) phrase, ‘webs of contractual relationships consisting of individuals who ban together for their mutual economic benefit’. Corporate crimes typically involve actions committed by some corporate agents without the knowledge and approval of others. It follows that the primary function of penalties imposed on the corporate level is not to deter in the conventional sense but to induce firms to monitor their agents and prevent crimes: that is, the classic justification for vicarious liability (see Fischel and Sykes, 1996, p. 324; Parker, 1996). The baseline penalty imposed on the corporation, then, should be civil liability equal to the social cost of crime discounted to reflect its probability of detection. A second critique of corporate criminal liability does not question penalty levels per se but asks: why prefer criminal penalties over equivalently scaled civil liability? The feature that arguably distinguishes criminal sanctions on the corporate level - social stigma and reputational loss - render these penalties less predictable and more costly than parallel civil penalties (see Karpoff and Lott, 1993; Khanna, 1996, pp. 1501-1512). Moreover, in most cases, the administration costs of criminal prosecution are likely to be larger than the costs of civil lawsuits by government agencies (Khanna, 1996, pp. 1512-1531). In light of these multiple critiques of corporate criminal liability, the justification for vicarious criminal liability for corporate principals - or principals more generally - remains an important topic for future research. If no plausible justification can be found, the implications for law reform are clear: vicarious corporate liability should be decriminalized.

Bibliography on Vicarious and Corporate Civil Liability (3400) Arlen, Jennifer H. (1994), ‘The Potentially Perverse Effects of Corporate Criminal Liability’, 23 Journal of Legal Studies, 832-867. Arlen, Jennifer H. (1995), ‘Commentary on Rewarding Whistleblowers: The Costs and Benefits of an Incentive-Based Compliance Strategy’, in Daniels, Ronald and Morck, Randall (eds), Corporate Decision-Making in Canada, 635-647. Arlen, Jennifer H. and Carney, William J. (1992), ‘Vicarious Liability for Fraud on the Market: Theory

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and Evidence. Vicarious Liability for Fraud on Securities Markets: Theory and Evidence’, 1992 University of Illinois Law Review, 691-740. Reprinted in Andersen, Jensen and Mortensen (eds), Governance by Legal and Economic Measures, 1993. Arlen, Jennifer H. and Kraakman, Reinier H. (1997), ‘Controlling Corporate Misconduct: A Comparative Analysis of Alternative Corporate Incentive Regimes’, 72 New York University Law Review, 687-779. Boyd, James and Ingberman, Daniel E. (1996), ‘The Polluter Pays Principle: Should Liability be Extended when the Polluter Cannot Pay?’, 21 Geneva Papers on Risk and Insurance. Chapman, Bruce (1992), ‘Limited Auditors’ Liability: Economic Analysis and the Theory of Tort Law’, 20 Canadian Business Law Journal, 180-214. Chapman, Bruce (1996), ‘Corporate Liability and the Problem of Overcompliance’, 69 Southern California Law Review, 1679-1703. Choi, Stephen (1998), ‘Market Lessons for Gatekeepers’, 92 Northwestern University Law Review, 916 ff. Chu, C.Y. Cyrus and Qian, Yingy (1995), ‘Vicarious Liability under a Negligence Rule’, 15 International Review of Law and Economics, 305-322. Croley, Steven P. (1996), ‘Vicarious Liability in Tort: On the Sources and Limits of Employee Reasonableness’, 69 Southern California Law Review, 1705-1738. Fischel, Daniel R. and Sykes, Alan O. (1996), ‘Corporate Crime’, 25 Journal of Legal Studies, 319-349. Franzoni, Luigi Alberto (1996), ‘Independent Auditors as Fiscal Gatekeepers’, Working Paper, Department of Economics, University of Bologna. Jackson, Howell E. (1993), ‘Reflections on Kaye, Scholer: Enlisting Lawyers to Improve the Regulation of Financial Institutions’, 66 Southern California Law Review, 1019-1074. Karpoff, Jonathan M. and Lott, John R., Jr (1993), ‘The Reputational Penalty Firms Bear from Committing Criminal Fraud’, 36 Journal of Law and Economics, 757-802. Khanna, V.S. (1996), ‘Corporate Criminal Liability: What Purpose does it Serve?’, 109 Harvard Law Review, 1477-1534. Kornhauser, Lewis A. (1982), ‘An Economic Analysis of the Choice between Enterprise and Personal Liability for Accidents’, 70 California Law Review, 1345-1392. Kraakman, Reinier H. (1984a), ‘The Economic Functions of Corporate Liability’, in Hopt, Klaus J. and Teubner, Gunther (eds), Corporate Governance and Directors’ Liabilities, New York, de Gruyter, 178-207. Kraakman, Reinier H. (1984b), ‘Corporate Liability Strategies and the Costs of Legal Controls’, 93 Yale Law Journal, 857-898. Kraakman, Reinier H. (1986), ‘Gatekeepers: The Anatomy of a Third-Party Enforcement Strategy’, 2 Journal of Law, Economics, and Organization, 53-104. Kramer, Larry and Sykes, Alan O. (1987), ‘Municipal Liability under Section 1983: A Legal and Economic Analysis’, 1987 Supreme Court Review, 249-301. Levmore, Saul (1995), ‘Gomorrah to Ybarra and More: Overextraction and the Puzzle of Immoderate Group Liability’, 81 Virginia Law Review, 1561-1604. Parker, Jeffrey (1996), ‘Doctrine for Destruction: The Case of Corporate Criminal Liability’, 17 Managerial and Decision Economics, 381-398. Polinsky, A. Mitchell and Shavell, Steven (1993), ‘Should Employees be Subject to Fines and Imprisonment Given the Existence of Corporate Liability?’, 13 International Review of Law and

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Economics, 239-257. Rapakko, Timo (1987), Corporate Control and Parent Firms’ Liability for Their Controlled Subsidiaries: A Study on the Regulation of Corporate Conduct, Helsinki, Helsinki School of Economics. Schwartz, Gary T. (1993), ‘Tobacco Liability in the Courts’, in Rabin, Robert and Sugarman, Stephen (eds), Smoking Policy: Law, Politics, and Culture, 131-160. Schwartz, Gary T. (1996a), ‘The Hidden and Fundamental Issue of Employer Vicarious Liability’, 69 Southern California Law Review, 1739-1767. Schwartz, Gary T. (1996b), ‘Assessing the Adequacy of State Products Liability Lawmaking’, 13 Yale Journal on Regulation, 359-370. Shavell, Steven (1997), ‘The Optimal Level of Corporate Liability Given the Limited Ability of Corporations to Penalize Their Employees’, 17 International Review of Law and Economics, 203-213. Sykes, Alan O. (1981), ‘An Efficiency Analysis of Vicarious Liability Under the Law of Agency’, 91 Yale Law Journal, 168-206. Sykes, Alan O. (1984), ‘The Economics of Vicarious Liability’, 93 Yale Law Journal, 1231-1280. Sykes, Alan O. (1988), ‘The Boundaries of Vicarious Liability: An Economic Analysis of the Scope of Employment Rule and Related Legal Doctrines’, 101 Harvard Law Review, 563-609. Verkerke, J. Hoult (1995), ‘Notice Liability in Employment Discrimination Law’, 81 Virginia Law Review, 273-385. Wilkins, David B. (1993), ‘Making Context Count: Regulating Lawyers After Kaye, Scholer’, 66 Southern California Law Review, 1145-1220.

Other References Landes, William M. and Posner, Richard A. (1987), The Economic Structure of Tort Law, Cambridge ,MA, Harvard University Press, 330 p. Shavell, Steven (1980), ‘Strict Liability Versus Negligence’, 9 Journal of Legal Studies, 1-25. Shavell, Steven (1987), Economic Analysis of Accident Law, Cambridge, MA, Harvard University Press. Restatement (Second) of Agency (1958), American Law Institute.

3500 TORT DAMAGES Jennifer Arlen Ivadelle and Theodore Johnson Professor of Law and Business University of Southern California Law School © Copyright 1999 Jennifer Arlen

Abstract This chapter surveys the literature on tort damages, including damages for serious physical injury and death. Section A presents the basic analysis of tort damages for injuries to replaceable commodities, focusing on the relationship between liability rules and optimal damage rules. Section B discusses damages for physical injury and death, examining, among other issues, the deterrence and insurance values of life. Section C examines special topics, such as optimal liability when corporations are defendants, whether recovery should depend on defendants’ wealth, economic and nonpecuniary losses, and the calculation of damages. An exhaustive bibliography is attached at the end. JEL classification: K13 Keywords: Tort Damages, Pain and Suffering, Tort Compensation, Wrongful Death, Physical Injury, Nonpecuniary Losses, Value of Life

1. Introduction Efficient damages awards are critical to the optimal functioning of the tort system. A rich literature now exists on the subject of efficient damage awards. This analysis has shown that no one damage rule is optimal in every situation, and that, contrary to common wisdom, damage awards need not necessarily fully compensate victims. Rather, the optimal damage award depends on: (1) the nature of the injury (harm to replaceable versus irreplaceable commodities); (2) the relationship of the parties and type of risk (unilateral, bilateral or market risks); (3) the liability rule (strict liability or negligence); (4) whether liability is individual or vicarious and (5) any existing imperfections, such as information costs, uncertainty, and judgment-proof problems. This analysis reveals that current rules governing recovery for replaceable losses may be optimal, but those governing recovery for death and physical injury generally are not.

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A. Replaceable Goods: Basic Analysis This section considers efficient tort damages for purely replaceable commodities. A commodity is replaceable if its owner believes that equivalent commodities are available on the market (Cook and Graham, 1977, pp. 144-146). A person can be fully compensated for the loss of a replaceable commodity if he is paid the market price of the good since he can use this money to buy a perfect substitute. Items such as cars, clothing and money generally are replaceable.

2. Efficiency Criteria and Initial Endowments Although the essential goal of economics is to maximize social welfare, law and economics scholars employ a number of different efficiency criteria to determine when this goal is satisfied. Some employ the Pareto criterion: a state of the world is Pareto efficient if no one’s utility can be increased without decreasing someone else’s utility. Others employ social utility maximization: under this criterion a tort rule is efficient if it maximizes the total utility of society, even if some people are made worse off by the change. Finally, others employ the Kaldor-Hicks criterion under which a change is an improvement if those who benefit from the change could compensate the losers monetarily for their losses and still come out ahead. A state of the world is Kaldor-Hicks efficient when there is no way to increase anyone’s utility in such a way that the winners could compensate the losers. Under any efficiency criterion, tort liability must minimize the joint costs of accidents and accident prevention. This in turn implies that tort liability and damage rules must induce optimal care-taking (defined as the efforts individuals undertake to avoid an accident given that they are engaged in the risky activity) and induce optimal activity levels (defined as the frequency with which individuals engage in the risky activity). In addition, a tort regime should induce optimal risk-spreading by any risk-averse parties by ensuring that they are optimally insured against risk, either through the insurance system or the tort system, whichever is most effective. The Pareto criterion imposes an additional requirement: to be Pareto efficient injurers’ risk-taking must make no one worse off than they would be otherwise, in the status quo ante. This requires that damage awards ensure that potential victims are left no worse off than they would have been ‘otherwise’. What that status quo ante is depends on the initial allocation of entitlements (see discussion below).

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3. Optimal Deterrence Damages Under Strict Liability Under the traditional economic model of accidents, the efficient tort damage rule for injury to replaceable commodities is simple: fully compensate victims for their losses. Specifically, victims should be awarded the market price of the good destroyed. Under a strict liability regime, this damage rule will optimally deter wrongdoing, ensure efficient risk-spreading by victims, and - depending on the liability rule and initial endowments - may satisfy the requirements for Pareto efficiency that no one be left no worse off than he would be otherwise. Risk averse injurers will not optimally spread their risk, however, unless they are able to purchase first-party insurance (Shavell, 1980, 1987). In the standard economic model of accidents, injurers impose risk on victims who are ‘strangers’ to them (that is, not in a market relationship with them) (Brown, 1973). The injurer can reduce the risk imposed on the victim both by taking ‘care’ in the manner in which he undertakes his activity and also by controlling the frequency with which he engages in the risky activity (Shavell, 1980). For simplicity, this section will assume that all parties are risk neutral (see Section 6, discussing risk-spreading). Initially, we will take the social goal to be maximizing total social welfare which is the benefit of the injurers’ activity minus total accident costs (defined as cost of care plus expected accident losses). Injurers’ behaviour is efficient when they employ the level of care and engage in the activity at the frequency that maximizes social welfare (Shavell, 1987, p. 21). Consider now what damage rule induces optimal deterrence when injurers are held strictly liable for any harms they cause. Under a strict liability rule, injurers will take the level of care that minimizes the joint social costs of care-taking and accidents if the expected cost to them of risk-taking - for example, their expected liability - equals the cost to society of their risk-taking. This implies that damages should equal the cost to society of the accident, which implies victims shall recover their losses (Brown, 1973; Shavell, 1980). This damage rule also generally will induce injurers to engage in the optimal amount of the activity because the injurers’ cost of engaging in another unit of the activity - the resulting increase in his expect liability - will equal the cost to society of his decision - the resulting increase in expected accident costs (Shavell, 1980). Yet this rule will not induce optimal activity levels if each injurer’s probability of being in an accident depends on the number of people engaged in the activity. In this case, even under strict liability, injurers will over-engage in the activity because they will not take into account the effect of their actions on other injurers’ probabilities of being in an accident (Hindley and Bishop, 1983, pp. 60-61). When potential victims’ care levels and activity levels affect expected accident costs, tort liability rules also must induce victims to take optimal care

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and engage in the efficient amount of the activity. Strict liability with full compensation damage awards may undermine this effort, however. When victims are fully compensated for their injuries, a pure strict liability rule will not induce victims to take either efficient care or efficient activity levels because victims do not bear the cost of any injuries they suffer; thus they have no reason to spend resources to avoid the harm (Shavell, 1980). Victims will take due care, however, when strict liability is supplemented with the defense of contributory negligence, because in this situation victims bear the full cost of any failure to take due care. Nevertheless, they still will not engage in the efficient amount of the activity because a victim who has taken due care will be fully compensated for any injuries he suffers (Ibid.). Under the Pareto criterion victims often must be fully compensated for their losses in order to ensure that the injurers’ risk-taking leaves potential victims no worse off than they would be otherwise. If victims possess the initial entitlement to the property in question, then they must be fully compensated in order to ensure that they are not made any worse off (see Section 3 which discusses the entitlement issue).

4. Optimal Deterrence Damages Under Negligence Liability Under a negligence rule, full ex post compensation of purely pecuniary losses is an optimal damage rule, although it is not the minimum optimal rule. Full compensation for property losses will induce injurers to take optimal care under a negligence rule, provided courts correctly set the standard of care (Brown, 1973; Shavell, 1980). However, a lesser award also may suffice. Cooter has shown that negligence liability can induce injurers to take due care using less-than-full-compensation damage awards because an injurer’s expected liability increases dramatically from zero to the expected damage award if he reduces his care-taking from due care to less than due care. This dramatic increase provides a strong incentive to take due care (Cooter, 1984). This result does not hold, however, if the application of ‘but for’ causation effectively eliminates the discontinuity in the injurer’s expected liability function. In this case, injurers will not take due care unless damages fully compensate victims (Grady, 1983; Kahan, 1989). In all events, under a perfectly functioning negligence rule, injurers will take due care if damages fully compensated victims forcing injurers to bear the full costs of their risk-taking (Shavell, 1980; Cooter, 1984). Negligence liability will not induce injurers to engage in efficient activity levels, however, because non-negligent injurers are not liable and thus do not bear the social costs of their activity level choices. Their activity levels therefore will be too high (Shavell, 1980).

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Negligence liability will induce victims to take efficient care and engage in efficient activity levels, however. Under this regime, injurers will take due care and thus will not be liable for the risks they impose. Victims, therefore, will bear the full cost of their injuries and will have the requisite incentive to take due care and reduce their activities to the optimal level (Shavell, 1980). Negligence liability thus will optimally deter to the extent it can, when damage awards fully compensate victims for their losses. Yet the question remains whether this regime is Pareto efficient. Whether this regime satisfies the Pareto criterion depends on the initial allocation of entitlements. Negligence liability implicitly grants to the injurer the right to impose reasonable risks on the victim, yet entitles the victim to freedom from harms from unreasonable risks. When this describes the victim’s initial endowment, then forcing injurers to fully compensate victims for injuries resulting from unreasonable risks satisfies the requirement for Pareto efficiency that victims be no worse off than they would be in the status quo ante. Negligence liability is not Pareto efficient, however, if the victim’s initial endowment is to be free from any risk of harm created by the injurer. In this situation, victims are made worse off by a rule that allows injurers to impose reasonable risks on victims without compensating them and only forces injurers to fully compensate victims for any unreasonable risks they impose (Arlen, 1985; see Calabresi and Melamed, 1972, discussing the intersection of entitlements and liability rules)).

5. Comparison with Existing Law The preceding analysis suggests that in the case of injury to replaceable commodities, damage awards generally should fully compensate victims for their losses. Thus tort law should force injurers to pay for any damage they cause. This implies that the ‘thin skull plaintiff rule’ - which holds injurers liable for a victim’s injuries even if the victim is unusually sensitive - is efficient because it forces the injurer to take into account all expected costs of his care-taking and activity levels. By contrast, the use of the proximate cause doctrine to eliminate liability for foreseeable but excessive losses is not efficient (Shavell, 1987, pp. 128-131). To induce efficient behavior, however, ‘full compensation’ should be based on the optimal loss caused by the injurer. After an accident occurs victims often can take steps to mitigate the harm - for example, by seeking medical treatment for an injury. To encourage optimal mitigation, victims’ recovery should be limited to optimally mitigated losses plus mitigation costs (Shavell, 1987, pp. 144-146; Wittman, 1981). Recovery also should be reduced - or set off - by those amounts the victim would have spent anyway had the loss not occurred (Shavell, 1987, p. 140).

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6. Efficient Risk Spreading The preceding analysis assumes that injurers and victims are risk neutral - that they care only about the expected value of losses and not their magnitude. This assumption may accurately describes many corporations. Thus, injurers in products liability cases may be risk neutral (but see Arlen, 1992b, pp. 419-420, discussing when corporations should be treated as being risk averse). Individuals, however, generally are risk averse: most individuals would prefer the certain loss of $10 to a 10 percent chance of losing $100, even though the expected value of these losses is the same. A risk-averse individual facing a potential loss, thus, would be better off if he could purchase actuarially fair insurance that fully compensates him for the loss (see generally Shavell, 1987, Ch. 8). 6.1 Insurance is Available If both injurers and victims are risk averse and both parties can buy actuarially fair first- and third-party insurance, then people will optimally spread risk by purchasing insurance; tort liability rules need only be concerned with optimal deterrence (Shavell, 1987, pp. 210-212). Indeed, in this situation tort liability probably should not be used as an insurance mechanism: the administrative costs of tort liability far exceed the administrative costs of either first- or third-party insurance (Weiler, 1993b, pp. 926-927). Tort liability should be imposed to optimally deter risk-taking, however. In this situation, full compensation damages are optimal. This conclusion holds even if there is moral hazard in the sale of liability insurance because insurers cannot observe the injurers’ precautions (Shavell, 1982; Shavell, 1987, pp. 211-212). 6.2. Insurance is not Available By contrast, if insurance is not available, then tort rules should not only induce optimal deterrence but also optimal risk-spreading by risk-averse parties. In the case of replaceable losses, the optimal amount of insurance is full compensation (Shavell, 1987, Ch. 8; see also Chapter 5700 on Insurance Regulation). Thus, victims’ risk-spreading will be optimal if they are fully compensated for any losses they may suffer. This implies that a full compensation damage rule will ensure that victims optimally spread risks when the injurers’ activity is governed by a rule of strict liability (Shavell, 1982; Shavell, 1987, pp. 210-227). Victims’ risk-spreading will not be optimal under a negligence regime, however, because a perfectly functioning negligence regime will induce injurers to take due care, in which case victims will not be compensated for their losses (Shavell, 1982; Shavell, 1987, pp. 210-227). If the regime does not function perfectly, however, and injurers are deemed to be negligent (for example, because of court error or principals’ inability to induce their agents to take due

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care), then a full compensation damage rule will induce efficient risk-spreading by victims (Shavell, 1982). If insurance is not available and injurers also are risk averse, then the very damage and liability rules that yield efficient risk-spreading by victims will produce inefficient risk-spreading by injurers, and vice versa. Strict liability forces injurers to bear any injuries they cause; by contrast, under a negligence rule injurers’ risk-spreading is efficient because they can avoid all losses by taking due care (Shavell, 1987, pp. 208-209). Moreover, the presence of risk-averse injurers who cannot purchase insurance also alters optimal damage rules. To induce due care and optimal activity levels under a strict liability rule when injurers are risk averse and uninsured, injurers must be liable for an amount that is less than the victims’ losses. This is because the injurer will view both the loss itself and the risk as a cost. Yet, if damage awards do not fully compensate victims, then victims’ risk-spreading will not be optimal. A full compensation damage rule will induce injurers to take due care when they are subject to a negligence liability rule, however, because they can avoid all risk by taking due care. As previously explained, however, neither injurers’ activity levels nor victims’ risk-spreading will be optimal under such a regime (Shavell, 1982; Shavell, 1987, pp. 209-210).

7. Accidents in a Market Setting When victims and injurers are in a consensual or market relationship and victims are fully informed about any risks imposed on them by injurers, market forces will ensure that injurers take optimal care and engage in the optimal level of the activity. This is because victims will treat the risk of harm as a cost of buying the product (or service), thus giving the potential injurer the incentive to minimize the joint cost of accident losses and his care-taking. Activity levels will be efficient because victims will only buy the commodity if the benefit to them exceeds the total cost, including expected accident costs (Polinsky, 1980; Shavell, 1980; Shavell, 1987, Ch. 3; Spence, 1977). In this situation, therefore, the only function for the tort system, if any, is to induce optimal risk-spreading in those situations where individuals cannot purchase insurance. As explained above, when it is appropriate to use the tort system to provide insurance to victims, then damages should fully compensate victims for their losses (see Epstein, 1985 and Chapter 5140 on Products Liability for a complete discussion of the use of the tort system to provide insurance to victims). Victims are not necessarily fully informed about risks, however. If victims do not accurately estimate the risk of loss, then market forces alone may not induce optimal care-taking and activity levels (Spence, 1977; see A. Schwartz, 1988; Shavell, 1987, Ch. 3). Consumers may fail to accurately estimate risks

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as a result of either imperfect information or cognitive ‘imperfections’ that cause people’s attitudes towards risk to deviate from that predicted by expected utility theory. For example, evidence suggests that consumers are likely to underestimate hidden product risks; they also tend to underestimate known but large risks, such as the risk of dying of cancer, and risks that are substantially within the individual’s control (Viscusi, 1991, pp. 64-65). When consumers underestimate risks, injurers will take insufficient care and engage in too much of the activity, unless they are liable for the injuries they cause or unless the problem can be corrected with warranties (Polinsky and Rogerson, 1983; Shavell, 1980; Shavell, 1987, pp. 52-53; Spence, 1977; see Schwartz and Wilde, 1985). Producers will not necessarily respond to markets with imperfectly informed consumers by offering full warranties, and the availability of warranties will not necessarily induce optimal product quality (Cooper and Ross, 1985; Grossman, 1981; Polinsky and Rogerson, 1983; Salop, 1977; Schwartz and Wilde, 1985; see Priest, 1981). Tort liability may be able to induce optimal care-taking and activity levels in those circumstances when market forces alone cannot do so. When consumers underestimate risks, injurers can be induced to take due care and engage in optimal activity levels if they are held strictly liable for consumers losses and subject to a full compensation damage rule. When injurers bear all expected accident costs, they will directly bear the full cost to society of their products. Thus, in their effort to minimize their own costs, they also will select the care levels that minimize social costs. Product prices thus will equal the social cost of producing the goods, provided product markets are competitive. Consumers, therefore, will purchase the optimal amount of the product, leading to optimal activity levels (Shavell, 1987, pp. 67-68; see Polinsky and Rogerson, 1983, modifying this conclusion when producers have market power). (For a more complete discussion of this topic, see Chapter 5140.) Of course, consumers do not necessarily underestimate all risks. Indeed, evidence suggests consumers overestimate small but known risks that have received substantial publicity, as well as risks that are vivid or dramatic (such as the risk of dying in a plane crash) (Viscusi, 1991, pp. 64-65; see Arlen, 1998). In this situation, market focus may cause injurers to take excessive care and engage in too little of the activity. Tort liability will only exacerbate this problem (Viscusi, 1991, pp. 64-65; see Arlen, 1998; A. Schwartz, 1988).

8. Automobile Accidents and other Bilateral Risks The preceding analysis assumes that individuals are either injurers and victims but not both - in other words that accidents result from ‘unilateral risk’ activities. Many common accidents, however, result from ‘bilateral risk’

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activities - situations where both potential parties to the accident risk being injured should an accident occur. For example, automobile collisions, the largest single source of tort cases, are bilateral risk accidents. In the bilateral risk context, a full compensation damage award will induce optimal care-taking by both parties to the accident if the activity is governed by a duty-based liability rule: such as negligence (with or without contributory negligence) or strict liability with contributory negligence. Each party will take due care because he is best off taking due care whether or not the other takes due care (Arlen, 1990a, 1990b, 1992a, compare with Diamond, 1974, p. 117, concluding that pure negligence is not efficient). In fact, duty-based liability rules can induce efficient care-taking employing a less-than-full-compensation damage rule. People will take efficient care provided that damage awards are sufficiently large that each is better off taking due care and getting the resulting reduction in liability than he is not taking due care and paying the additional cost. The damage award that induces efficient care-taking is less than the amount that fully compensates victims for their losses (Arlen, 1990a, 1990b, 1992a). When people are risk averse, the three duty-based liability rules will not induce optimal risk-spreading, however, even when combined with a full compensation damage award. Under these regimes, each party will take due care. Thus, under negligence (with and without contributory negligence) each party will take due care and thus will bear his own losses. Accordingly, negligence is consistent with efficient risk spreading only if parties can purchase first-party insurance. Under strict liability with contributory negligence each party will take due care and thus will bear the other parties’ losses but not his own. Thus this regime is consistent with efficient risk-spreading only if parties can purchase third-party insurance (Arlen, 1990b). Regardless of the damage rule, however, pure strict liability will not induce efficient care-taking. To see why, assume both people suffer the same injury whenever an accident occurs. In this case, each person’s expected damages equals his expected recovery. Thus, pure strict liability is equivalent to a no liability regime: neither is efficient because neither risk-imposer bears the cost to the other person of his risk-taking (Arlen, 1990a, 1990b, 1992a).

9. Factors Affecting Liability Of course, even in the standard ‘unilateral risk’ case, determining the optimal damage award may be more complicated than it might at first appear. This part considers several factors that may affect the magnitude of liability, focusing on the traditional model of accidents in which parties to the accident are strangers and are either potential victims or injurers, but not both.

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9.1 Litigation Costs The standard analysis of tort law assumes that there are no litigation costs. Yet litigation costs are substantial. This raises the issue of whether damages should equal the victims’ actual losses plus their litigation costs. (a) Pareto Criterion Under the Pareto criterion, damage rules must include the victims’ litigation costs because a damage rule that limits compensation to harm suffered without including the victims’ litigation costs does not leave the victim no worse off than he would be otherwise, at least in those cases where the victim originally possessed the entitlement the injured property. (b) Strict Liability Under strict liability injurers should compensate victims for their litigation costs in some circumstances but not in others. According to Polinsky and Rubinfeld (1988) optimal deterrence requires that injurers compensate victims for their litigation costs. Injurers must compensate victims for two reasons. First, if victims bear their own litigation costs, some victims with good claims will not find it worthwhile to sue because litigation costs exceed their expected recovery. Thus, injurers will not bear the full expected cost of the harms they impose because not all victims will sue. Second, even if all victims sue, injurers will not bear the full social cost of their actions because, properly defined, the social cost of the injurers’ risk-taking is the sum of the victims’ losses and the cost of litigation. Thus, under a rule of strict liability with compensatory damages injurers will not take efficient care or engage in efficient activity levels. Litigation costs also will be excessive (Polinsky and Rubinfeld, 1988). Yet, Polinsky and Rubinfeld argue, deterrence is not the only objective of the tort system. A full analysis reveals that in some circumstances victims should not be compensated for their litigation costs. In addition to inducing due care, an optimal regime must minimize litigation costs. Whether compensatory damages should be adjusted upwards or downwards depends on the effect of changes in damages on the injurers’ incentives to take care and the victims’ incentives to sue. Specifically, if the injurers’ care-taking affects not only the probability of an accident but the magnitude of the harm, it may be optimal to enable the victim to recover some but not all of his litigation costs: enough so that it is worthwhile for the victim to sue when an injurer takes less than optimal care and the victim’s harm is large, but not enough so that it is worthwhile for a victim to sue if the injurer takes optimal care, thereby reducing the amount of harm suffered (and thus the amount of recover) (Polinsky and Rubinfeld, 1988). This would induce optimal care-taking and minimize on litigation costs by effectively transforming the strict liability rule into a negligence rule. As with any negligence rule, such a regime would not induce injurers to undertake the optimal amount of the activity.

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Victims should recover less than their compensatory damages, Polinsky and Rubinfeld argue, in those situations where injurers’ care-taking is not productive, and thus optimal care is to take none at all. In this case, a strict liability regime is optimal if it reduces the victims’ recovery to ensure they will not sue (Polinsky and Rubinfeld, 1988). Again, this will not produce optimal activity levels, however. (c) Negligence Liability Under a negligence rule, a damage rule limiting defendants’ liability to victims’ losses will either result in optimal care or too little care. Thus, when needed, any adjustment to compensatory damages should always be positive (Polinsky and Rubinfeld, 1988). Under a negligence rule, injurers will invariably take due care if victims’ litigation costs are not so high as to discourage suit. This results in first-best efficiency because once injurers take due care, victims have no reason to sue. If, however, litigation costs are high enough to discourage many suits, injurers will not take due care. This also will lead to excessive litigation costs if some victims nevertheless find it worthwhile to sue. Increasing damages to ensure that victims sue will induce optimal care-taking and minimize litigation costs, since once injurers take due care victims no longer have a reason to sue (Polinsky and Rubinfeld, 1988, pp. 161-162). (d) Fees Imposed on Plaintiffs and Defendants The previous analysis assumes that the state cannot impose fees on either plaintiffs or defendants. Shavell (1996, 1997) shows that once one allows for such fees, optimal damages imposed on defendants equals the harm to the plaintiff plus the plaintiff’s litigation costs plus the state’s litigation costs. This ensures that each injurer’s total expected costs equals the total cost to society of her risk-taking activities. In order to ensure that plaintiffs have the optimal incentive to sue, the state can impose fees for bringing a suit when plaintiffs would otherwise have excessive incentives to sue or subsidies when plaintiff’s incentives are inadequate. Shavell argues that a plaintiff’s incentives are excessive if the social benefit of the suit - measured by its deterrence impact, not the plaintiff’s injury - are less than the costs of bringing the suit (Shavell, 1997, pp. 575-581, 584-585). Shavell explains that this system is superior to one in which plaintiffs must pay the state’s litigation costs. He notes that in this situation one should not always force plaintiffs to pay the state’s costs because often a plaintiff’s suit provides an external benefit - deterrence - that exceeds his private benefit. Thus, even when the fee is not imposed plaintiff may not have sufficient incentives to sue since he does not reap the full gains from his suit (Shavell, 1996, p. 587, 1997). Similarly, Shavell rejects a simple loser-pays fee shifting arrangement noting that under such a regime victims with good suits will always sue. Yet whether the victim will prevail does not determine whether,

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from society’s standpoint, the suit should be brought. This, he argues, depends on the deterrence impact of the suit. Shavell’s analysis raises an interesting question about how to measure the deterrence value of a suit. Shavell argues that deterrence value should not be measured ex post. Rather liability will not have a deterrence value if, ex ante, the injurer does not expect to cause this type of accident (Shavell, 1987, pp. 129-130). Such a suit would have deterrence value, however, if the finding of liability - separate from the occurrence of the accident - would be likely to educate other potential injurers (or victims) about the risk (see Arlen, 1993, p. 1124, n. 110; Rubin, 1993, p. 50). 9.2 Uncertainty and Court Error Optimal damage awards also are affected by whether the legal process is plagued by error. (a) Court Error in Determining Negligence The possibility of court error in determining whether the injurer is liable under a negligence rule also may affect the optimal damage rule. Specifically, if courts are likely to err in determining whether the injurer took due care, negligence liability rule with full compensation damages will not necessarily induce injurers to take due care. Even when courts are likely to err in either direction - to find a non-negligent injurer liable and a negligent injurer not liable - under plausible conditions, care-taking will be excessive if damage awards fully compensate victims for their losses. When courts err, the cost to the injurer in deciding to take due care rather than excessive care is significant - the resulting increased likelihood of being found negligent. This will exceed the additional cost to her of taking excessive care, under plausible assumptions. In contrast, the possibility of error in her favor will not induce her to take less than due care. Doing so only saves her the additional cost of taking due care but subjects her to a significant risk of being found liable when she otherwise would not have been. Thus, even when courts are as likely to err in the injurer’s favor and against her, the cost of an error going against the injurer will exceed the benefit of an erroneous finding in her favor. Thus injurers will respond to uncertainty by taking excessive care - provided that there is a positive probability of the court underestimating injurers’ care levels and the distribution of errors is not too dispersed (Calfee and Craswell, 1984; Craswell and Calfee, 1986; Shavell, 1987, pp. 79-83, 93-97; compare Diamond, 1974). This problem can be addressed in a couple of ways. The state can retain negligence liability but implement a less-than-full compensation damage awards (Calfee and Craswell, 1984) or it can switch to a strict liability regime (if courts can correctly determine damage awards) (Cooter, 1984).

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(b) Role of Causation Rules Uncertainty in the determination of negligence will not induce excessive care-taking if on average courts get the due care standard right and causation rules function perfectly, thus eliminating the discontinuity in the injurer’s expected liability. Causation rules may eliminate this discontinuity because a negligent injurer is liable only if his negligence caused the harm. Thus, if courts err in determining due care but not in assessing causation, an injurer falsely judged to be negligent still will not be liable because the court will recognize that it is not more likely then not that the accident would not have occurred but for the injurer’s negligence (Grady, 1983; Kahan, 1989, pp. 437-439). Should causation rules eliminate the ‘discontinuity’ produced by negligence liability, then the risk of court error in determining whether an injurer is negligent generally will result in injurers taking less than due care - not excessive care - because uncertainty over care-taking may lead courts to hold, incorrectly, that negligent injurers took due care, whereas correct application of causation rules will ensure that non-negligent injurers incorrectly found to be negligent will escape liability (Kahan, 1989, pp. 437-439). In this situation, inducing efficient care may require super-compensatory damage awards. (c) Error in Determining Plaintiffs’ Losses Courts also may err in assessing plaintiffs’ losses. Cooter has argued that when courts are subject to this type of error the solution is to employ a negligence liability rule. He argues that injurers’ risk-taking is less sensitive to errors in determining the damage award under a negligence regime than under strict liability because under a negligence rule the injurer’s expected liability increases dramatically if she fails to take due care. Cooter argues that this implies that negligence is the superior rule when courts cannot accurately determine damages (Cooter, 1984). Shavell argues that possible court error in the calculation of losses does not necessarily imply that strict liability will be inefficient. Strict liability will provide correct incentives if courts’ estimates of losses are correct on average (Shavell, 1987, pp. 131-132). Moreover, even when courts err on average, Kaplow and Shavell (1996) argue that negligence is not superior to strict liability. Kaplow and Shavell show that, in order to determine due care, courts must be able to calculate victims’ losses. Thus, if courts cannot accurately determine damage awards under a strict liability rule, they also will be unable to determine due care under a negligence rule, and injurers’ care-taking under a negligence regime will not be optimal. It has been suggested that due care might nevertheless be easier to determine because courts can rely on custom and other sources of information on due care. Yet in order to determine whether the custom is efficient courts still will need to be able to estimate harm (Kaplow and Shavell, 1996; compare with Arlen and Kraakman, 1997, discussing strict versus duty-based vicarious liability rules).

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Thus, any difficulty the court faces in assessing damages should afflict negligence liability as well as strict liability (Kaplow and Shavell, 1996). The choice between the regimes, therefore, will likely depend on relative administrative costs. Kaplow and Shavell argue that since determining due care requires more information than determining damages, the risk of error and administrative costs are higher under a negligence regime and thus strict liability is superior. Nevertheless, negligence may produce lower administrative costs because fewer suits will be brought (see generally Shavell, 1987, pp. 264-265). 9.3 Injurers’ Ability to Escape Liability for Losses Other imperfections also can affect optimal damage awards. For example, if injurers are not necessarily liable for their wrongs - for example, because torts go undetected - full compensation damage awards will not optimally deter wrongdoing. Empirical evidence suggests that injurers are not liable for many of the torts they cause. For example, empirical evidence suggests that a tiny portion (less than 6 percent) of victims of medical negligence will obtain compensation (Danzon, 1985, pp. 22-25; Weiler et al. 1993a, pp. 74-75). Indeed, even the probability of detecting the source of a substantial oil spill is only 60 percent (Cohen, 1987). When wrongdoers may escape liability, optimal deterrence of a risk-neutral tortfeasor appears to require a damage award equal to the victim’s loss divided by the injurer’s probability of detection (specifically, the injurer’s probability of being formal liable) (h/p) because this rule ensures that an injurer’s expected liability equals the social cost of the harm (Becker, 1968; Cooter, 1989b; Landes and Posner, 1981; Polinsky and Shavell, 1998; see Arlen, 1994). This could be implemented using a regime of compensatory damages coupled with punitive damages or compensatory tort liability coupled with government-imposed civil or criminal penalties. This damage rule is not necessarily optimal, however. As previously explained, under a negligence regime expected damages need not equal victims’ losses if the injurer’s expected liability function increases substantially (and discontinuously) if he takes less than due care. Moreover, even under strict liability reasons exist why the damage multiplier should not necessarily equal one over the probability of detection (see, for example, Becker, 1968, p. 178; Craswell, 1996; Karpoff and Lott, 1993; Kaplow, 1992). (See Chapter 3700 on Punitive Damages for a more detailed discussion of this issue.) Finally, this rule must be modified for corporate defendants held liable for torts (or crimes) committed by their agents (Arlen, 1994; Arlen and Kraakman, 1997; see Part C for a discussion on vicarious liability).

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9.4 Intentional Torts Optimal compensation for intentional torts also may exceed the victim’s actual losses even if injurers are invariably found liable. Intentional torts generally are those which require the injurer to expend resources in order to commit. It would appear that holding injurers fully and strictly liable for such torts would optimally deter them. But, as Landes and Posner initially observed, this assumes that there are ‘optimal’ intentional torts. Many intentional torts involve low transactions costs; thus, market transactions are possible. All else equal, market transactions are preferable to the involuntary taking of another’s property, particularly once one considers victims’ costs of avoiding non-market takings. To force such transactions into the market, expected damages should exceed the injurer’s gain from the transaction. This may exceed the victims’ losses (Landes and Posner, 1987, pp. 160-163; see Haddock, McChesney and Spiegel, 1990; see also the following articles on benefit-based damages: Epstein, 1994; Levmore, 1994; Polinsky and Shavell, 1994; Wittman, 1984, 1985). 9.5 Supercompensatory Damage Awards and Decoupling Although super compensatory damage awards are necessary to solve some problems, they may create others. For example, excess compensation may reduce victims’ incentives to take care, unless a victim’s right to recovery is governed by contributory negligence. Excess compensation also may preclude victims from optimally spreading losses, because the marginal utility of wealth of victims who receive excess compensation will be less than their pre-accident marginal utility of wealth (Polinsky and Che, 1991; see Arlen, 1990b). Excess compensation creates problems less often than might at first appear, however. As Rubinfeld observes, whether victim compensation is excessive depends on a victim’s compensation net of attorney’s fees and litigation costs, not the gross compensation paid. Litigation costs and attorneys’ fees are sufficiently high that defendants’ liability can exceed victims’ losses by a considerable amount without victims being over-compensated (Rubinfeld, 1984, pp. 553-555). Nevertheless, when injurers may escape liability, the optimal deterrence award net of other costs often will exceed victims’ losses. This creates two potential problems. First, if victims can influence the probability or magnitude of the accident, super-compensatory awards may cause victims to engage in very excessive activity levels (victims will take due care, however, provided they are subject to a contributory negligence defense). In addition, victims’ risk-spreading will not be optimal because the optimal amount of insurance is full compensation, not excessive compensation. One potential solution to the problem of excessive victim compensation is to decouple injurers’ liability from victims’ compensation, with victims being fully compensated for their losses (including litigation costs) and any liability in excess of full compensation

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being paid to the state (Polinsky and Che, 1991; see Danzon, 1984; Spence, 1977). This possibility is discussed later in this entry.

B. Damages for Death and Serious Physical Injury Economic analysis of damages for death and serious permanent physical injury differs substantially from the standard analysis of property damage because these injuries include harm to irreplaceable commodities. A commodity is irreplaceable if its owner does not perceive any equivalent commodities available on the market (Cook and Graham, 1977, pp. 144-146). Loss of this commodity results in a ‘nonpecuniary loss’. Health is generally considered an irreplaceable commodity. Under current law, victims are not compensated for their total losses arising from an accident that results in death or serious permanent injury. Rather, victims are compensated for the pecuniary losses associated with the injury plus an award for the ‘pain and suffering’ occasioned by the loss. In some cases, victims also may receive punitive damages. This section first examines evidence on the actual operation of the tort system: how much are victims compensated and how much do defendants pay? It then addresses the issue of what are optimal awards for death and physical injury.

10. Actual Awards for Death and Physical Injury In a 1991 study, Hensler et al. concluded that liability payments total $15.7 billion annually. Three-quarters of this amount went to victims of automobile accidents, even though this group constituted only 59 percent of the pool of victims who received compensation. Compensation net of legal fees and property damage totaled $12.9 billion (Hensler et al., 1991, pp. 100-101). This study found that the average compensation paid to victims was $11,173. The average net compensation for personal economic cost - net of damages for pain and suffering, property damage and attorneys’ fees - was $5,432. The average liability payment for automobile accidents was $14,444. In both situations, the distribution of payments was highly skewed, with most victims receiving substantially less than the average. The median payment for all cases was only $2,500; the median for automobile accidents was $4,000 (Hensler et al. 1991, pp. 102-103). Evidence suggests that victims of nonfatal accidents generally are not compensated for all the losses they suffer. Hensler et al. found that nonfatal accidents impose direct and work-loss costs of $175.9 billion annually. Victims

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generally bear 38 percent of the monetary loss directly; they only recover 62 percent from other sources (including the tort system and insurance). The study found that the recovery rate for direct costs is 75 percent, but for work loss is only 34 percent. Tort liability payments, net of attorneys’ fees, comprise only 7 percent of the total compensation victims receive (Hensler et al. 1991, pp. 102-107). Similarly, Viscusi’s study of product liability claims paid in 1977 found that the average bodily injury loss, $27,446 (1990 dollars) exceeded the average bodily injury payment of $19,990 (1990 dollars) (Viscusi, 1991, p. 102). Other studies also conclude that seriously injured victims are likely to be under-compensated (Galanter, 1996, pp. 1117-1119). This finding that seriously injured victims are under-compensated holds even though most victims receive awards for pain and suffering. Viscusi found that 62.5 percent of the cases with positive awards for bodily injury included awards for pain and suffering. There was considerable variation in the amount paid, however. The mean value of pain and suffering awards over all cases where such damages were awarded is $200,000 (1990 dollars) in cases involving brain damage and paraplegia. However, in 14 of the 18 injury categories for which pain and suffering was awarded, mean awards are below $60,000. On average, pain and suffering awards constitute two-thirds of the total compensation awarded in those cases where pain and suffering damages are awarded (Viscusi, 1991, pp. 103-107). Leebron (1989) analyzed cases involving pain and suffering before death and found that the mean award was $83,700 and the median award was $28,500 (in 1987 dollars). In general, pain and suffering awards averaged about 23 percent of the total award and almost 76 percent of the wrongful death amount. Leebron also found considerable variation in the awards, however, not only in absolute terms but in the per minute payment for suffering. Differences in the manner of death explains some, but not all, of this variation. The previous discussion of whether damages under-compensate victims compares victims’ compensation with actual ex post losses suffered. It also is instructive to compare compensation to the value the individuals place on their life and health, as determined by the amount that workers require to compensate them for additional risk of death or injury. Examining workers’ preferences, Viscusi concluded that their behavior yields an ex ante compensation demand value of life of $6.4 million. There is considerable variation, however. Workers in high-risk jobs appear to place an implicit value on their lives of $1 million or less, whereas workers in very low-risk jobs may value their lives at $10 million or more (Viscusi, 1991, p. 108). Valuations of nonfatal injuries yield estimates of $12,000 (1984 dollars) to $50,000 (1987 dollars) per injury. Approximately half of this amount is for noneconomic loss (Viscusi, 1991, pp. 109-110).

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11. What is Optimal Full Compensation for Death or Injury? The preceding discussion suggests that actual damage awards, therefore, do not fully compensate victims of serious injuries for their losses. This raises the issues: what is full compensation for death or permanent injury and should the tort system try to fully compensate victims of these injuries? The answer to the first question depends on what efficiency criterion is employed. Under the Pareto criterion, tort liability must ensure that the injurers’ risk-taking leaves no one worse off than he would be otherwise. This criterion would seem to require that victims be fully compensated for their losses. But whether, and to what extent, victims must be compensated depends on the initial allocation of entitlements. This part discusses the damage rule that satisfies the Pareto criterion’s requirement that no one be made worse off than otherwise. The next part examines the tort regimes that minimize the joint costs of accidents and accident prevention. 11.1 Injurers are Entitled to Impose Risks at Will Society may grant to potential injurers an entitlement to impose certain risks on others. In this case, the Pareto optimal solution to the accident problem is determined - as in Shavell (1987, pp. 247-254) - by maximizing the utility of the potential victim subject to the constraint that injurer be made no worse off than otherwise. Tort damage awards thus need not compensate victims for their losses because, in essence, they have nothing to lose (see Shavell, 1987, pp. 247-254). 11.2 Victims Possess Initial Entitlement to Their Health Alternatively, victims may possess the right to be completely free from certain types of risks. In this context, the Pareto-optimal solution to the accident problem is determined by maximizing the utility of the injurer subject to the constraint that the victim be no worse off than if the injurer does not engage in the risky activity. This would seem to imply that tort damage awards must fully compensate the victim for his losses by awarding his sufficient compensation to return the victim to his pre-accident (healthy) level of utility. But this is not necessarily the case. (a) Ex Ante Compensation and Complete Insurance Markets The standard accident of economic models of tort law assumes that accidents occur as the result of injurers imposing risks on victims, without either party imposing any risk of harm on the injurer. In this situation, fully compensating the victim apparently requires that the award leave the injured victim no worse off than when he was healthy (see, for example, Arlen, 1985; Friedman, 1982). A

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problem arises, however, because many serious permanent injuries dramatically effect the victim’s marginal utility of wealth. For example, a victim of a fatal accident may not derive any utility from wealth paid to her after the accident. Thus full ex post compensation for such injuries would seem to be impossible (alternatively, it is sometimes said that ex post full compensation award is infinite, see, for example, Buchanan and Faith, 1979, pp. 245-246; Friedman, 1982; Mishan, 1971, p. 693). Yet, as David Friedman observes, the reason injurers cannot fully compensate victims for such injuries is not that life has infinite value, but rather that money paid to a dead person has no value (Friedman, 1982). The full compensation amount would be finite - and perhaps quite small - if it were determined ex ante: if those who impose risk compensated all potential victims ex ante, before any one is injured. Because the money would be paid to healthy people who value it, only a finite amount of compensation would be required (Friedman, 1982, p. 83; see Graham and Peirce, 1984). Implementing a system of ex ante damage awards probably is unworkable, however, because it would require courts to calculate, in advance, the risks imposed by an enormous variety of activities and to oversee constant cash payments to millions of people (Friedman, 1982, p. 83). Yet, Friedman argues, it may be possible to implement a system which awards damages only ex post based on the ex ante value of life. Friedman notes that victims could be fully compensated for their losses with substantially smaller awards than at present if mechanisms exist that enable potential victims to obtain the benefit of the compensation while healthy - when the money is valuable. If victims could benefit from the compensation while healthy, then the proper measure of full compensation is the amount paid to the victim once injured that fully compensates her for her loss given that she will get the benefit of some (or all) of this money while healthy (Friedman, 1982, pp. 83-85, 89-90; compare with Fraser, 1984a). This solution would be possible if insurance markets were complete, in that victims could sell insurance on themselves (Friedman, 1982). Alternatively, the state could allow a market in unmatured tort claims, where healthy victims could sell their potential claims to others (Cooter, 1989a; see Shukaitis, 1987, discussing the merits of a market in matured tort claims). Currently, however, victims cannot sell unmatured tort claims and there are reasons to doubt the feasibility of either such a market or of ‘reverse insurance’ (Arlen, 1990b, p. 61, n. 90). Yet even so tort damage awards need not necessarily fully compensate victims ex post in order to ensure that potential victims are no worse off than otherwise. (b) Bilateral Risk Accidents First, most accidents result from bilateral risk - not unilateral risk - activities. Bilateral risk activities are those where both parties to the accident risk being injured should an accident occur. Car crashes are an example of a bilateral risk accident.

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In many cases, each potential victim of a bilateral risk accident risks injury only if he also is engaging in a risky activity. Each person thus can avoid being subject to the risk in question - thereby ensuring his initial level of utility - by refraining from imposing risk on others. In turn, each assumes a risk of injury to himself in return for the ability to impose risk on others. In this situation, tort liability rules are Pareto efficient if they maximize the utility to individuals of engaging in the risky activity by minimizing the joints costs of accidents and accident prevention. There is no additional requirement that injured victims be compensated for their losses. The system compensates each person ex ante for any risk imposed on him by allowing him to engage in a risky activity, imposing risks on others which they would otherwise be entitled to be free from. Moreover, individuals would not want damage awards to be higher than that necessary to achieve optimal deterrence and risk spreading because this would require each person to expend greater resources while healthy in return for the right to receive additional compensation if injured, which necessarily is worth less to the person if risk spreading is optimal (Arlen, 1990b, pp. 63-65). This analysis may extend, with some modifications, to the tort system generally, if we view it as a general set of rules that allow us to impose certain risks on others in return for the right of others to impose risk (perhaps different risks) on us. In this situation, the measure of compensation afforded by the tort system to each potential victim should include the benefit to him of imposing risks on others under this rule. People thus might generally prefer damage awards which do not fully compensate victims ex post if in return for not receiving full compensation if injured (when the money may have less value) each party has to pay less to injure others (thus reducing their expected liability which they often must pay while healthy, when the money is more valuable). In this case, properly defined, a ‘full compensation’ damage rule - which ensures that no one is worse off than in the status quo ante where no risks are imposed - would set ex post recovery at less than the amount that returns an injured victim to his pre-accident utility (See Arlen, 1990b, 1985, p. 1136). (c) Products Liability Damage awards also need not fully compensate victims ex post in product liability cases if fully informed customers can avoid product-related injuries by not buying the product. Customers will purchase the product only if its purchase - including the resulting risk - leaves them no worse off than they would be otherwise. Thus, regardless of the damage award, customers are never made worse off (Shavell, 1980). This analysis assumes, however, that customers are fully informed. If customers underestimate the risk in question, then they will not be as well off as they would be otherwise unless tort damages fully compensate them for any harm they suffer (see Section 14).

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11.3 Injurers are Entitled to Impose Reasonable Risks Victims may only be entitled to be free from unreasonable risks of harm imposed by injurers (Graham and Peirce, 1984). In this situation, under a system of ex ante damage awards, victims will be as well off as they would be otherwise if they are compensated only for the cost to them of any risks imposed on them over the ‘reasonable’ level - for example, the level that results if the injurer takes optimal care. If, by contrast, compensation is only paid ex post, then to be as well off as they would be otherwise, victims must be paid the full ex post compensation demand value of the risk imposed.

12. Inducing Efficient Deterrence and Risk-spreading To minimize the joint costs of accidents and their prevention, tort rules must optimally deter injurers’ risk-taking (and, where relevant, victims’ risk-taking) and be consistent with optimal risk-spreading by risk-averse victims and injurers. The present analysis examines what tort liability and damage rules governing serious permanent injuries induce injurers to undertake efficient care and activity levels, while being consistent with efficient risk-spreading by victims. The question of what rules will also induce victims to undertake optimal care and activity levels is addressed earlier in this chapter and in Chapter 3100. The issue of how to induce injurers to efficiently spread risk is addressed both in Chapter 5700 and in Chapter 3800. 12.1 The Potential Conflict between Deterrence and Risk-spreading When accidents result in death or serious physical injury, it may be difficult to induce both optimal deterrence and optimal risk-spreading. Optimal deterrence requires that injurers bear the full social cost of their risk-taking activities, including nonpecuniary losses. Yet were the tort system to award damages to victims that fully compensated them, ex post, for death or serious permanent injury, the award would preclude victims from engaging in optimal risk-spreading, because, assuming that health is a normal good, full ex post compensation for death or serious permanent injury exceeds the amount that induces efficient risk-spreading. Victims efficiently spread the risk of loss when they derive that same marginal benefit from a unit of wealth whether healthy or injured. If health is a normal good, then the optimal amount of insurance is less than the amount needed to fully compensate the victim for his full loss. In other words, a potential victim’s marginal utility of wealth will be the same, whether healthy or injured, if he is paid an amount if injured which fails to return him to his preaccident level of utility (Arrow, 1974; Cook and Graham, 1977; Spence, 1977). To take an extreme example, a person with no heirs would prefer to

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have more wealth when alive than when dead, because money has no value to him once he is dead. Thus, he will not purchase life insurance. And, absent deterrence concerns, he would prefer to receive even a small amount of money while healthy to receiving millions of dollars after his death. Thus, any compensation paid to him after he dies would produce greater social utility if given to someone who is healthy. Similarly, in the case of serious permanent injuries, if health is a normal good then individuals would not fully insure against the risk of a serious permanent physical injury (Arrow, 1974; Cook and Graham, 1977; Spence, 1977). Thus, damage awards which fully compensate a victim for serious physical injuries - in the sense of returning him to his preaccident level of utility - overcompensate victims in that they exceed the efficient amount of insurance coverage (Cook and Graham, 1977; Spence, 1977). 12.2 Does the Conflict Exist? The preceding analysis suggests there is an apparent conflict between deterrence and risk-spreading. In order to be efficient, a tort regime must take this conflict into account. Yet in order to address this conflict, we must understand exactly when it arises, and when it does not. For example, the conflict between deterrence and risk-spreading may be overstated in the case of negligence liability. Indeed, under a perfectly functioning negligence rule, there is no conflict between deterrence and risk-spreading, provided victims can purchase first-party insurance. Under a perfectly functioning negligence rule with optimal (deterrence-based) damage rules, injurers will take due care and thus will not be liable. Thus, tort liability will deter without compensating, and damage awards will not distort victims’ ability to spread risks using first-party insurance (Arlen, 1990b; Calfee and Rubin, 1992, p. 403). Of course, negligence liability does not eliminate the conflict between deterrence and risk-spreading if injurers are found negligent, for example because courts err or because principals are unable to induce agents to take due care. In addition, even the activity is governed by a strict liability regime (or if injurers risk liability under a negligence regime) employing deterrence-based damage awards will not necessarily interfere with victims’ ability to optimally spread risks. Although it is true that in order to induce optimal deterrence injurers must bear the full cost of any harms they cause, this does not imply that injurers’ liability must equal the amount that leaves the victim as well off after the serious injury as before - that is, equal to the full ex post compensation demand value of the injury. From society’s standpoint, the cost of an injurer’s risk-taking activities is better measured by the cost of the risk he imposed on all potential victims than by the ex post compensation value of the actual injuries suffered by any victims. In other words, the deterrence award should

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be based on the ex ante compensation demand value of the injury: on the amount individuals would require to accept the risk the injurer imposed, divided by the expected number of accidents (Arlen, 1990b, 1993; Viscusi, 1991, p. 108). While this amount may be large, in the case of very serious injuries it generally will be less than the amount needed to compensate injured victims ex post. Ex ante compensation is based what amount must be awarded to healthy individuals to compensate them for bearing a risk of a harm that may never materialize. People often accept relatively less when compensated ex ante, because they are receiving the money when they are healthy and can enjoy it more; indeed, individuals often are willing to accept relatively small sums of compensation for relatively small risks of quite serious injuries. The sum of all the compensation required generally is much less than the ex post compensation demand value of the injury. By contrast, the ex post value is based on the amount needed to compensate a seriously injured person for his loss. If the injury eliminates, or dramatically reduces, any utility to the victim of money, then this amount might be astronomical. Indeed, in the case of death, no such amount may exist - or, the amount may be infinite (Mishan, 1971) even though a healthy person might require a relatively small amount ex ante to induce him to accept a risk of such loss (Arlen, 1993, pp. 1097-1098; Danzon, 1984; Viscusi, 1991, pp. 89-91; see Geistfeld, 1995, pp. 804-810). Thus, in order to optimally deter injurers it is not necessary that the award fully compensates victims for their actual losses. The award must simply equal the cost to society of the risk imposed. Should this amount equal - or, if there is first-party insurance, should it be less than - the victim’s optimal insurance coverage, then even under a strict liability rule, setting damage awards equal to the amount necessary to optimally deter injurers will not preclude victims from engaging in efficient risk spreading. Moreover, even if the ex ante deterrence award exceeds the optimal amount of insurance, holding injurers liable for this amount will not necessary result in victims being over-compensated. While injurers’ behavior is based on the gross award paid - including injurers’ litigation costs and any part of the award that goes to victims’ litigation costs - victims’ compensation depends on the net award. A victim’s compensation is excessive only if the net award - net of attorneys’ fees and litigation costs - exceeds the efficient amount of insurance. Thus, even if an injurers’ liability equals the full deterrence award, the net award to the victim may be less than or equal to the optimal amount of insurance (Geistfeld, 1995, pp. 800-802; Rubinfeld, 1984, pp. 553-555). Evidence suggests that if damage awards were set equal to optimal deterrence levels, litigation costs would substantially reduce the risk of excess compensation. For example, currently pain and suffering awards appear to roughly equal the standard lawyers’ contingency fee (Viscusi, 1991, p. 114). Thus, the victim’s net award may be roughly equal to pecuniary losses.

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Provided victims can purchase first-party insurance against nonpecuniary losses, this net award will be consistent with optimal risk-spreading by victims. Similarly, Geistfeld argues that on net victims will not be over-compensated if victims are not compensated for all tortuously caused injuries; any over-insurance for some injuries may offset under-insurance for others (Geistfeld, 1995, p. 800). Yet while for some injuries the net deterrence award may be less than or equal to the optimal amount of insurance, for many it still will exceed the optimal insurance award. Scholars have estimated the ex ante value of life to be approximately $3-6 million (Viscusi, 1991, p. 108; see Danzon, 1984, p. 527, placing the value at approximately $1.4 million (1980 dollars), citing Arthur, 1981; see generally, Kornhauser, 1990). Even net of litigation costs, this ex ante deterrence damage award likely exceeds the efficient amount of insurance - particularly if, as some have suggested, individuals would only insure against pecuniary losses (Danzon, 1984, pp. 522-524; Priest, 1987, p. 1547; A. Schwartz, 1988, pp. 364-367; Leebron, 1989, p. 274; see also Viscusi, 1991, p. 110; Viscusi and Evans, 1990). 12.3 Measure of Optimal Insurance The magnitude of the gap between the optimal deterrence award and the optimal insurance award depends critically on what is the optimal amount of compensation to pay to victims. A number of scholars have argued that individuals only insurance against pecuniary losses, even when faced with a risk of a serious nonpecuniary loss, such as is occasioned by death or serious permanent physical injury (Danzon, 1984, pp. 522-524; Priest, 1987, p. 1547; A. Schwartz, 1988, pp. 364-367; Leebron, 1989, p. 274). Yet whether optimal insurance for such injuries is indeed limited to purely pecuniary losses remains an open question. As a theoretical matter, optimal insurance can exceed pecuniary losses: optimal insurance for injuries that increase the victims’ marginal utility of wealth exceeds the victims’ pecuniary losses. Individuals will insure against nonpecuniary losses if the injury increases the marginal utility of wealth: implying that the individual derives more utility out of a dollar spent if injured than he did if healthy. This might occur if an injured person would be using the wealth to enable him to get essentials, like mobility, whereas when healthy he would only be using the money to purchase luxuries. Individuals will not insure against nonpecuniary losses (and will not even insure against all their pecuniary losses), however, if the injury decreases the marginal utility of wealth, as occurs with wrongful death (Calfee and Rubin, 1992; Cooter, 1989a, pp. 388-391; Viscusi, 1991, p. 90). Empirical evidence suggests that serious on-the-job injuries may reduce the victim’s marginal utility of wealth (see Viscusi and Evans, 1990). In this case, the net optimal deterrence award will exceed the optimal amount of compensation because the former generally exceeds the victim’s pecuniary

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losses. Yet there is some evidence to suggest that some injuries do increase the marginal utility of wealth - or at least that individuals anticipate that it will. For example, people currently insure against nonpecuniary losses - purchasing, for example, uninsured motorist coverage. This suggests that such insurance may be optimal in some circumstances (Arlen, 1990b, pp. 73-74, n. 149; Croley and Hanson, 1995; Geistfeld, 1995, pp. 795-796). However, even when optimal insurance includes some nonpecuniary losses, individuals do not fully insure against nonpecuniary losses, and optimal insurance often (indeed generally) will be less than the net optimal deterrence value of the injury. Thus, even when optimal insurance includes insurance for nonpecuniary losses, the optimal insurance damage award nevertheless generally will be lower than the (net) optimal damage award, thus presenting a conflict between risk-spreading and deterrence. 12.4 Eliminating the Conflict Between Risk-Spreading and Deterrence Thus, in the standard model of accidents - where accidents occur between ‘injurers’ and ‘victims’ who are strangers to each other - if injurers must pay victims an award based on the deterrence value of the risk, victims’ risk-spreading generally will be suboptimal. (a) Decoupling The state may be able to eliminate this conflict between deterrence and risk-spreading by decoupling the injurer’s liability from the victim’s recovery. In other words, the state can require the injurer to pay the victim an amount that ensures that the victim’s net recovery equals the insurance value of the harm, and then, where necessary, impose a deterrence surcharge on the injurer payable to the state to ensure that the injurer’s total liability equals the ex ante cost of the risk he imposed (Danzon, 1984; Shavell, 1987, pp. 233-235; Spence, 1977). It has been suggested that this solution may not be feasible because a majority of cases settle out of court, enabling the injurer to avoid paying the fine to the state (Geistfeld, 1995, pp. 799-800; Rubinfeld, 1984, pp. 553-557). Yet Polinsky and Che argue that decoupling may enhance efficiency even if cases settle (Polinsky and Che, 1991, pp. 566-567). Kahan and Tuckman (1995) argue, however, that Polinsky and Che’s result does not necessarily hold, and that the requisite levies may be ineffective if agency problems affect the plaintiff-lawyer relationship. Yet Shavell shows that settlements will not undermine the state’s ability to collect fines if the state refuses to enforce any settlements that are not registered with the court, with the injurer being required to pay a levy when he registers. This would ensure that injurers are not tempted to settle secretly because plaintiffs on the receiving end of secret settlements could turn around and sue the injurer. The only way for the injurer to get the benefit of settling would be to register and pay the fine (Shavell, 1996; 1997).

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(b) Bilateral Risks Even without decoupling, most standard torts resulting in serious permanent injury or death may not produce a conflict between deterrence and risk-spreading. Most tortuous injuries result from bilateral risk accidents - those in which both potential parties to the accident risk being injured. Indeed, most tort cases are automobile accidents - which are single activity accidents where both parties to the accident are engaged in the same activity and impose risks on each other. In this situation, the tort system operates more effectively as a mechanism for deterring risk-taking than for compensating victims, and tort damage awards may not interfere with victims ability to engage in optimal risk-spreading through the purchase of first-party insurance. Consider the most extreme type of bilateral risk accident: single activity accidents where both parties will be injured should an accident occur and will suffer identical losses. In this situation, neither party will receive any net compensation under any of the standard liability rules. Under negligence liability, each party will take due care and will not be liable. Under strict liability with contributory negligence, each will take due care and will be liable to the other, but because the accidents are symmetrical, damages paid will equal damages received with the result that on net neither receives or pays any compensation. Tort liability thus does not result in victims receiving net compensation and thus does not interfere with each parties’ ability to employ first-party insurance to optimally spread the risk of loss. Rather it serves a purely deterrent function: it will induce due care if the state employs a duty-based liability rule - that is, negligence liability or strict liability with contributory negligence - because each party takes due care in order to avoid net liability for the other’s losses (Arlen, 1990b; see Diamond, 1974, discussing deterrence but not insurance). The state also can induce optimal care-taking and promote optimal risk-spreading when parties to bilateral risk accidents do not suffer the identical losses. Under any negligence-based liability rule (for example, pure negligence, negligence with contributory negligence, and strict liability with contributory negligence) each injurer will take optimal care if damages are set such that the injurer is better off taking due care than bearing net liability for the accident (Arlen, 1992a; see Arlen 1990b; compare with Diamond, 1974). If damages are based on ‘deterrence values’ - that is, on the amount necessary to induce efficient care-taking - then under either negligence liability rule recovery also will be consistent with efficient risk-spreading by victims, provided victims can purchase first-party insurance. Under both negligence and negligence with contributory negligence, each risk-taker will take due care and thus neither will be liable. Thus, tort damages only affect potential injurers’ care levels and do not affect the parties’ ability to spread the risk of loss efficiently. Each will do so by purchasing first-party insurance (Arlen, 1992a).

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Under strict liability with contributory negligence, each will take due care and thus will be liable. Because each is liable for the other’s losses, the defendant who suffered the larger injury will receive an award greater than his liability; the other party will not receive any net compensation. Thus, the party who faces net liability invariably can spread his risk of loss, provided that he can purchase insurance, because there is no risk of his being over-compensated. The party who will receive net compensation should an injury occur also may be able to optimally spread the risk of loss, if he can purchase insurance and if his net recovery (net of fees, costs, and the liability to the other) is less than the amount needed to induce optimal risk-spreading. Alternatively, the state can guarantee that risk-spreading is efficient by arbitrarily ruling that both parties to a bilateral risk accident will pay the same damages, with the amount of the award equaling that minimum award necessary to make each party take due care. In this case, even under strict liability with contributory negligence, neither receives any net compensation when each takes due care, and damage awards do not interfere with victims’ ability to spread risks optimally by purchasing first-party insurance (Arlen, 1992a). For a more detailed discussion of efficient insurance, see Chapter 5700. (c) Products Liability Products liability cases also may not involve a conflict between deterrence and risk-spreading. If consumers are perfectly informed about product risks, the market will induce producers to take optimal care and produce the optimal amount of the product. Thus, damage awards need only induce optimal risk-spreading by victims. Awards thus should be based on ‘insurance’ values, not deterrence values (A. Schwartz, 1988; Priest, 1987; see Shavell, 1980). Many argue, however, that tort liability must promote optimal deterrence if consumers underestimate the risk of harm (see Section 14). Thus, injurers’ liability should equal the optimal deterrence award, which may exceed optimal compensation to victims (for example, Danzon, 1984; Geistfeld, 1995, pp. 798-799; A. Schwartz, 1988; Spence, 1977). Yet, as previously discussed, a victim often will be over-compensated - from an insurance standpoint - if his recovery equals the injurers’ liability. As before, it may be possible to solve this problem by decoupling the victims’ recovery from the injurers’ liability (Polinsky and Che, 1991; Spence, 1977). (See the discussion above.) Of course, this raises the issue of whether consumers do indeed underestimate the risks of being injured by a product. Schwartz (1988, pp. 378-384) disputes the claim that consumers generally underestimate product risks sufficiently to produce inefficient equilibria. However, Viscusi and others have shown that consumers do underestimate some risks (Viscusi, 1991, pp. 134-139; see generally Sunstein, 1997, p. 1183, discussing self-serving biases). Yet, Viscusi also has shown that consumers overestimate other product risks,

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such as risks that are called to their attention (for example, by product warnings) and risks of certain low-probability events (like cancer) (Viscusi, 1991, pp. 134-139). When consumers overestimate risks, products liability may lead to over-deterrence. Moreover, some scholars argue that even if victims are imperfectly informed, damages in some products liability cases need not equal the ‘deterrence’ value of the injury. Calfee and Rubin claim that imperfect information does not necessarily justify products liability for products, like vaccines, which overall serve to reduce the risk of harm. If consumers underestimate both the risk of harm from the product (for example, the risk of side effects) and the background risk the product reduces (the risk of disease), the consumer demand for the product may be suboptimal. In this situation, employing deterrence-based damage awards may reduce efficiency by deterring consumers from purchasing a product they should purchase (Calfee and Rubin, 1992; but see Geistfeld, 1995, p. 798, n. 99). Similarly, Knoll argues that stiff penalties for products liability may have the perverse result of encouraging firms to keep dangerous products on the market (Knoll, 1996b; see Arlen, 1994, examining the impact of strict liability on a firm’s willingness to monitor to determine it has done something which is likely to lead to liability). Finally, the government may be able to better solve imperfect information problems by giving consumers information on risk rather than by imposing tort liability. This depends in part on the consumers’ ability to rationally interpret information about their own risk of being injured (see, for example, Sunstein, 1997).

13. Deterrence Awards: Willingness to Pay vs. Willingness to Accept The optimal deterrence damage award for a particular injury is not the same in every case. First, a population’s ex ante evaluation of the cost of a particular risk will depend not only on the magnitude of the risk but also on the background risk affecting the population, assuming, as is likely, that preferences are nonlinear in risk (Arlen, 1985, pp. 1132-1134; Kornhauser, 1990, p. 215; see Linnerooth, 1979, pp. 57-58). In addition, it will depend whether the optimal award is properly based on potential victims’ willingness to pay to avoid the risk or the amount they must be compensated to accept the risk. Willingness to pay and willingness to accept produce very different estimates of the deterrence value of life (Hoffman and Spitzer, 1993; Geistfeld, 1995, pp. 822-825; Knetch, 1984; Kornhauser, 1990). The willingness to accept (or compensation demand) measure is most appropriate for accidents between strangers governed by a strict liability rule because strict liability implicitly grants the victim the entitlement to his health (Arlen, 1985).

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Under social welfare maximization or Kaldor-Hicks efficiency, the determination of due care and damages under a negligence rule also should be based on the willingness to accept risk if the presumption is that people possess the right to their health and reasonable risks are those which create benefits which equal or exceed the amount victims would require to compensate them for those risks (Arlen, 1985). Willingness to pay may be the appropriate measure of damages for accidents resulting from bilateral risks (Geistfeld, 1995, pp. 826-828). Willingness-to-pay also may be the proper measure of damages in products liability cases because potential victims are in fact paying for safety through higher product prices. Yet Geistfeld argues against using this measure on the grounds that it would be unfair: rich and poor consumers would pay the same product prices and yet the rich would be entitled to more compensation because they would have a higher willingness to pay (Geistfeld, 1995, pp. 805-806, n. 123). This problem disappears, however, if injurers’ liability is based on ex ante deterrence value of the risk - that is, on the aggregate willingness-to-pay of all consumers who purchase the product divided by the expected number of accidents. In this case, all victims would receive the same amount. Where this award conflicts with risk-spreading goals, the state could decouple victims’ recovery from injurers’ liability by forcing injurers to pay a fine to the state (see the discussion above). When implementing any damage rule, however, it is important to recognize that actual damages awarded by courts may also be affected by how the issue is ‘framed’. Specifically, both cognitive decision theory and experimental evidence suggests that juries’ and judges’ determination of the value of life is likely to depend on whether the judge or jury views tort damages as a gain to an injured victim or as making up a loss to a previously healthy person: whether they are told to consider the amount needed to make the victim whole or the amount she would have to be paid to subject herself to the injury in the first place (McCaffery, Kahneman and Spitzer, 1995).

14. Efficiency of Existing Tort Law The present review of the literature on efficient tort damage rules for death and injury reveals that the existing rules governing recovery for wrongful death and physical injury are not efficient. Under current law, recovery from wrongful death and physical injury is based on the victim’s lost wages and medical expenses plus an award for ‘pain and suffering’. Current measures of pain and suffering generally are designed to measure just that - the pain of death or injury - and generally are not an attempt to measure the lost quality of life. Moreover, and more important, pain and suffering is victim-specific, and thus is not tied to the total cost of the risk

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the injurer imposed on the entire population. Thus existing damage awards do not equal either the ex post value of the victim’s loss or the ex ante cost of the risk the injurer imposed (the efficient ex ante damage award). Thus, the injurers’ total liability for wrongful death and serious physical injury is not based on the social cost of the harms they cause. Accordingly, the tort system is unlikely to be providing the correct incentives for injurers to take due care and limit their activity levels (Arlen, 1985, 1993). Indeed, actual damage awards for wrongful death or serious permanent injury rarely exceed the efficient ex ante deterrence award of approximately $3-6 million (Viscusi, 1991, p. 108). This suggests that the tort system may not induce individuals to reduce the risks they impose to efficient levels. But, from the standpoint of inducing optimal risk-spreading, the compensation victims actually receive may be higher than is efficient - although this is unclear given that much of the award will go to attorneys fees and other costs. Finally, in the unilateral risk context, damage awards do not satisfy the requirement for Pareto efficiency that injurers’ risk-taking leave victims no worse off than they would be otherwise if victims are initially entitled to be free from risks imposed by others.

C. Special Topics 15. Damages for Corporate Defendants The standard analysis of optimal damages assumes that liability falls on the actual injurer. In other words, the standard analysis assumes that the defendant is the actual injurer, and that both people are natural persons. Yet often the defendant is a corporation which is being held liable for wrongdoing of its managers or other employees. Indeed, most of the famous tort cases involve corporate defendants - for example, U.S. v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947); The T.J. Hooper, 53F.2d 107 (S.D.N.Y. 1931); Palsgraf v. Long Island R.R., 162 N.E. 99 (N.Y. 1928). Analysis of corporate liability for torts of managers or other employees reveals that the standard analysis of individual injurers does not necessarily apply to corporate liability. Holding firms liable for their employees’ torts induces employees to take optimal care and firms to engage in optimal activity levels if firms either can directly control employees’ care levels or can use wages to force employees to bear the full social cost of wrongdoing. This regime does not induce optimal care, however, if firms cannot directly control employees’ care levels and employees cannot pay the optimal damage award (Kornhauser, 1982; Shavell, 1987, pp. 170-175; Sykes, 1984). In this situation, optimal deterrence requires that corporate tort liability induce firms to optimally deter their employees’ wrongdoing. To do this,

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however, one must do more than simply force firms to pay for any harms caused. When employees are insolvent and firms cannot directly control their employees’ care-taking, to optimally deter wrongdoing it may be necessary to induce firms to implement measures which increase employees’ expected liability by increasing the probability that they will be liable for their torts. These measures - hereinafter called policing measures - include monitoring employees, conducting self-evaluative audits of the firm’s compliance with the law, investigating suspected wrongdoing, and reporting wrongdoing. In addition, to optimally deter wrongdoing firms may need to undertake preventive measures - such as screening employees - and also adjust activity levels to reflect the full social cost of wrongdoing (Arlen and Kraakman, 1997). The current civil corporate liability regime is best described as being a regime of traditional strict vicarious liability, under which firms are liable for every harm caused by their employees’ in the course of their employees’ employment and subject to a fixed damage award equal to the harm caused, with no mitigation if the firm took steps to avoid the harm (Arlen, 1994). This regime is not in and of itself efficient. First, if the probability of detection is less than one, the firm will not undertake optimal prevention measures or activity levels unless the firm’s liability equals the social cost of the harm divided by the probability of detection (h/p) - an amount which may be many times higher than actual harm (Arlen and Kraakman, 1997; see Kornhauser, 1982; Polinsky and Shavell, 1993, 1998; Sykes, 1984). Second, in order to induce optimal policing measures - specifically measures that affect the probability that the firm will be found liable traditional strict liability generally should be replaced with a partial duty-based regime (‘composite regime’). Under this regime firms would be subject to a legal duty to monitor, audit, investigate and report optimally. In order to induce optimal prevention measures and activity levels, the firm would be subject to a sanction of h/p* - where p* is the optimal probability of detection - if it satisfied its policing duties but would be subject to a much higher sanction of h/po if it did not - where po is the probability of detection if the firm does not undertake any policing (Arlen and Kraakman, 1997). Strict liability will not induce firms to undertake optimal policing, unless the sanction is h/p, where p depends on the actual probability of detection (Arlen, 1994; Arlen and Kraakman, 1997). Full analysis of corporate tort liability also would require examination of the impact of criminal laws and also market-based sanctions. The present analysis reveals that one cannot simply apply the findings of the standard economic models of torts to cases involving corporate defendants. This suggests that we need to develop a better understanding of why corporations commit torts and how firms respond to liability, and that we should be circumspect about basing policing decisions governing corporate liability on economic models of how individuals behave. This topic is discussed in more

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detail in Chapter 3400 on Vicarious and Corporate Liability.

16. Economic and Nonpecuniary Losses Even where full compensation is efficient, concern for efficiency suggests that victims should not necessarily be compensated for their economic losses. Economic loss usually refers to foregone profits or earnings. Scholars argue that victims should not necessarily be compensated for economic losses because only some economic losses are social costs. For example, assume that a firm loses business to a competitor selling the same product at a lower price as a result of the tortuous activity of the latter. In this case, from the perspective of ‘static’ efficiency, the ‘victim’s’ lost profits are not a measure of social loss but are actually a measure of social gain. Similarly, when an accident halts a firm’s production of a good, the firm’s lost profits on foregone sales are not social costs if other firms produce perfect substitutes at the same cost (Shavell, 1987, pp. 135-140). Nevertheless, in other cases economic losses may also be social losses. For example, an accident that interferes with production will cause social losses if alternative goods are manufactured at higher cost. This cost difference is the measure of the social loss and is a proper component of damages. This amount will be less than economic losses, however, if the price of the good does not change. Social costs may exceed economic losses if no alternative sale is made, because the social costs equal the lost consumer surplus which necessarily equals or exceeds the producer’s economic loss (Bishop, 1982; Shavell, 1987, pp. 135-140). (For additional discussions of tort liability for economic losses see Goldberg, 1994; Landes and Posner, 1987, pp. 251-255; Rabin, 1985; Rizzo, 1982; G. Schwartz, 1986, 1996.) In contrast to economic losses, which often should not be included in damage awards, nonpecuniary losses generally should be included. Nonpecuniary loss generally refers to the loss of an ‘irreplaceable’ commodity a commodity which cannot be purchased on the market. Irreplaceable goods include the sentimental value a person attaches to a family photo or other personal possessions. Health is another irreplaceable good (see discussion above). Nonpecuniary losses are social costs: the cost is the reduction in the victims’ utility. In order to ensure that injurers take into account the full social cost of their actions, injurers must be liable for both pecuniary and nonpecuniary losses (Bishop and Sutton, 1986; Shavell, 1987, pp. 133-135). The one exception to this is where nonpecuniary loss is small enough that the benefit of holding injurers liable for this nonpecuniary loss is less than the administrative cost of estimating them (Shavell, 1987, pp. 133-135). This condition is satisfied only if the benefit of including such losses measured by

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the effect of including them on all injurers who impose risks to such commodities (whether injury results or not) exceeds the administrative cost of calculating them in the (relatively fewer) cases where the commodity is actually injured. Additional issues concerning recovery for nonpecuniary losses are discussed above.

17. Role of Defendants’ Wealth The standard analysis generally assumes that potential injurers are identical. The question arises, however, what if potential injurers have different wealth? Should this affect the damage award? Under the Pareto efficiency criterion, defendants’ wealth should be irrelevant to the determination of damages (see Shavell, 1987, pp. 215-227; Miceli and Segerson, 1995). This result also holds under the total social utility maximization criterion if each individual has the identical marginal utility of wealth for all levels of wealth - that is, if individuals are identical and are risk neutral (Arlen, 1992b; Abraham and Jeffries, 1989). When social welfare is measured by maximizing total social utility, then employing a simple model in which individuals are risk averse but are otherwise identical it can be shown that total social utility is maximized if wealthier people spend more on care; which can be achieved by forcing them to pay higher damages. The reason is that in this situation defendants have declining marginal utility of wealth. Thus, the wealthier the defendant the less impact an expenditure of a dollar has on his welfare. Thus, optimal due care for wealthier individuals exceeds optimal due care for poorer defendants, because, all else equal, the marginal cost of care for a wealthier defendant is lower. It is possible to induce greater care-taking by wealthier defendants by having damages vary with defendants’ wealth (Arlen, 1992b). This conclusion results from the fact that under the social welfare maximization criterion transfers of wealth can increase social welfare - as defined as maximizing total social utility. The fact that when the total social utility criterion is employed it is possible to increase ‘social welfare’ through purely distributional changes is a reason that many economists prefer other measures such as the Pareto criterion or Kaldor-Hicks criterion (Arlen, 1990b). Moreover, Miceli and Segerson question the conclusion that having defendants’ damages vary with wealth maximizes total social utility. They agree that the efficient standard of care and damage awards vary with defendants’ wealth when a negligence liability rule is employed and tort liability rules are the only instrument employed to increase social utility (Miceli and Segerson, 1995, pp. 202, 204-205). However, they conclude that under strict liability care levels and damage awards should be independent of defendants’ wealth (Miceli and Segerson, 1995, pp. 204-205).

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Furthermore, there are additional reasons to question whether wealth differences should affect damages, Arlen argues that we should not necessarily base damages on defendants’ wealth - even where static analysis might suggest that basing damages on defendants’ wealth would maximize total social utility because basing damages on defendants’ wealth would have negative affects on willingness to accumulate wealth. In addition, it would entail substantial administrative costs (Arlen, 1992b, pp. 427-429; see Polinsky and Shavell, 1998, pp. 910-913). Moreover, it is far from clear that society should design tort rules to maximize total social utility, instead of rules that are Pareto or Kaldor-Hicks efficient (see Arlen, 1985, 1990b). Finally, this analysis only examines one method of achieving redistribution. Other instruments, such as the tax system, might be superior for affecting the redistribution of wealth potentially required for social utility maximization (Kaplow and Shavell, 1994). Indeed, Kaplow and Shavell argue that income taxes are superior to liability rules for redistributing wealth because while both instruments distort people’s choice between labor and leisure, redistribution through legal rules imposes an additional cost: it distorts the behavior the legal rule was meant to regulate. They, therefore, conclude that legal rules should focus on efficiency alone (Shavell, 1981; Kaplow and Shavell, 1994). Recently, Sanchirico (1997) has challenged this conclusion that legal rules need only focus on efficiency because equity concerns are better addressed through the tax system. He argues that even if income taxes are optimal, tort rules may need to take considerations other than efficiency into account if people with different wealth levels respond in different ways to the tort system for example, if the wealthy are more cautious. In addition, equity considerations may be relevant if wealth differences are explained primarily by income differences and high income individuals tend to be more accident prone. Moreover, complete analysis of the issue of whether taxes or legal rules should be used to serve equity concerns would require analysis of the political economy of legislatures versus judges - of which institution is more likely to adopt an optimal, or second-best efficient, regime (Sanchirico, 1997). Christine Jolls (1998) argues that the case for using legal rules to achieve redistribution is strengthened once one takes into account well-known features of human behavior that depart from the rational choice model. She argues that if - as experimental research suggests - people are overly-optimistic about uncertain events, exhibit risk-seeking behavior towards losses, and engage in mental accounting, then redistrubtion through tort liability may distort work incentives less than an income tax. This conclusion undermines a central argument against using tort liability to achieve redistrubtional goals. More research is needed to determine whether behavioral economic analysis argues in favor of using tort liability to achieve redistribution, however.

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18. Sharing Losses Among Multiple Tortfeasors Many torts involve multiple tortfeasors. Under current law, generally joint tortfeasors are jointly and severally liable for a plaintiff’s losses. This rule holds each defendant potentially liable for the full amount of the plaintiff’s losses. Apportionment rules, by contrast, apportion tort liability between defendants in relation to their responsibility for the harm. This raises the issue of how to apportion damages amount multiple tortsfeasors. This issue is discussed at length in the chapter on Joint Tortfeasors (3200) and thus will only be considered briefly in this chapter. The standard legal regime holds multiple defendants jointly and severally liable for any losses they cause. This implies that each defendant is potentially liable for the full amount of the victim’s losses. Alternative regimes apportion this liability between the defendants. Under a negligence liability regime, joint and several liability will induce potential injurers to take due care if they are fully solvent (Kornhauser and Revesz, 1989; Landes and Posner, 1980; Landes and Posner, 1987, pp. 190-227; see Shavell, 1987, pp. 164-167). By contrast, if each injurer is only liable for the amount of damage attributable to his own negligence - for example, in a pollution case each is not liable for damage caused by the other person’s dumping - then injurers will fail to take due care (Kornhauser and Revesz, 1998, p. 372; 1989). Kornhauser and Revesz argue that the result is different under strict liability, however. They conclude that neither joint liability nor non-joint liability will cause injurers to take due care (Kornhauser and Revesz, 1989, 1998). By contrast, Shavell concluded that under strict liability an apportionment rule will result in injurers taking due care if they act in concert, but not if they act independently (Shavell, 1987, pp. 164-167, 177-179). For a discussion of apportionment rules when injurers are insolvent see Kornhauser and Revesz (1990). For a discussion of the effect of joint and several liability on settlement see Kornhauser and Revesz (1994a; 1994b).

19. Calculation of and Timing of Damage Awards 19.1 Accuracy in the Assessment of Damages Litigants often devote substantial effort to establishing the level of harm. The question is, are the costs of increased accuracy socially optimal? Kaplow and Shavell (1996) argue that if injurers know the harms they will cause, accurate damage awards will lead potential injurers to internalize the true cost of the risks they impose, leading to optimal care-taking and activity levels. But if injurers do not know the harms they will cause, then simply knowing that damages are accurate will not induce injurers to engage in optimal behavior.

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In this situation, expenditures on accuracy are wasteful, if all we are concerned about is optimally deterring injurers’ behavior. Injurers can be optimally deterred by basing damages on the average harm caused. Yet this conclusion does not hold if courts’ efforts to assess harms correctly causes injurers to learn more about the expected harms they may cause. At present, however, both parties are likely to have excessive incentives to provide information to courts about harm because litigants have ex post incentives to provide information about harm if actual harm is differs from estimated harm, even if this information has no social value (Kaplow and Shavell, 1996). 19.2 Individualized versus Scheduled Awards Danzon (1984) argues that in products liability cases, the current system of individualized awards should be replaced by a system of scheduled awards, under which a victim’s recovery for a particular injury is pre-determined, based on the average cost of such an injury. Rubinfeld (1984) suggests that scheduled awards will not necessarily reduce administrative costs and that the variance associated with individual awards may produce some benefits. Arlen (1990b, 1993) and Viscusi (1991) also argue for scheduled awards and against basing awards on victims’ actual losses. They argue that optimal damages for physical injury should be based on the ex ante cost to society of the risk the injurers imposed, and not on the actual victim’s ex post losses. This proposal differs from Danzon’s in that damage awards would depend on the magnitude and nature of the risk imposed - not just on the harm. Thus an injurer’s liability for a given loss - for example, wrongful death - would not be a fixed amount but rather would depend on the magnitude of the risk imposed and the nature of the risk (say fire versus being crushed). It might well be, however, that the victim’s recovery could be decoupled from the injurer’s liability, so that victims who suffer a particular type of harm - say loss of an arm - would receive the same amount. Those who would prefer to receive more could purchase insurance. 19.3 Lump-Sum versus Periodic Damages Compensatory damages often must cover not only past losses but also future losses, for example future lost wages associated with a serious permanent physical injury. The question arises whether this system of lump-sum awards should be replaced by a system under which awards are made periodically, contingent on the actual amount of the future loss. Those who support periodic contingent awards argue that contingent awards reduces the calculation problems associated with the uncertain nature of future losses. Rea (1981) argues, however, that the case for lump-sum awards is stronger than it might seem because periodic awards can add substantially to accident costs. First, Rea notes that ex ante victims will never be made better

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off by switching to periodic awards because a victim who would prefer periodic awards can always transfer a lump-sum award into a periodic award by purchasing insurance. Second, he notes that defendants may be risk averse. A risk-averse defendant will prefer a certain lump-sum payment to uncertain contingent payments with the same expected value. The defendant thus subject to a contingent award will likely purchase insurance. Rea suggests that a system under which the victim obtains a lump-sum award and purchases insurance is preferable to one under which the defendant is subject to a periodic award and purchases insurance (Rea, 1981; see also Schuck, 1990). 19.4 Prejudgment Interest Because it often takes many years from the time of an injury for a successful plaintiff to receive an enforceable judgment, courts award prejudgment interest. A proper award of prejudgment interest is necessary both to ensure that the plaintiff is fully compensated and that the defendant pays the full cost of the injury. The question is, what is the appropriate rate of prejudgment interest? Michael Knoll argues that economic and finance theory implies that when the parties have ready access to the capital markets (as publicly traded corporations do) prejudgment interest should be awarded at the defendant’s cost of unsecured borrowing. A defendant who is assessed a judgment has in effect borrowed the judgment amount from the plaintiff. As with other loans, the plaintiff is compensated if he receives interest at the defendant’s borrowing rate. Because judgment creditors are treated along with other unsecured creditors in bankruptcy, awarding prejudgment interest at the defendant’s cost of unsecured borrowing will both compensate the plaintiff and prevent the defendant from being unjustly enriched (Knoll, 1996a). For other articles discussing this topic see Fisher and Romaine (1990), Patell, Weil and Wolfson (1982).

20. Conclusion Economic analysis has greatly enriched our understanding of damage rules. It reveals that damages serve a complex and multi-faceted role: deterring risk-takers, helping victims spread risks, and compensating them for their losses. Economic analysis reveals how to design tort liability and damage rules to serve these goals. This analysis can guide legislators and courts as they design tort liability and damage rules. Existing research suggests that at present damage awards for serious personal injury and death generally are not sufficiently large to induce potential injurers to take due care and engage in optimal activity levels. Yet economic analysis also suggests that victims of physical injuries may be receiving too much compensation. This suggests that states should consider decoupling

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defendants’ liability from victims’ compensation. Economic analysis also suggests that the fact that tort liability for certain accidents is too low does not imply that all damages awards should be increased. Although defendants’ liability is too low in some circumstances, existing research suggests that it may be too high in others. A defendant’s full costs of risk creation include litigation costs, any market penalties the defendant bears as a result of either the harm or being held liable, and any additional government-imposed sanctions, such as civil penalties imposed by an administrative agency or criminal penalties. These costs must be included in any assessment of whether tort damage rules are adequate. Moreover, more empirical evidence is needed on the questions of what is the optimal ex ante deterrence award for different risks, and what are potential victims’ preferences for spreading the risk of various losses. Economic analysis of tort damages also would benefit from additional analysis on why accidents happen in the first place - particularly, why are people negligent? Simple economic models predict that if damages and liability rules are set correctly, no one will be negligent. Yet there is considerable anecdotal evidence - and some empirical evidence - that people are indeed negligent (see Weiler, 1993a, pp. 72-73 showing that doctors are negligent in a substantial portion of cases). The question is why? Is it that damages are too low? Is it that optimal care is set incorrectly? Or are there other forces at work - perhaps informational or institutional problems - that result in the tort system not creating adequate incentives for people to take due care. Economists have explored some of the possible reasons: such as the risk of court error; the possibility injurers will not be liable for their torts; and the fact that many tort defendants are business organizations, not individuals. These and other possible explanations warrant additional analysis.

Acknowledgments I would like to thank Linda Cohen, Bob Cooter, Lewis Kornhauser, Mitchell Polinsky, Chris Sanchirico, Gary Schwartz, Steven Shavell, Matthew Spitzer, Eric Talley, and two anonymous referees for their helpful comments.

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3600 NO-FAULT COMPENSATION SYSTEMS R. Ian McEwin Case Associates, Sydney, Australia © Copyright 1999. R. Ian McEwin

Abstract No-fault compensation systems are designed to overcome alleged deficiencies in the tort system as a means of compensation. Tort proponents argue that the tort system provides important safety incentives but this is generally discounted by no-fault advocates. This chapter surveys the no-fault compensation literature and concludes that the main focus has been the adequacy of the tort system as a system of compensation and deterrence. The law and economics literature has not shown much concern with efficient no-fault design. JEL classification: K13 Keywords: No-Fault, Tort, Liability, Insurance

1. Introduction No-fault insurance has been increasingly seen by many as a preferred alternative to the tort system. This view is driven, mainly, by perceived deficiencies in the tort system itself, rising liability insurance premiums and a belief that accident victims are not adequately compensated. During the 1960s and 1970s the main concern was automobile accidents. During that time many automobile no-fault schemes were introduced in the United States, Canada and Australia. In 1974, New Zealand introduced a no-fault scheme that covered all accidents. During the 1980s no-fault schemes were proposed covering product and medical malpractice accidents. No-fault insurance commonly refers to changes in liability rules and compulsory insurance arrangements such that accident victims need not prove fault to receive compensation. Victims are made to buy self-insurance or tortfeasors are made strictly liable and forced to buy liability insurance, or some combination. For example, automobile no-fault schemes typically cover the driver-owner (self-insurance) as well as other drivers of the vehicle, passengers and any pedestrians injured by the vehicle (compulsory strict vehicle liability insurance). Product liability no-fault schemes involve imposing some form of strict liability on producers coupled with compulsory liability insurance (self-insurance may be permitted). But strict liability may be in name only - as Posner (1975, p. 471) puts it: 735

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Although we speak of strict liability for product accidents, the term is a misnomer. Liability is restricted to defective products and the determination whether a product is defective resembles the usual negligence determination.

There are many variants of no-fault compensation schemes with varying degrees of residual tort liability and various types of insurance or non-insurance compensation. Germany and Austria introduced workplace no-fault schemes in the early 1880s, which involved compulsory industry insurance schemes. In England the Workmen’s Compensation Act was enacted in 1897, purportedly based on the workers’ compensation scheme introduced by Bismarck in Germany. However, the English legislation simply increased employers’ common law liability and made no provision for compulsory employer liability insurance. Yet the Act was widely regarded in England as one of the most important pieces of legislation in the nineteenth century and later termed, despite the absence of insurance, ‘the pioneer system of social security’ (Beveridge, 1942, p. 41). With the exception of automobile accidents there are striking similarities in the way industrialized countries treat accident victims. Chapman and Trebilcock (1992, pp. 799-780) point out that: in most parts of the industrialized world, from the turn of the century onwards, the tort system has been largely displaced with respect to workplace injuries by no-fault workers compensation schemes …. On the other hand … with respect to injuries or disabilities resulting from medical malpractice or product use, the tort system remains the primary compensatory vehicle for most victims … with respect to auto-related accidents a very different picture emerges … from about 1970 onwards massive diversity in policy choices has emerged.

Compensation became the focus of tort scholarship in the late 1960s after Keeton and O’Connell (1965) proposed an automobile no-fault scheme. Undoubtedly this reflected as Schwartz (1985, p. 548) put it: the revolution in social policy perception and evaluation that characterized the 1960s and early 1970s … the principle of broad social responsibility upon which the new evaluations rested made a tort style of reasoning seem excessively individualistic and moralistic.

Tort law critics argue that accident law does not effectively deter accidents nor adequately compensate victims. Accident law does not deter, it is argued, because any deterrent effect is swamped by imperfect insurance that does not properly penalize careless or unsafe behavior - see Fleming (1967, p. 823) and Atiyah (1980, Ch. 24). Instead, deterrence is better achieved by safety regulation. No-fault schemes re-allocate costs away from lawyers to accident

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victims. Franklin (1967) described the tort system as a ‘negligence lottery’ due to the difficulties and considerable legal costs involved in proving fault assessing causation and determining whether there was failure to take reasonable care is problematic after a number of years. Even if fault can be proved critics argue that victims face great uncertainties about the likely compensation amount and when it will be paid. Compulsory self-insurance, it is argued, ensures all accident victims are compensated without the need to prove fault. Savings in legal costs and the other costs of administering a liability system mean that compensation can be provided to those not compensated through the tort system. Also, compensation can be paid promptly and according to changed circumstances unlike the tort system, which takes time because it involves a once-for-all assessment of loss. As O’Connell (1975a, p. 461) put it: The solution for auto accidents is not seen to be a system whereby, after an accident between Smith and Jones, each will be paid regardless of anyone’s fault, by his own insurance company, periodically, month by month as his losses accrue, for his own out-of pocket expense (relatively easy to tot up from, say the medical bills, in contrast to fighting over what pain is worth in dollars and cents). As a corollary each will be required to waive his tort claim based on fault against the other. With the savings from arguments over fault and from no longer paying for non-pecuniary losses, more people are eligible for payment from the insurance pool into which fewer - or surely no more - dollars need to be paid. This is, in essence, the ‘miracle’ being wrought by no-fault auto insurance.

Automobile no-fault schemes were introduced in many jurisdictions in Australia, Canada and the United States during the 1970s. These schemes mostly introduced compulsory self-insurance but still allowed for tort claims to varying degrees. ‘Add-on’ schemes allow full tort recovery while ‘threshold’ schemes allow for tort recovery if loss exceeds a minimum dollar amount or a ‘verbal’ threshold (such as death). Comprehensive or pure no-fault schemes abolish tort claims altogether. Quebec and the Northern Territory in Australia abolished tort claims for automobile accidents while New Zealand has abolished tort claims for all accidents, introducing a universal social insurance scheme for accidents in its place. While no-fault compensation schemes are common for workplace accidents and to a lesser extent for automobile accidents, there are few no-fault schemes for product accidents and for medical malpractice. Dewees, Duff and Trebilcock (1996) provide an impressive, comprehensive analysis of no-fault schemes (including for environmental damage, which is not covered here). While most of the literature has pointed to deficiencies in the tort system, scant attention has been paid to the design of optimal no-fault schemes. As a

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result, those proposing no-fault solutions have largely ignored practical lessons from insurance, which balance compensation and incentives to take care. Often, the different roles played by social security, social insurance and private insurance have not been properly recognized or understood. Social security provides assistance through cash transfers or payments in kind on the basis of need, funded from general tax revenues. Social security provides a safety net for redistributing national income across the life cycle, between rich and poor and across generations. Social insurance is a compulsory insurance scheme, either publicly or privately run. Benefits are not usually related to contributions. Rather, social insurance schemes usually favor particular groups on the basis of need. Private insurance differs from social insurance in a number of ways. Individuals decide how much protection they want, which together with premiums and the terms of the insurance contract are determined in advance. Premiums are related to expected payout (the probability of an accident times the expected harm) to the extent justified by the costs of setting risk classes. Further, in their haste to abolish the tort system those proposing no-fault solutions have generally not take into account the background of medical, hospital, and social security schemes that co-exist with the tort system. For example, 85 percent of American families had life insurance and private health insurance (see Dewees, Duff and Trebilcock, 1996, p. 26). No-fault schemes are grafted not only onto pre-existing tort laws but also onto existing social security and social insurance arrangements. Thus no-fault schemes favor particular kinds of accident victims over others who may be similarly injured by other kinds of accidents (or in the case of comprehensive no-fault schemes, over those similarly disabled by congenital defects) - see Ison (1980). No-fault scheme proposals have focussed on providing minimal levels of compensation to accident victims through ‘accident funds’ contributed to by those engaging in the risky activity. Contributions are not usually based on the amount of risky activity undertaken nor the likelihood of suffering or causing an injury. As a result, schemes have tended to ignore incentive effects and be designed along social insurance principles. Law and economics scholars generally criticize no-fault design because, as Trebilcock (1989, p. 53) puts it: the notion that the consequences of accidents, and perhaps other classes of misfortunes, should be solely a community rather than an individual responsibility ignores the fact that accident (or misfortune) rates are often significantly influenced by the conduct of individuals, which targeted pricing and benefit policies and a residual role for the tort system are likely to influence significantly. In short, it is assumed, without justification, that economic incentives do not influence individual behavior. Neither theory nor empirical evidence supports this assumption.

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Thus the law and economics literature has focussed on whether there are deficiencies in the tort system sufficient to justify no-fault insurance and whether no-fault schemes change incentives sufficiently to affect accident rates. The literature has not been concerned, generally, with the design of efficient no-fault systems until very recently.

2. Automobile No-Fault Many studies have demonstrated that the tort system is not only slower to provide compensation than no-fault but also tends to overcompensate small losses and undercompensate large losses. Carroll and Kakalik (1991, pp. 32-33) show that no-fault schemes banning non-economic loss reduce transaction costs by 80 percent and that threshold systems can reduce overall compensation costs by 10 percent. Seen simply as a system of victim insurance, automobile liability insurance is not efficient. Yet the tort system still provides considerable compensation. Rolph, Hammitt, and Houchens (1985) found that about two-thirds of those compensated by automobile no-fault would be compensated by the tort system. Automobile no-fault schemes differ considerably. Most do not provide compensation for non-pecuniary loss and so recovery depends on the extent to which tort actions are permitted. Add-on states do not change the tort systems and so litigation is unlikely to be affected. Caldwell (1977, pp. 941-942) found a negligible reduction in litigation in add-on jurisdictions. Threshold states have had mixed experience in limiting tort actions. Caldwell (1977) found that the strict verbal threshold in Michigan reduced claims by 87 percent between 1973-75. Low pecuniary thresholds reduce claims much less. But, as Dewees, Duff and Trebilcock (1996), p. 57) point out: since their introduction in the 1970s both monetary and verbal thresholds have been greatly eroded by claims ‘padding’ to surmount thresholds, by expansive judicial interpretations of verbal thresholds, and by the impact of inflation on monetary thresholds - most of which are not indexed to increases in the nominal costs of injury compensation.

Evidence on premium costs is mixed. Premiums increase in add-on systems. Caldwell (1977, p. 965) found that premium increases between 1971 and 1977 in add-on states were twice that of states abolishing tort altogether. Premium increases in states with tort thresholds depend on the size of benefits (including the size of deductibles and the extent to which collateral benefits are offset) and the tort threshold.

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But even if no-fault or first-party schemes can provide victim insurance more effectively, do they lead to more accidents because would-be negligent drivers are no longer responsible for the harm they cause? A number of empirical studies have attempted to assess whether reducing driver liability affects accident rates. In the United States Medoff and Magaddino (1982) found no-fault increased liability loss rates (claims weighted by average claim cost per premium dollar). Landes (1982a) found that states in the United States that imposed minor restrictions on tort claims experienced increases of 2-5 percent in fatal accidents while those imposing greater restrictions suffered 10-15 percent more. On the other hand, Kochanowski and Young (1985) and Zador and Lund (1986) found no relationship between no-fault and fatalities. In a study of New Zealand and Australia, McEwin (1989) found that add-on no-fault schemes did not increase automobile fatalities but in schemes where tort liability was abolished altogether fatalities increased by 16 percent. McEwin admitted that the size of the impact is questionable given the problems involved in isolating the various determinants of road fatalities. Both Gaudry (1988) and Devlin (1988) found increased accidents as a result of the introduction of a no-fault scheme in 1978. Gaudry attributed the increase not to the change in liability but rather to the fact that previously uninsured drivers now drove less carefully and a flat-rate premium that reduced the cost of insurance to high-risk drivers. Devlin, on the other hand, attributed the increase to the abolition of tort claims. Modeling and testing the impact of automobile no-fault schemes has not yielded unambiguous results. Some studies have been flawed methodologically for a summary see Dewees, Duff and Trebilcock (1996, pp. 22-26). Some empirical tests fail because they take no account of changes in incentives due to changes in the way insurance premiums are set, the extent to which merit rating and deductibles are used, or whether no-fault benefits offset benefits from other sources.

3. Other Accidents - Product and Medical Malpractice Unlike automobile accidents, product, medical and workplace accidents involve some negotiation and bargaining. In a perfect world without transaction costs, perfect information and actuarially fair insurance (the insurance premium equals the expected loss) self-interested participants will result in efficient levels of risk and compensation (Coase, 1960). Any attempt to impose a no-fault scheme, by definition, imposes welfare costs - workers receive more compensation and have fewer accidents than they are willing to pay for. Proponents of product and medical malpractice no-fault schemes point to the fact that the tort system is costly, bargaining and other transaction and

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information costs are high. Like many no-fault advocates O’Connell (1975a) stresses defects in the tort system as follows: What about other accident victims - those injured by, say, manufactured products such as a power tool, or falls in stores, or in the course of medical treatment? … the plight of those who suffer losses from such accidents is much worse than that of auto accident victims … In the first place, the issues in, say, a products liability case are far more technical and demanding than in a typical auto case …. The scenario for medical malpractice cases follows that for products liability … surgical procedures … are so very complicated that trying to determine whether they were properly executed makes even many difficult products liability cases look easy.

Much of the impetus in the literature for expanding the scope of no-fault schemes resulted from the liability insurance crisis in the 1980s - although as Schwartz (1991, pp. 46-51) notes, the product liability crisis was mainly confined to the United States. Croley and Hanson (1991) argue that increases in product liability insurance premiums in the United States represented an efficient internalization of producer costs. It is worth noting that product liability insurance was usually combined with general liability policies and was not merit-rated - see The Inter-Agency Task Force on Products Liability Contractors Study (1978). Increasing liability premiums have led to a trend towards self-insurance and so the likelihood that incentives to take care have improved (Priest, 1989). But strict liability may not improve safety. Dewees, Duff and Trebilcock (1996, p. 204) argue that strict liability ‘impounds the costs of non-negligently caused accidents … to the extent that non-negligently caused accidents are in part a function of intensity of consumer use, a negligence regime enjoys advantages over a strict liability regime’. They go on to argue ‘that is would be desirable to reinstate the negligence regime, preferably accompanied by a fairly robust regulatory compliance defense’. Hensler et al. (1991) found in a survey of 26,000 households that almost one-third of injuries in the sample were product related. Half of these occurred at work and so were covered by workers’ compensation - the tort system contributed only about 5 percent of compensation. Hensler et al. found that for accidents outside the workplace only 2 percent of those injured took action and only 1 percent retained a lawyer. Nevertheless, tort law serves as the only basis for direct compensation for nearly all products-related accidents outside the workplace. Little has been written about product no-fault schemes. Instead, product no-fault is generally considered together with universal no-fault schemes covering all accidents (see below). Schwartz and Mahshigian (1987) consider the prospects for a no-fault scheme to cover all product accidents but conclude that there is no causation ‘trigger’ available to cover many different types of

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product defect. Thus a general product no-fault scheme is unlikely. Dewees, Duff and Trebilcock (1996, pp. 240-245) describe limited compensation schemes for vaccine- and drug-related injuries in a limited number of jurisdictions such as California, Germany, France, Japan and the United Kingdom. There are some notable differences between vaccines and other products. Vaccine injuries ‘tend to be imposed on the consumer’, ‘the vaccinee may face a greater risk of suffering a vaccine-induced adverse reaction than of contracting the disease through wild virus in the community’ and ‘the so-called liability insurance crisis has been particularly acute with vaccines’ (pp. 240-241). They also point out, in relation to the National Childhood Vaccine Injury Act of 1986 in the United States which introduced a mandatory no-fault scheme but retained tort after a no-fault claim was made, that ‘it appears that the rationale behind preserving the tort system at all was to maintain incentives for the manufacture of “safe” vaccines’. More interest has been shown in designing medical malpractice no-fault schemes - see, for example, O’Connell (1985). Pure medical no-fault schemes were introduced in New Zealand in 1974 (as part of its universal scheme), in Sweden in 1975 and in Finland in 1987. After noting that there are few empirical analyses, Dewees, Duff and Trebilcock (1996, p. 146) conclude that: comprehensive no-fault patient compensation ensures that substantially more injured patients will be eligible for benefits than under the current tort system. Furthermore, the no-fault plans in Sweden and New Zealand have had reasonable success in defining the concept of a medical injury and in compensating most injured patients promptly and at relatively low administrative cost.

4. Universal No-Fault In 1974 New Zealand abolished tort law remedies for all personal injuries by accident and replaced it with a no-fault compensation scheme administered by a state monopoly. The scheme was based on five principles from the Woodhouse Royal Commission (1967) Report. They are: community responsibility (the community collectively bore a basic responsibility for the social costs of accidents; comprehensive entitlement (equity required giving assistance to all those disabled by accident, irrespective of cause, time or location); complete rehabilitation (accident victims should recover in the shortest possible time); real compensation (compensation should reflect real loss) and administrative efficiency (collecting funds and paying benefits should be conducted as efficiently as possible). Cover was provided without proof of ‘fault’ no matter how or where the accident occurred, whether at work, at home, on the road, or while participating

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in a sporting or recreational activity. In return, the common law right to sue for damages for personal injury (except for punitive or exemplary damages) was abolished. The scheme was administered by a monopoly, the Accident Compensation Commission. The major justification for the scheme was deficiencies in the common law yet as Palmer (1979) noted: The argument against the common law in the 1967 Royal Commission was largely based on principle. There were almost no empirical data in New Zealand on who got what, when, and how from the common law system. Only modest amounts of information were collected by the Royal Commission itself. (p. 26)

Currently, the scheme has six accounts: Employers; Earners; Non-Earners; Motor Vehicle; Subsequent Work Injury; Medical Misadventure. The Employers Account pays for all work-related injuries except for work-related motor injuries. Employers pay a premium based on payroll (like workers’ compensation). Only since 1996 has the premium depended on the risk involved in the work carried out by the employer’s workers. Prior to that, bonuses were given for good safety records. The Earners Account was established in 1992. Earners pay a premium on their total earnings, collected through normal ‘Pay As You Earn’ taxation arrangements. Most of these premiums are paid into the Earners Account to cover non-work-related injuries in the home, playing sport or other recreational activities. Prior to that non-work accidents suffered by workers were paid from the Earners Fund. No empirical studies have been carried out to determine to what extent risk-compensating wages have compensated for premiums formerly paid by employers. The Non-Earners Account pays for injuries suffered by those not in the workforce, except injuries caused by motor vehicle accidents which are funded by the Motor Vehicle Account. The Government pays the ACC for these costs from general taxation revenues and so forms a (more generous) part of social security. The Motor Vehicle Account pays for all motor vehicle injuries. It is funded from part of the annual licensing fee for motor vehicles and a tax of two cents per litre on petrol sales. The Subsequent Work Injury Account pays the cost of work-related claims that involve a recurrence of an injury received in previous employment. It is funded from the four principal accounts, the Employers, the Earners, the Non-Earners and the Motor Vehicle accounts. The Medical Misadventure Account pays the cost of injuries that result from error by medical practitioners or from rare and severe outcomes of medical or surgical procedures. It is funded from the Earners and Non-Earners accounts.

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The universal scheme was built on pre-existing funding sources - workers’ compensation and compulsory automobile liability insurance. When initially set up the primary focus was on providing compensation and promoting rehabilitation. Increasing scheme liabilities have led to concerns that the behavioral assumptions underlying the scheme are inadequate. As a result the scheme has been continually reviewed. In 1979, it was decided to review the scheme and assess its overall cost. The review also took into consideration employers’ concerns that they were subsidizing the cost of non-work claims. A Cabinet Committee recommended that claimants should meet part of the cost of the first two visits to the doctor, lump-sum awards for minor injuries and for pain and suffering and loss of enjoyment of life be abolished except for serious cosmetic disfigurement. As a result several amendments were made to the Act in 1982. These included: changing from a fully-funded to a ‘pay-as-you-go’ system: first week compensation payable by employers for work accidents was reduced from 100 percent of pre-injury earnings (exclusive of overtime) to 80 percent of pre-injury earnings (including overtime); the ACC was given the power to refuse to pay compensation to people injured while committing a crime; compensation for work-related motor vehicle accidents were no longer funded from the Earners Account but from the Motor Vehicle Account. The maximum amount of compensation for the loss or impairment of bodily function was increased from $7,000 to $17,000. However, the amount of compensation payable for pain and suffering and loss of enjoyment of life remained at the 1974 level of $10,000. Employer pressure in 1992 led the Government set up another committee to review the scheme. The Accident Rehabilitation and Compensation Insurance Act 1992 was aimed at controlling premium costs its objective being: ‘to establish an insurance-based scheme to rehabilitate and compensate in an equitable and financially affordable manner those persons who suffer personal injury’. Lump-sum compensation was abolished and compensation for work-related motor vehicle accidents was transferred from the Earners Fund. Despite considerable discussion of the scheme, there have been virtually no empirical studies of its impact by independent researchers. Most studies have been internal. Soon after the scheme began employers started to complain that injury rates had soared. In particular, complaints by the meat-freezing industry led to the ACC setting up an independent inquiry. The inquiry found that worker lost time in the meat-freezing industry increased by 92 percent in the first two years (initially, workers were fully paid for the first week after a work-related accident) (Palmer, 1979, p. 373). The New Zealand Business Roundtable (1987) expressed concern that no-fault insurance was provided by a public monopoly. They argued that the scheme constrained the ability of people to determine their own insurance arrangements. They proposed that the universal no-fault scheme be replaced

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with a requirement that New Zealanders buy a minimum level of first-party accident coverage and that private insurers supply this. On 14 May 1988 the New Zealand Government announced that employers and self-employed people would be able to buy 24-hour accident insurance from either private insurers or the Accident Compensation Corporation.

5. Conclusions Fault and no-fault compensation systems should not be considered in isolation. Fault systems can be combined with safety regulation and compulsory first- or third-party insurance systems. So can no-fault systems. From a policy perspective different combination of insurance/safety regulation should be considered in terms of their ability to provide optimal compensation and safety as well as satisfying societal demands for ‘retribution’ and ‘justice’. But while a considerable amount has been written, we still don’t know whether no-fault insurance, taken together with other compensation sources and other incentives to take care, increases overall welfare. One thing seems clear. If we are concerned solely with accident compensation, the tort system is unsatisfactory. However, the tort system seems to provide important safety incentives, although how important is difficult to determine empirically. Experience with no-fault schemes suggests that proponents were so concerned to fight battles to abolish tort that little time was given to designing efficient no-fault systems that took into account elementary insurance principles such as merit rating and incomplete insurance to overcome adverse selection and moral hazard problems. However, those administering no-fault schemes have learnt from experience and have made some adjustments. The law and economics literature, concerned primarily with the adequacy of the tort system and deterrence, has not concerned itself much with no-fault design. At the end of the day public policy towards accidents should be concerned with empirical evidence about the efficacy of alternate compensation systems incorporating elements of tort, disability insurance and social security. To date this has not been accomplished.

Acknowledgements The author would like to thank an anonymous referee whose comments were very helpful.

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3700 PUNITIVE DAMAGES A. Mitchell Polinsky Stanford University

Steven Shavell Harvard University © Copyright 1999 A. Mitchell Polinsky and Steven Shavell

Abstract This chapter concerns punitive damages. In considering the rationale for the award of punitive damages, we refer to two broad social goals: deterrence and punishment. In Section 2 we review the basic theory of deterrence, and in Sections 3 through 6, we discuss the main deterrence-related justifications for punitive damages: the possibility of escaping sanctions; underestimation of harm; socially illicit gains; and inducing parties to bargain rather than acting unilaterally to cause harm. Then in Section 7 we examine the punishment goal and how it is served by punitive damages, and in Section 8 we consider how the punishment and deterrence goals should jointly determine damages. Finally, in Section 9 we address a variety of extensions to the analysis and certain legal doctrines that bear on the award of punitive damages: reprehensibility of conduct; wealth of injurers; whether victims are strangers or customers; litigation costs; insurability; and tax treatment. JEL classification: K13, K41 Keywords: Punitive Damages, Deterrence, Punishment

1. Introduction This chapter concerns punitive damages, an important form of damages that sometimes are awarded to plaintiffs in addition to compensatory damages. (The term ‘punitive damages’ is somewhat inapt because the purpose of such damages is only partly, and perhaps not even mainly, to punish; we nevertheless use the term because it is conventional.) In the United States, punitive damages are awarded in approximately 6 percent of all cases in which plaintiffs prevail. While punitive damages are granted mainly in tort case, they are increasingly employed in contract disputes and other areas of litigation; see generally Eisenberg et al. (1997) for an evaluation of the empirical significance of punitive damages. Outside of the United States, punitive damages and other forms of extra-compensatory damages are of lesser importance (see Stoll, 1983, 764

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pp. 99-106). (Much of what we have to say, however, is relevant to publicly imposed penalties that exceed harm, which are common in all countries.) In considering the justification for awarding punitive damages, we will refer to two broad social goals: deterrence and punishment. By deterrence we mean the use of sanctions to influence behavior, so as to maximize the following measure of social welfare: the benefits parties obtain from their actions, less the costs of precautions, the harm done, and the expenses due to use of the legal system. By punishment, we mean the imposition of sanctions to satisfy a desire for retribution against wrongdoers. We generally do not consider compensation and the reduction of risk as social goals; this simplification is not of great consequence because punitive damages are extra-compensatory; thus, there is no need to insure victims (although the bearing of liability risk by injurers remains an issue, as will be noted). The remainder of this chapter is organized as follows. In Section 2, we review the basic theory of deterrence, and in Sections 3 through 6 we discuss the main deterrence-related justifications for punitive damages: the possibility of escaping sanctions; underestimation of harm; socially illicit gains; and inducing parties to bargain rather than acting unilaterally to cause harm. Then in Section 7 we examine the punishment goal and how it is served by punitive damages, and in Section 8 we consider how the punishment and deterrence goals should jointly determine damages. Finally, in Section 9 we address a variety of extensions to the analysis and certain legal doctrines that bear on the award of punitive damages.

2. Optimal Damages when Injurers are Found Liable for Sure: The Basic Theory of Deterrence We summarize here the basic principles of the economic theory of deterrence and liability assuming that, whenever a party causes harm, he will be sanctioned for sure. (For integrated treatments of the standard theory of liability and deterrence, see Landes and Posner, 1987 and Shavell, 1987.) In this setting, the point on which we want to focus is that the proper magnitude of damages is the harm that the party has caused. (The term ‘damages’ means the magnitude of liability payments.) We first discuss this point when liability is strict - when injurers are liable for harm regardless of the care they took - and then when liability is based on the negligence rule - when injurers are liable for harm only if they were at fault. Readers familiar with the basic theory of deterrence and liability may want to proceed directly to Section 3. There are two basic reasons why it is best for damages to equal harm under strict liability. The first concerns the level of precautions taken by parties, where the term ‘precautions’ is to be interpreted generally (including, for

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example, the use of safety devices, attention to hazards, and the monitoring of employees by firms). If damages equal harm, parties will have socially correct incentives to take precautions; they will be induced to invest in precautions if and only if the cost is less than the resulting reduction in expected harm. If, however, damages are less than harm, precautions will tend to be inadequate, and if damages exceed harm, precautions will tend to be excessive. The second reason why it is desirable for damages to equal harm involves parties’ level of activity - the extent to which individuals and firms participate in risky activities. A party’s level of activity affects the magnitude of expected harm, whatever precautions are taken by the party when engaging in the activity. For example, the more miles a person drives (his level of activity), the greater the number of accidents that he is likely to cause, whatever is his level of care when he drives. Similarly, the more units of a product produced and sold by a firm (its level of activity), the greater the number of accidents that will be caused by the product, whatever are the safety features of the product (which affect the expected harm per unit sold). If damages equal harm, parties will have socially correct incentives to engage in risky activities. In particular, because an individual’s expected damages will equal the expected harm he causes by participating in an activity (such as driving), he will participate in the activity if and only if the benefit he obtains from the activity exceeds the resulting expected harm. Likewise, a firm will produce a product if and only if its value, as reflected in the willingness of customers to pay for it, exceeds the full cost of its production, including the expected harm that it causes. (This is because the price of the product will equal its full cost of production, assuming for simplicity that the firm produces in a competitive environment.) However, if damages are less than harm, levels of activity will tend to be socially excessive, and if damages exceed harm, levels of activity will tend to be too low. Let us turn now to the negligence rule, under which a party whose level of precautions is below a specified standard is said to be negligent and must pay damages. Assume that the negligence standard is set equal to the optimal level of precautions (the level that minimizes the sum of precaution costs and expected harm). Then, if damages for negligence equal harm, parties will decide to comply with the negligence standard and thus will take appropriate precautions. However, if damages are less than harm, parties might not meet the standard. If damages exceed harm, parties will have a more-than-adequate incentive to meet the standard, and no reason to exceed it, assuming that the negligence determination is accurate. Realistically, however, there will be errors in the negligence determination. For example, courts may err in determining the negligence standard or in assessing parties’ behavior. Because of the risk of such mistakes, parties may have an incentive to take greater precautions than they would otherwise, in

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order to reduce the chance that they will incorrectly be found negligent. If the chance of mistake leads parties to take excessive precautions, raising the level of damages will exacerbate this problem. Next consider the relationship between damages and the level of activity under the negligence rule. In the absence of mistakes, the negligence rule will tend to cause parties to participate in risky activities to a socially excessive extent. This is because, once a party takes the precautions required by the negligence standard, he will not be found liable for any harms that he causes. For example, a person who drives with reasonable care will not be found negligent, and therefore will not have to pay for any harm caused by his driving; consequently, he will drive more than is socially desirable. However, because non-negligent parties sometimes will be found liable by mistake, they will sometimes bear damages. In principle, this could ameliorate the problem of excessive participation in risky activities under the negligence rule. It also is possible, however, that finding parties negligent by mistake will result in their bearing damages in excess of the harm they have caused, and thereby overly discourage their participation in activities. This effect, if it occurs, will be exacerbated by raising the level of damages. The preceding discussion shows that there is not a simple, theoretically correct answer to the question of what level of damages is optimal under the negligence rule. We will assume for simplicity that optimal damages under the negligence rule are equal to the harm, as under the rule of strict liability. Accordingly, we generally will not distinguish between the two rules in our subsequent discussion. In passing, we want to note that the conclusion that damages should equal harm depends on our implicit assumption that parties are risk neutral. If injurers are risk averse and cannot purchase liability insurance, the optimal level of damages tends to be lower than harm, both to reduce the imposition of risk on injurers and because damages do not need to be as high to induce injurers to behave appropriately. But if, as is realistic, liability insurance is available (even if only partially available due to moral hazard), the optimal level of damages remains equal to the harm. Also, publicly-held firms should be treated as approximately risk neutral - implying that damages should equal harm - if their shareholders have well-diversified portfolios, which often, if not usually, will be the case. We next turn to various deterrence-based rationales for setting damages in excess of harm - that is, for imposing punitive damages. The first and most important of these arises when injurers might escape liability.

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3. Optimal Damages when Injurers Might Escape Liability There are several reasons why injurers sometimes escape liability for harms for which they should be liable under a liability rule. First, it may be difficult for the victim to determine that the harm was the result of some party’s act - as opposed to simply being the result of nature, of bad luck. This might be the case, for instance, if an individual develops a form of cancer that could have been caused by exposure to a naturally occurring carcinogen but which was in fact caused by exposure to a man-made carcinogen. Second, even if the victim knows that he was injured by a person’s conduct and not by nature, it might be difficult for him to prove who caused the harm. The owner of a parked car that was damaged might know that it had been struck by another vehicle but not be able to identify the injurer or be able to establish his identity in court. Third, even if the victim knows both that he was wrongfully injured and who injured him, he might not sue the injurer because of the effort and expense a suit would entail. The consequences of the possibility that injurers can escape liability are clear. If damages merely equal harm, injurers’ motivations to take precautions will be inadequate and their incentive to participate in risky activities will be excessive. To remedy these problems, the damages that are imposed in those instances when injurers are found liable should be raised sufficiently so that injurers’ expected damages will equal the harm they cause. This implies that total damages should equal the harm multiplied by the reciprocal of the probability that the injurer will be found liable when he ought to be. Formally, if h is harm and p is the probability of being found liable, the injurer should pay h . (1/p) = h/p when he is found liable; his expected damages therefore will be p . (h/p) = h. We will refer to 1/p as the total damages multiplier. For example, if the probability of being found liable is 0.25, the total damages multiplier is 4 (= 1/0.25), so the injurer should pay, in total, four times the level of harm if he is found liable. The excess of total damages over compensatory damages can be labeled punitive damages. Thus, the optimal level of punitive damages is the optimal level of total damages less compensatory damages. If the harm is $100,000 and the probability of being found liable is 0.25, implying a total damages multiplier of 4, total damages should be $400,000; since $100,000 of this total represents compensatory damages, the $300,000 remainder is the optimal punitive damages amount. This amount also can be described as a multiple of harm or, equivalently, of compensatory damages. Since optimal total damages are h/p, optimal punitive damages are h/p − h, which can be rewritten as [(1 − p)/p]h. The term in brackets - the ratio of the injurer’s chance of escaping liability to the injurer’s chance of being found liable - is the punitive damages multiplier. In the preceding example, the punitive damages multiplier is 3 (= 0.75/0.25), which, when multiplied by the harm of $100,000, yields the

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$300,000 punitive damages amount. Note that the award of punitive damages may itself raise the probability of suit, and therefore the probability that an injurer will be found liable. This effect, when applicable, should be taken into account. In general, there will be a level of damages that, given the resulting probability of suit, will lead to optimal deterrence. Basing punitive damages on the relatively low probability of suit that would occur if just compensatory damages were awarded would tend to lead to excessive damages. The general point that, to achieve proper deterrence, sanctions must be inflated if injurers can escape liability, dates back at least to Bentham ([1838-1843] 1962, pp. 401-402) and has been applied to the subject of punitive damages by many commentators. The first explicit references to the factor of escaping liability as a justification for punitive damages apparently are Posner (1972, pp. 77-78) and Ellis (1982, pp. 25-26); this justification has been developed most thoroughly by Cooter (1989) and Polinsky and Shavell (1998).

4. Optimal Damages when Harm is Underestimated Even if injurers are always found liable when they are responsible for harm, if the magnitude of harm is underestimated, compensatory damages will be less than harm and deterrence will be inadequate. This possibility is realistic because hard-to-measure components of harm (such as nonpecuniary losses) often are excluded from damages. Such missing components of harm are commonly mentioned as a reason to impose punitive damages (see especially Ellis, 1982, pp. 26-31 and Galligan, 1990). However, as emphasized in Polinsky and Shavell (1998, pp. 939-941), there is a problem with employing punitive damages as a substitute for missing components of compensatory damages. Namely, a component of harm might be excluded from compensatory damages because of the difficulties and expense that would be encountered in its estimation. For example, were the pain and suffering experienced by the friends of a person who dies included in compensatory awards, the number of claimants in cases of wrongful death could become quite large, and the cost of litigation would also increase as parties contested the degree of their psychological losses. It may well be best, then, for the law to exclude from compensatory damages many such speculative, difficult-to-determine elements of harm, even though these elements are real and their omission does undesirably dilute deterrence. If a component of loss is excluded from compensatory damages for such reasons, arguably it should be excluded from punitive damages for the same reasons. Conversely, if a component of loss should have been included in compensatory damages, despite the costs of doing so, this mistake in legal

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policy should be rectified by incorporating the component in such damages. Including the component only in punitive damages would still result in underdeterrence, for the component would remain omitted in the large majority of cases in which only compensatory damages are awarded. Moreover, the component of loss would probably be more poorly measured as a form of punitive damages because the calculation of such damages is not disciplined by the procedures and evidentiary requirements common to the determination of compensatory damages.

5. Optimal Damages when Injurers’ Gains are Socially Illicit We have implicitly assumed to this point that the gains that parties obtain from committing harmful acts count in social welfare, whereas here we consider the situation when their gains are not counted in social welfare because they are treated as socially illicit. Suppose that a person, out of spite, punches another individual. Society might well deem the pleasure the injurer obtains from this act to be socially illicit. This view of an injurer’s gains would seem especially plausible when the injurer’s utility derives solely from causing harm (that is, when the injurer’s act is malicious). However, certain conduct that is not intended to cause harm might also be treated as socially illicit, for instance, driving at high speed for the fun of it. If an injurer’s utility from an act is considered socially illicit (whatever the explanation for this), it is desirable for the act to be deterred completely. To accomplish this, damages must exceed the injurer’s utility from committing the act. And since the injurer’s utility could be greater than the harm, the required level of damages might exceed the harm. For instance, if the illicit gain from an act is equivalent to $500 to the injurer and the harm is $100, damages of at least $500 are necessary to deter the act. This justification for punitive damages was first noted by Ellis (1982, pp. 31-33) and Cooter (1982, pp. 86-89); for more formal treatments, see Shavell (1987, pp. 159-161) and Diamond (1997a, pp. 8-11). It should be noted, though, that the present justification for punitive damages is limited in scope. Many, if not most, socially undesirable acts committed by individuals, including some very reprehensible ones, do not seem to be associated with socially illicit utility; often this is because such acts are not committed with the intention of causing harm. Similarly, most conduct of firms is unlikely to be associated with socially illicit utility, since the goal of firms is to make profit, not cause harm.

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6. Optimal Damages when Parties can Bargain and Transact in the Marketplace In some circumstances it is possible for a party to communicate with a potential victim before causing harm. This would usually be so, for example, when a firm contemplates infringing on another’s copyright. When prior communication is possible, a potential injurer could negotiate in advance with the potential victim to purchase the right to engage in the harm-creating conduct. The firm deliberating about the copyright violation could secure a license to use the copyrighted material. In such circumstances, it may be socially desirable to induce a potential injurer to bargain and purchase the right to engage in harm-creating conduct by threatening to impose punitive damages if the injurer acts unilaterally to cause harm. This point apparently originated with Calabresi and Melamed (1972) and was further developed by Biggar (1995), Haddock, McChesney and Spiegel (1990), Kaplow and Shavell (1996) and Landes and Posner (1981). To amplify on this rationale for punitive damages, suppose that compensatory damages alone are employed and that they are underestimated. A potential injurer then might cause harm when doing so is socially undesirable - because the benefit to the injurer might be less than the harm done, but greater than the low estimate of compensatory damages. There may be additional undesirable repercussions from underestimating compensatory damages. If injurers can take property from victims without having to pay its full value, injurers will devote effort to identifying and taking such property (copyright violators will seek out material to copy), and victims will expend effort to protect their property (copyright owners will invest resources in preventing duplication of their material). Such efforts are socially wasteful; they are similar to those associated with the theft of property. The foregoing problems can be avoided if punitive damages are imposed for unilaterally causing harm. If the level of such damages is set so that total damages substantially exceed the value of the property at issue, a potential injurer will be induced to bargain with the property owner - it will be cheaper to pay an agreed upon price than to pay damages. Consequently, property will be exchanged only if the injurer’s benefit exceeds the property owner’s loss, and the wasteful incentives to take and to protect property will be eliminated. Another possible reason to employ punitive damages to encourage bargaining and market transactions concerns administrative costs. If compensatory damages are used alone, harm and the taking of property will tend to be mediated through the legal system by the bringing of lawsuits. But if punitive damages are used as a threat, harm and the shifting of property interests will be much more likely to occur through voluntary transactions, the costs of which are likely to be lower than those associated with litigation.

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The preceding arguments favoring the use of punitive damages to promote negotiation and market transactions obviously do not apply if bargaining between parties is not possible or if there are substantial impediments to it. Suppose, for instance, that a hiker lost in the mountains discovers an unoccupied cabin. The benefit he would obtain from using the cabin and consuming the food in it presumably would exceed the loss borne by the cabin’s owner. But because there is no opportunity for the hiker to bargain with the owner, the threat of punitive damages might discourage the hiker from using the cabin, which would be undesirable. Hence, when parties cannot bargain, it may be better just to employ compensatory damages (despite the possibility of errors in estimation). Additionally, even if bargaining is feasible, there may be other impediments to efficient exchange - such as bargaining failures due to strategic behavior that could justify relying solely on compensatory damages. Because many harms cannot, as a practical matter, be resolved beforehand by bargaining - including most harms due to accidents between strangers, such as automobile accidents - and because bargaining failures are important, the present justification for punitive damages often will not be relevant.

7. Optimal Damages and Punishment Having discussed the use of punitive damages to accomplish proper deterrence, let us now turn to the punishment objective. We treat this objective as deriving from the desire of individuals to have blameworthy parties appropriately punished. We equate blameworthiness with the reprehensibility of a party’s conduct, that is, with its maliciousness or the extent to which it reflects disregard for the safety of others. Given the degree of a party’s blameworthiness, we assume that there is a correct level of punishment, and that either higher or lower punishment detracts from satisfaction of the punishment objective. When the defendant is an individual, the connection between imposition of punitive damages and accomplishment of the punishment objective is conceptually straightforward: if, after assessing the blameworthiness of an individual’s act, appropriate punitive damages are imposed, the punishment objective is achieved. However, when the defendant is a firm, the role of punitive damages in relation to the punishment objective involves a number of complexities; these have been considered in Polinsky and Shavell (1998, pp. 948-954). One is that there are different ways of viewing the objective of punishment: the goal may be to punish firms as entities, that is, without reference to whether anyone within a firm behaved inappropriately or was punished as a consequence; or the goal may be to punish firms only as a means of punishing culpable individuals in the firms. We find the former conception of the punishment goal

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unappealing both because it requires a definition of blameworthiness of a firm that is divorced from the behavior of any individuals who are affiliated with it, and because it necessitates believing that people would, after reflecting about the matter, want to impose a penalty on what ultimately is an artificial legal construct. Notwithstanding these reservations, it is possible that people do want to personify firms and punish them as entities, and the reader can make up his or her mind about the importance of this way of defining the punishment objective. Now consider the alternative reason for punishing firms - as a means of punishing blameworthy individuals within them. Supposing that this is the purpose of punishment, we turn to the question of the extent to which the imposition of punitive damages on firms will in fact result in the punishment of blameworthy employees. Because firms clearly have an interest in discouraging culpable conduct by their employees that could give rise to punitive damages, firms can be expected to seek to control such conduct through the use of internal sanctions (such as demotion or dismissal). However, several considerations suggest that the imposition of punitive damages on firms will have a smaller effect on the punishment of blameworthy employees than might at first be supposed. First, culpable employees may not be punished by firms because firms may have difficulty identifying them. Second, even if culpable individuals within a firm can be identified and punished by the firm, imposing punitive damages on firms often will have little or no marginal effect on their punishment. That is, the internal sanction imposed on such employees may not be much (if at all) greater as a result of the firm’s bearing both punitive and compensatory damages than if the firm had borne compensatory damages alone, because the latter may result in the firm imposing the maximum internal sanction on the employee. Additionally, there may not even exist culpable employees in the firm to punish: responsibility for a decision may be so dispersed that no one person would be considered blameworthy with respect to it; and even if there are such persons, they may have changed jobs, retired, or died by the time a judgment is rendered. A further point is that imposing punitive damages on firms often penalizes the firms’ shareholders and customers, who ordinarily would not be thought to deserve punishment. This adverse consequence of punitive damages must be weighed against the beneficial effects of such damages in furthering the punishment goal. To amplify, shareholders, as residual claimants on a firm’s profits, obviously will be made worse off when punitive damages are imposed on a firm. The question, however, is whether they should be punished. If a shareholder owns a significant share of a firm’s stock, participated actively in the firm’s decisions and acted egregiously, then his position would be much the same as that of a blameworthy employee with decision-making power; each would be morally culpable. But if a shareholder owns a minuscule fraction of

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the stock of the firm, and was a passive investor with no direct involvement in the firm’s decision-making processes, then his degree of blameworthiness is small, if it exists at all. A firm’s customers also will suffer from the imposition of punitive damages on the firm if such damages cause the prices of the firm’s products or services to rise. This can occur because firms may regard punitive damages as an additional cost of doing business - a cost that, with a positive probability, will be borne by them beyond their ordinary costs. To cover the added cost of punitive damages, therefore, firms will have to raise their prices, which will cause the welfare of their customers to decline. It seems clear, however, that customers would not ordinarily be considered blameworthy, because they do not exert direct control over the actions of firms that pose risks to other persons. Thus, assuming that the punishment objective with respect to firms is to ensure that blameworthy individuals are penalized, punitive damages do not accomplish this objective in a direct way and also tend to penalize parties who are not blameworthy.

8. Optimal Damages in the Light of Both Objectives The levels of damages that are optimal from the perspective of the two separate objectives of deterrence and of punishment generally will be different. Notably, the level that is best for deterrence is likely to exceed that which is best for punishment if the chance of being found liable is low and the magnitude of punitive damages necessary for deterrence therefore is high. Conversely, the level that is best for punishment is likely to be higher if the chance of being found liable is high, because then optimal damages for purposes of deterrence are approximately equal to harm, but the reprehensibility of the defendant’s act presumably calls for extra-compensatory damages to serve the punishment objective. It is evident that the optimal level of damages overall - that which maximizes a measure of social welfare combining both objectives - is a compromise between the levels that are optimal when each objective is considered independently, as noted in Polinsky and Shavell (1998, pp. 955-956) and developed in Diamond (1997b).

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9. Extensions of the Analysis In this Section we will consider a variety of additional topics, focusing on the deterrence objective and usually restricting attention to the rationale for punitive damages stemming from the chance that the injurer can escape liability. We will, however, mention the punishment objective when it seems of particular importance. Reprehensibility of Conduct The law requires that a defendant be found to have acted in a reprehensible manner before punitive damages can be imposed on him. However, as emphasized in Galligan (1990, pp. 62-64) and Polinsky and Shavell (1998, pp. 905-910), this legal policy often is inconsistent with the deterrence objective. On one hand, emphasis on reprehensibility may lead to imposition of punitive damages when such damages are not needed to achieve deterrence because the injurer is virtually certain to be found liable (as when a surgeon fails to remove a surgical tool from his patient). On the other hand, the converse problem may arise: an individual’s harmful conduct may not be reprehensible but nevertheless may be unlikely to result in his liability (as when a truck inadvertently spills toxic wastes onto a highway at night). Notwithstanding the preceding observations, basing the level of punitive damages on the reprehensibility of the defendant’s conduct may be proper with respect to the deterrence objective for acts leading to gains that are socially illicit: such acts usually are considered reprehensible and, as observed in Section 3, punitive damages may be necessary to deter them. From the perspective of the punishment objective, the focus on reprehensibility clearly is sensible, because reprehensibility of conduct is essentially synonymous with the actor’s blameworthiness and thus with the need for punishment. Wealth of Injurers The courts often state that a defendant’s financial condition is a relevant factor in setting a punitive damages award, with the understanding that higher punitive damages may be appropriate for defendants with higher wealth. With regard to deterrence, however, damages usually should not depend on the injurer’s wealth (see, for example, Abraham and Jeffries, 1989; Cooter, 1989, pp. 1176-1177; and Polinsky and Shavell, 1998, pp. 910-914). The reason, in essence, is that if parties make decisions about precautions and choice of activity based on the expected value of their liability - that is, if they act in a risk-neutral way - their decisions will not depend on their wealth, and thus there is no reason to link damages to wealth. This point generally applies to corporations since, for the reason discussed at the end of Section 2, they can

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be treated as risk neutral. It also applies to individuals if they are risk neutral or have access to liability insurance. A qualification is that if individuals are risk averse and cannot obtain liability insurance, then optimal damages may depend on their wealth. To elaborate, the optimal level of damages for such individuals tends to be lower than that indicated by the multiplier formula presented in Section 3. (We noted an analogous point at the end of Section 2, where we observed that, for uninsured, risk-averse individuals who are found liable for sure, optimal damages are less than harm.) Further, the more risk averse an individual is, the lower the optimal level of damages. Assuming that poor individuals are more risk averse than rich individuals, this implies that the optimal level of punitive damages is lower for poorer individuals. Equivalently, punitive damages should be higher for wealthier individuals. Another qualification to the conclusion that a defendant’s wealth should not bear on the level of damages needed for proper deterrence arises when an injurer’s gain is considered socially illicit. An injurer’s wealth then may be relevant because the sanction necessary to offset his illicit gain will be higher the higher is his wealth, assuming that his marginal utility of money declines with his wealth. Similarly, an individual’s wealth may be relevant to the level of punitive damages that will achieve appropriate punishment. For to impose a given disutility on an individual, he must pay more if he is wealthy than if he is not, assuming that his marginal utility of money declines with his wealth. But if the injurer is a firm and the punishment objective is concerned with punishing culpable employees, the firm’s wealth generally would not be relevant to satisfaction of the punishment objective. This is because there is no general reason to believe that the penalties that a firm imposes on its employees for misbehavior will be a function of the firm’s wealth, and thus no reason to think that achievement of the punishment objective will be served by linking punitive damages to a firm’s wealth. Whether Victims are Strangers or Customers Although we have so far implicitly assumed that the parties harmed by injurers are ‘strangers’ - parties who have no market or contractual relationship with the injurer - victims of harm often are customers of defendant firms. The status of victims either as strangers or as customers is important to consider, although courts generally do not observe this distinction. When customers might be harmed by the products (or services) they buy, firms will tend to be concerned that customers may not be willing to pay as much for the products or that they may stop purchasing the products altogether. Given that firms have this market-based incentive to be attentive to the risk of harm to their customers, the need for liability in general, and for punitive

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damages in particular, to control injurer behavior is diminished. The more knowledgeable customers are about product hazards, the less the need for punitive (or any) damages. Obviously, this market mechanism cannot operate if the victims are strangers to the defendant. On punitive damages and the customer relationship, see Craswell (1996) and Polinsky and Shavell (1998, pp. 934-936). Litigation Costs Litigation costs may be relevant to the calculation of punitive damages because they may influence the probability of suit, and therefore the chance of escaping liability. If litigation costs are significant relative to the expected gain from suit, the probability of suit may be small, and this fact may justify imposing punitive damages on the injurer. However, litigation costs often will be insignificant in relation to the expected gain from suit, so that the probability of suit may be presumed to be very high. Then, consideration of litigation costs does not provide a basis for imposing punitive damages. Note that punitive damages should not be awarded for the purpose of spurring suit. The damage multiplier formula is designed to achieve appropriate deterrence when suit does not always occur, so it is not necessary to award damages to increase the probability of suit (provided that the probability of suit is not so low that the implied level of damages exceeds the defendant’s ability to pay). Indeed, encouraging lawsuits would increase social costs and therefore is socially undesirable, other things equal. The tendency of higher damage awards to increase litigation costs lends appeal to the policy of decoupling punitive damages, that is, awarding the plaintiff only a part of the punitive damages judgment paid by the defendant, with the remainder going to the state. Use of decoupling allows society to discourage excessive spending on litigation (the plaintiff receives less than otherwise) without diluting deterrence (the defendant can still be made to pay an appropriate penalty). On punitive damages and litigation costs generally, see Polinsky and Shavell (1998, pp. 921-923); see also Kahan and Tuckman (1995) for a discussion of punitive damages and decoupling. Insurability The question whether liability insurance for punitive damages should be permitted is of interest, in part because legal policy on this matter varies among the states. The basic answer to this question is that punitive damages should be insurable when the justification for punitive damages is that injurers might escape liability. The reasons for allowing liability insurance for punitive damages are essentially the same as those for allowing liability insurance for compensatory damages. These reasons are easiest to explain when liability is strict and harm

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is solely monetary. In that case, the sale of liability insurance cannot hurt potential victims, since they will be fully compensated for any loss; and the insurance must raise the wellbeing of injurers if they elect to buy it. The arguments for allowing liability insurance in other contexts are more complicated. A potential qualification to all of these arguments arises if injurers are judgment-proof; the availability of insurance could worsen injurers’ behavior in these circumstances (although insurance also could improve matters). (For discussions of insurance and punitive damages, see Priest, 1989; and Polinsky and Shavell, 1998, pp. 931-934.) Tax Treatment If punitive damages are imposed on an injurer as a result of his engaging in a business activity, such damages generally are tax deductible, just as are compensatory damages in those circumstances. This policy is socially desirable given the deterrence objective. For if punitive damages were not deductible, their after-tax cost to injurers would be artificially inflated relative to the costs of taking precautions, which are deductible. Consequently, injurers would be induced to take excessive precautions (and, for similar reasons, to be overly deterred from participating in risky activities). The general point that damages should be deductible, given that precaution costs are deductible, originated with Png and Zolt (1989) and carries over to the situation when parties might escape liability and punitive damages might be imposed as a result.

Acknowledgments Polinsky’s research was supported by the Center for Advanced Study in the Behavioral Sciences (through National Science Foundation grant #SBR-960123) and the John M. Olin Program in Law and Economics at Stanford Law School. Shavell’s research was supported by the John M. Olin Center for Law, Economics, and Business at Harvard Law School. This chapter previously appeared with a less comprehensive bibliography in Peter Newman (ed), The New Palgrave Dictionary of Economics and The Law, London, Macmillan Reference Ltd. (1998).

Bibliography on Punitive Damages (3700) Abraham, Kenneth S. and Jeffries, John C., Jr (1989), ‘Punitive Damages and the Rule of Law: The Role of Defendant’s Wealth’, 18 Journal of Legal Studies, 415-425. Bentham, Jeremy ([1838-1843] 1962), ‘Principles of Penal Law’, in Bowring, John (ed), The Works of Jeremy Bentham, New York, Russell & Russell Inc., 365-580.

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Biggar, Darryl A. (1995), ‘A Model of Punitive Damages in Tort’, 15 International Review of Law and Economics, 1-24. Boyd, James and Ingberman, Daniel E. (1995),Do Punitive Damages Promote Deterrence?, Business Law and Econonomics Center, Washington University, St. Louis, BLE-95-08. Calabresi, Guido and Melamed, A. Douglas (1972), ‘Property Rules, Liability Rules, and Inalienability: One View of the Cathedral’, 85 Harvard Law Review, 1089-1128. Chapman, Bruce and Trebilcock, Michael (1989), ‘Punitive Damages: Divergence in Search of a Rationale’, 40 Alabama Law Review, 741- 829. Cooter, Robert D. (1982), ‘Economic Analysis of Punitive Damages’, 56 Southern California Law Review, 79-101. Cooter, Robert D. (1989), ‘Punitive Damages for Deterrence: When and How Much?’, 40 Alabama Law Review, 1143-1196. Craswell, Richard (1996), ‘Damage Multipliers in Market Relationships’,25 Journal of Legal Studies, 463-492. Daniels, Stephen and Martin, Joanne (1990), ‘Myth and Reality in Punitive Damages’, 75 Minnesota Law Review, 1-64. Daughety, Andrew F. and Reinganum, Jennifer F. (1997a), ‘Everybody Out of the Pool: Products Liability, Punitive Damages, and Competition’, 12 Journal of Law, Economics, and Organization, 410-432. Daughety, Andrew F. and Reinganum, Jennifer F. (1997b),Settlement, Deterrence and the Economics of Punitive Damages Reform, Department of Economics and Business Administration, Vanderbilt University Working Paper No. 97-W04. Diamond, Peter (1997a), Efficiency Effects of Punitive Damages, Department of Economics, M.I.T., Working Paper No. 97-17. Diamond, Peter (1997b), Integrating Punishment and Efficiency Concerns in Punitive Damages for Reckless Disregard of Risks to Others, Department of Economics, M.I.T., Working Paper No. 97-19. Dobbs, Dan B. (1989), ‘Ending Punishment in “Punitive” Damages: Deterrence-Measured Remedies’, 40 Alabama Law Review, 831-917. Eisenberg, Theodore, Goerdt, John, Ostrom, Brian, Rottman, David and Wells, Martin T. (1997), ‘The Predictability of Punitive Damages’, 26 Journal of Legal Studies, 623-661. Ellis, Dorsey D., Jr (1982), ‘Fairness and Efficiency in the Law of Punitive Damages’, 56 Southern California Law Review, 1-78. Farber, Daniel A. (1980), ‘Reassessing the Economic Efficiency of Compensatory Damages for Breach of Contract’, 66 Virginia Law Review, 1443-1484. Friedman, David (1989), ‘An Economic Explanation of Punitive Damages’, 40 Alabama Law Review, 1125-1142. Galanter, Marc (1996), ‘Real World Torts: An Antidote to Anecdote’, 55 Maryland Law Review, 1093-1160. Galligan, Thomas C., Jr (1990), ‘Augmented Awards: The Efficient Evolution of Punitive Damages’, 51 Louisiana Law Review, 3-85. Haddock, David D., McChesney, Fred S. and Spiegel, Menahem (1990), ‘An Ordinary Economic Rationale for Extraordinary Legal Sanctions’, 78 California Law Review, 1-51. Hylton, Keith N. (1997), Punitive Damages and the Economic Theory of Penalties, Unpublished manuscript, Boston University School of Law.

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Johnston, Jason S. (1987), ‘Punitive Liability: A New Paradigm of Efficiency in Tort Law’, 87 Columbia Law Review, 1385-1446. Kahan, Marcel and Tuckman, Bruce (1995), ‘Special Levies on Punitive Damages: Decoupling, Agency Problems, and Litigation Expenditures’, 15 International Review of Law and Economics, 175-185. Kaplow, Louis and Shavell, Steven (1996), ‘Property Rules versus Liability Rules: An Economic Analysis’, 109 Harvard Law Review, 713-790. Landes, William M. and Posner, Richard A. (1981), ‘An Economic Theory of Intentional Torts’, 1 International Review of Law and Economics, 127-154. Landes, William M. and Posner, Richard A. (1986), ‘New Light on Punitive Damages’, 10(1) Regulation, 33-36, 54. Landes, William M. and Posner, Richard A. (1987), The Economic Structure of Tort Law, Cambridge, MA, Harvard University Press. Moller, Erik, Pace, Nicholas M. and Carroll, Stephen J. (1997), Punitive Damages in Financial Injury Verdicts, Institute for Civil Justice, Rand Corp. , No. MR-888-ICJ. Perczek, Jacqueline (1993), Note, ‘On Efficiency, Punishment, Deterrence, and Fairness: A Survey of Punitive Damages Law and a Proposed Jury Instruction’, 27 Suffolk University Law Review, 825-904. Perlstein, Barry (1992), ‘Crossing the Contract-Tort Boundary: An Economic Argument for the Imposition of Extracompensatory Damages for Opportunistic Breach of Contract’, 58 Brooklyn Law Review, 877-911. Peterson, Mark, Sarma, Syam and Shanley, Michael (1987), Punitive Damages: Empirical Findings, Institute for Civil Justice, Rand Corp. , No. R-3311-ICJ. Png, I.P.L. and Zolt, Eric M. (1989), ‘Efficient Deterrence and the Tax Treatment of Monetary Sanctions’, 9 International Review of Law and Economics, 209-217. Polinsky, A. Mitchell (1997), ‘Are Punitive Damages Really Insignificant, Predictable, and Rational? A Comment on Eisenberg et al.’, 26 Journal of Legal Studies, 663-677. Polinsky, A. Mitchell and Che, Yeon-Koo (1991), ‘Decoupling Liability: Optimal Incentives for Care and Litigation’, 22 RAND Journal of Economics, 562-570. Polinsky, A. Mitchell and Rubinfeld, Daniel L. (1988), ‘The Welfare Implications of Costly Litigation for the Level of Liability’, 17 Journal of Legal Studies, 151-164. Polinsky, A. Mitchell and Shavell, Steven (1998), ‘Punitive Damages: An Economic Analysis’, 111 Harvard Law Review, 869-962. Posner, Richard A. (1972), Economic Analysis of Law, 1st edn, Boston, MA, Little, Brown and Company. Priest, George L. (1982), ‘Punitive Damages and Enterprise Liability’, 56 Southern California Law Review, 123-132. Priest, George L. (1989), ‘Insurability and Punitive Damages’, 40 Alabama Law Review, 1009-1035. Rubin, Paul H., Calfee, John E. and Grady, Mark F. (1997), ‘BMW v Gore: Mitigating The Punitive Economics of Punitive Damages’, 5 Supreme Court Economic Review, 179-216. Rustad, Michael (1992), ‘In Defense of Punitive Damages in Products Liability: Testing Tort Anecdotes with Empirical Data’, 78 Iowa Law Review, 1-88. Schwartz, Alan (1990), ‘The Myth that Promisees Prefer Supracompensatory Remedies: An Analysis of Contracting for Damage Measures’, 100 Yale Law Journal, 369-407. Schwartz, Gary T. (1982), ‘Deterrence and Punishment in the Common Law of Punitive Damages: A

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Comment’, 56 Southern California Law Review, 133-153. Shavell, Steven (1987), Economic Analysis of Accident Law, Cambridge, MA, Harvard University Press. Shavell, Steven (1997), ‘The Fundamental Divergence between the Private and the Social Motive to Use the Legal System’, 26 Journal of Legal Studies, 575-612. Stoll, H. (1983), ‘Consequences of Liability: Remedies’, in Tunc, André (ed), International Encyclopedia of Comparative Law, Tübingen (Germany), J.C.B. Mohr (Paul Siebeck) and Dordrecht (The Netherlands), Martinus Nijhoff Publishers. Sunstein, Cass R., Kahneman, Daniel and Schkade, David (1998), ‘Assessing Punitive Damages (With Notes on Cognition and Valuation in Law)’, Forthcoming in Yale Law Journal. Sykes, Alan O. (1997), Constitutionalizing Punitive Damages, Unpublished Manuscript. Wheeler, Malcolm E. (1989), ‘A Proposal for Further Common Law Development of the Use of Punitive Damages in Modern Product Liability Litigation’, 40 Alabama Law Review, 919-973.

3800 PROPERTY RULES VS. LIABILITY RULES Michael I. Krauss Professor of Law George Mason University School of Law © Copyright 1999 Michael I. Krauss

Abstract All of private law can be seen as rules for the ownership and exchange (forcible or voluntary) of entitlements. Property Rules and Liability Rules can be seen as shorthand terms describing two different means of protecting entitlements. Analysis of the choice between these types of rules provides a useful purchase on the jurisprudential foundations of a legal system. JEL categories: K11 Keywords: Property Rule, Liability Rule, Inalienability, Rights, Coase Theorem, Calabresi

1. Introduction To enjoy a legal right means, inter alia, that one will be able to rely on the protection of governmental agencies in case these rights are encroached upon. But different types of rights enjoy different degrees of legal protection. The systematic analysis and resultant taxonomy of protection of rights has been one of the most important contributions of the law and economics movement to the understanding of tort and contract law. The elaboration of property rules and liability rules has been especially useful in enhancing our awareness of what it means to have a right. In this survey, both the original contribution to this field and more recent treatments will be discussed, and their jurisprudential implications occasionally examined.

2. The Basic Taxonomy Property Rules The civilian concept of patrimony is a useful way to approach this subject. A person’s patrimony is essentially composed of his rights and obligations. If we focus on the rights side of the equation, we notice that these rights receive differential degrees of protection.

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Some rights are fully protected against unwanted takings. Thus, if Jill hears that Jack plans to take her car, he can typically obtain a court order forbidding this taking. If Jill has not obtained such an order or if, in violation of the order, Jack takes her car, Jill can obtain (in addition to appropriate criminal law punishment of Jack) an order for its restitution. Only if the restitution is impossible (because, say, Jack has intentionally destroyed the car) will Jill have to be content with its replacement by money damages. The amount of these damages will of course be determined by the court: typically, though, damages will include a punitive element reflecting societal condemnation of Jack’s action. In an article critical to the evolution of law and economics (Calabresi and Melamed, 1972), this type of protection of an entitlement was termed a property rule. The name is intuitively attractive, because property rule protection is what the man on the street thinks he deserves if he has a property right. Thus, Jill believes she is immune to claims that Jack may take her car because he values it more than she does. Presumably Jack can demonstrate the higher value he attaches to the car by acquiring rights to it from Jill in a Pareto-superior transaction (that is, a contract). This contract will, by definition, compensate Jill for any subjective value (over and above the market price of the vehicle) which she attaches to her car, for the simple reason that any offer inferior to this value will be declined by Jill. To have a property right (that is, an entitlement protected by a property rule), then, is to have a right that is in some important way shielded from felicific or wealth-maximizing social functions. Ronald Dworkin captured the vital importance of property rule protection when he coined the phrase, ‘rights trump utility’ (Dworkin, 1975). Liability Rules Property rules are, however, not the only legal methods used to protect entitlements. To see this, realize that Jack and Jill engage in risk-creating behavior every time they leave their premises. When Jack hunts, or drives, or wheels his cart down an aisle while shopping for groceries, he creates risks for Jill and others. Yet Jack may NOT be enjoined ex ante from these activities, even though they probabilistically endanger Jill’s property. Rather, only if and when Jill’s property is damaged will Jack’s activity be examined ex post to determine if compensation is required. When such compensation is ordered, it will typically NOT reflect the subjective value Jill attaches to her damaged property. Rather, it will reflect the property’s market price, which by definition underestimates its value to Jill (since she had not chosen to sell the property at its market-clearing price) (Polinsky, 1980a, p. 1103).

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3. An Illustration: Intentional but Non-Negligent Externalities in Property Disputes The externality of environmental pollution, discussed in Coase’s seminal piece (Coase, 1960), illustrates the ways in which both the owner of an entitlement and the means of protecting that entitlement might be determined. Suppose P(laintiff) claims that D(efendant) is polluting P’s holdings. D admits to this pollution but insists that it is non wrongful. If P and D bring their dispute before the courts, then even if D’s pollution was not negligent it must be declared who, as between them, has the favor of the law: may D pollute, or may P legally object to the pollution? After having answered this question, the court must then determine how to protect the entitlement it has found. •

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•

•

Thus, suppose the court finds in favor of P. If it enjoined the pollution, this would be the equivalent of declaring that P possessed an entitlement which was protected by a property rule. D would be able to continue emitting pollutants if and only if D and P could come to some agreement whereby P would waive the judgment (that is, transfer the entitlement to D). The consideration for this injunction would by definition compensate P for damages suffered. On the other hand, the court could find that the D’s pollution was not legal, but that D could continue to pollute upon payment of court-ordered damages to P. The court here is in essence imposing the terms of the post-injunction contract negotiated by the parties in the immediately preceding example. This is the equivalent of declaring that P’s entitlement is protected by a liability rule: in effect, the court is condemning P’s land to suffer a servitude of pollution, and is fixing the price of this servitude itself. There is no guarantee, of course, that this price fully reflects P’s subjective damages. Rather, the award typically reflects the market-clearing loss of value of P’s land. The court might also determine that D was not illegally polluting: that is, that D possessed the entitlement to pollute. Typically, this entitlement would be protected by a property rule: P’s suit would be dismissed, and that P would have to meet D’s price in a post-judgment transaction if P wished to oblige D to cease polluting. Finally, if the procedural rules of the jurisdiction permit holding a plaintiff liable for damages, the court could also protect D’s claim with a liability rule. It could recognize D’s right to pollute, then proceed to take it away from D after awarding D damages payable by P. A court accomplishing this would essentially be setting the terms of the post-judgment transaction between P and D imagined in the immediately preceding paragraph. The payment by P to D would be accompanied by an injunction against further

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pollution by D. This would protect D’s entitlement, but only with a liability rule (Spur Industries v. Del E. Webb Development Co (1972). A 2 × 2 grid illustrates the alternatives available to the court: Table 1 Method of Protection of Entitlement:

Holder of entitlement:

Property Rule

Liability Rule

P

[Box 1] injunction against pollution

[Box 2] Pollution allowed, damages awarded to P

D

[Box 3] Pollution allowed, no damages awarded

[Box 4] Injunction against pollution, damages awarded to D

4. Another Illustration: Negligent and Unintentional Externality Most tort suits do not result from a pattern of continuous harms, like the polloution example above. Even in one-time harm cases, however, the Calabresi-Melamed taxonomy is useful in understanding the different ways in which rights might be protected. For example, in a dispute that resulted in a celebrated Supreme Court decision (LeRoy Fibre Co. v. Chicago, Milwaukee & St. Paul R.R. (1914), it was conceded that the defendant railroad had negligently allowed sparks to land on the plaintiff’s land. The railroad claimed, however, that the plaintiff was negligent in stacking his crops; they were placed on the plaintiff’s own land but, alleged the railroad, they were located too near the tracks, such that the damages were therefore much greater than would have otherwise been the case. This, the railroad claimed, was contributory negligence by the plaintiff (which under tort rules then in effect would bar plaintiff’s suit). The United States Supreme Court divided in its judgment. The majority observed that the defendant had not purchased a servitude from the plaintiff, and concluded that as a matter of law the latter could therefore not be negligent for planting his own crops on his own land. This is the equivalent of protecting the plaintiff’s entitlement to plant crops with a property rule. Dissenting Justice Oliver Wendell Holmes, Jr agreed that, in the absence of a servitude, the railroad could not enjoin the stacking of crops near its track. But Holmes insisted that if the farmer’s decision did not maximize joint (farmer-railroad)

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output, then the farmer was negligent and could not recover the value of his destroyed crops. In essence Holmes was protecting the farmer’s entitlement to plant crops with a liability rule, which under the particular circumstances of the case might result in no damages being awarded. The LeRoy Fibre case illustrates the close link between liability rule protection of entitlements and the counter-intuitive bilateral causation concept which was the raison d’^etre of Coase’s insights (Coase, 1960). In everyday language, it would be said that the railroad caused the crop loss by the emission of sparks. But Holmes (and Coase) would assert that, if the farmer was the cheaper cost avoider of the accident, it was he (and not the railroad) that caused the loss. Some cases have recognized bilateral causation quite explicitly (Kansas Pacific Ry v. Brady (1877), p. 386). Entitlement holders who believe their rights are protected by a property rule typically insist that they are the victims, not the cause, of damage: otherwise, their rights would be trumped by utility- or wealth-maximizing constraints, which is contrary to the very notion of property-rule protection. The Calabresi-Melamed typology highlights the link between rights language and causal language. To the extent entitlements are protected by liability rules, rights (and therefore causation) are inherently contingent; the cause of an injury is the efficient avoider of the injury. The cheaper-cost avoider of a loss will always be said to have caused the loss if entitlements are protected by liability rules.

5. A Further Complication: Inalienability Rules The choice between these two mechanisms of protection of entitlements (property and liability rules) will be explored further below. Realize, though, that in reality the choice is not binary at all. As Calabresi and Melamed pointed out, and as others have developed (Radin, 1987, p. 8; Rose-Ackerman, 1985, p. 9), there exists a third protective mechanism: inalienability rules. An entitlement protected by a property rule may be alienated only by its holder, while a right subject to a liability rule may be forcibly exchanged when a third party deems it to be in the interest of a social utility (or wealth) function. But an inalienability rule provides iron-clad protection against alienation, including voluntary alienation by the rights-holder himself. Some, but not all, constitutional rights (for example, in the United States, the right to vote and the right not to be free from cruel and unusual punishment, but not the constitutional right to a jury trial), and many corporal entitlements (entitlements to one’s heart, to one’s legs, but not to one’s hair) are protected by inalienability rules. Sometimes (for example, in some jurisdictions as regards blood and kidneys) the inalienability rule is partial only: donation of the entitlement is allowed while sale is prohibited (Calabresi and Melamed,

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1972, pp. 1111-1115). As is the case for property rules, but a fortiori, rights protected by inalienability rules may not be sacrificed in the name of a social maximand. The explanation of inalienability rules goes beyond the subject matter of this encylcopedia entry: suffice it to note that profound jurisprudential beliefs about the human condition, and about the limits of rationality, underlie inalienability rule protection.

6. Non-Tort Applications Insights gleaned from the Calabresi-Melamed taxonomy have been implemented with profit in fields other than tort. In contract law, a creditor (promisee) has an entitlement to the performance of the promise by the debtor (promisor). If this entitlement is to be enforced with a property rule, specific performance would be available at the creditor’s option. If, on the other hand, the entitlement is to be protected only by a liability rule, then specific performance would not be a creditor’s option - rather (as Justice Holmes once observed in a famous dictum), the promise to perform would in reality only be a promise to pay damages adjudicated by a third party, the court, at the debtor’s option (Kronman, 1978; Schwartz, 1979). And some contractual risks are apparently protected by inalienability rules, such that their voluntary alienation will be deemed unconscionable and therefore unenforceable by the courts (Craswell, 1993).

7. Who Should Get an Entitlement, and How Should this Entitlement be Protected As shown, the property rule/liability rule taxonomy has proven extremely useful in positive analysis. But beyond understanding what exactly courts are doing, does the typology provide insights as to how rights ought to be allocated and protected? In the move from positive to normative analysis, here as in law and economics generally, explanations are much more controversial. Note initially, as Coase famously pointed out (Coase, 1960, pp. 2-8), that if there are no impediments to bargaining, the initial assignment of an entitlement will not thwart or even (abstracting from wealth effects) influence its ultimate allocation, which will be efficient . To many, the Coase theorem detachment of initial distribution from final efficient allocation implies that non-economic motives should determine initial allocation of entitlements (Frank, 1987; Schwab, 1989). If transaction costs are high, of course, the initial distribution of the legal entitlement may also be the final one, and Kaldor-Hicks efficiency would then only be attained if the initial

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allocation was to the social-cost-minimizing party. However, the two states of the world (one in which the initial allocation was to the social-cost-minimizing party, one in which it was to another party, with high transactions costs preventing easy assignment) are not Pareto-comparable, and it is therefore difficult to establish the moral, or even economic (Buchanan, 1987) superiority of that assignment. More interesting for the purposes of this encyclopedia entry is the question, assuming it has been decided for some reason to allocate an entitlement to someone, whether that entitlement should be protected by a property rule or by a liability rule. The rest of this abstracts from the additional possibility that an inalienability rule might be appropriate. The conventional law and economics answer to this question is that a property rule should be chosen if transaction costs are low (in which case the parties can arguably best establish the relevant values by bargaining after the assignment of the entitlement), while a liability rule should be chosen if transaction costs are high (as might be the case if large numbers of parties are involved either as plaintiffs or defendants, creating risks of free-riding or of holdouts, if the entitlement is incorrectly assigned from an efficiency standpoint). Thus, Posner wrote that, where transaction costs are high, the allocation of resources to their highest-valued uses is facilitated by denying property right holders an injunctive remedy against invasions of their rights and instead limiting them to a remedy in damages (Posner, 1972, p. 29). But it has been pointed out (Polinsky, 1980a) that this answer assumes that while transaction costs between parties are high, information costs for the judge who determines damages payable (or for the jury, if the jury sets the damages) are low. If, on the contrary, both transaction costs and judicial assessment costs are high, there is little reason to believe that protection of an entitlement with a liability rule will be particularly conducive to efficiency (Polinsky, 1980a, p. 1111; Krier and Schwab, 1995, p. 455). Thus, in the pollution example applied earlier, if Defendant’s pollution abatement costs were $100,000 and Plaintiff’s actual damages were $120,000 but were set by the judge (who ignored idiosyncratic value) erroneously at $90,000, then if transaction costs were high the defendant would pollute and pay damages rather than abate, even though abatement is the true social-cost-minimizing result. As implied on several occasions above, there are indeed reasons to believe that assessment of damages will be incorrect. Judicially determined damages typically and systematically neglect a plaintiff’s idiosyncratic value or consumer surplus (the assessment cost of which is prohibitively high in most cases - there is a strong likelihood that plaintiff would exaggerate such surplus at trial in order to obtain a windfall). Thus in one famous case in which Defendant had polluted Plaintiff’s summer home, Judge Learned Hand stated that ‘A country residence, on which so much is spent to suit the owner’s fancy,

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cannot be said to have a [social] value equal to its cost’ (Smith v. Staso Milling Co.,1927, p. 739). If damages are systematically mis-assessed, then the economic basis for choosing between property and liability rule protection of entitlements in high transaction cost situations would disappear. These problems might lead one to believe that, from an efficiency perspective, property rules (injunctive relief) are no worse than liability rules. In fact, property rules (which do not require any calculation of the amount of harm on the part of the court) might possibly be cheaper than liability rules. Recently it has been argued that arbitrary, Solomonic liability awards might encourage Coasean trades as well as and more cheaply than detailed efforts to calculate damage (Ayres, 1995). This argument has been criticized by Kaplow and Shavell (1995), who have recently offered an additional plea for liability rules (1996). They essentially reason that liability rules promote at least some comparison of costs and benefits, forcing one party or the other to compare its opportunity costs to an amount of damages representing the judge’s best estimate of them. But this best estimate itself is simply and unpersuasively assumed to be relatively accurate. These two authors have summed up the choice between property and liability rules, in the face of transaction and-or assessment costs, as follows: Table 2 Property vs. Liability Rules High Assessment Costs

Low Assessment Costs

High Transaction Costs

Neither rule likely to be efficient

Liability rules rreferable

Low Transaction Costs

Both rules likely to be efficient

Both rules likely to be efficient

Again, there is no particular reason to assume that assessment costs will be lower than transaction costs. An Austrian approach (questioning the assumption that state agents can discover information more efficiently than market processes) argues particularly strongly against such an assumption (Krauss, 1994). Economic variables may simply be too indeterminate to advocate on efficiency grounds some fine-tuned academic recommendations based on simplifying assumptions (G. Schwartz, 1994, p. 444). If these reflections are cogent, then the choice between property and liability rules as enforcement mechanisms for entitlements may turn on non-economic

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variables. Demanders of corrective justice (Coleman, 1992; Krauss, 1992) and natural attachment of entitlement holders to their rights (Michelman, 1967) might argue for the priority of property rules in situations where neither rule has a clear efficiency advantage. Analogously, the case can and has been made that inalienability rules might be the best way to expand personal liberty (Arneson, (1992).

8. Conclusion The literature describing property rules and liability rules has provided fascinating insights into the different ways in which tort, contract and property law protect our entitlements. But the taxonomy, like economic analysis generally, should not be used on a normative level without caution. There is nothing in Calabresi’s formulation, or in the Coase theorem which inspired it, which authorizes using the courts (or indeed the market) to invade the realm of ethics. Such an invasion, like the domination of liability rules, would give us a quantitative rendering of value that would fail to do justice to the richness and variety of our ethical experience, all the while serving to inspire unneeded hostility for economic analysis in general (Anderson, 1993).

Bibliography on Property Rules v. Liability Rules (3800) Anderson, Elizabeth (1993), Value in Ethics and Economics, Cambridge, MA, Harvard University Press. Arneson, Richard (1992), ‘Commodification and Commercial Surrogacy’, 21 Philosophy And Public Affairs, 132-164. Atias, Christian (1986), ‘La Distinction du Patrimonial et de l’Extra-Patrimonial et l’Analyse Economique du Droit: un Utile Face à Face (The Distinction Between Patrimonial and Extra-Patrimonial Rights and the Economic Analysis of Law)’, 1 Revue de la Recherche Juridique. Ayres, Ian and Talley, Eric (1995), ‘Solomonic Bargaining: Dividing a Legal Entitlement to Facilitate Coasean Trade’, 104 Yale Law Journal, 1027-1117. Bouckaert, Boudewijn and De Geest, Gerrit (1995), ‘Private Takings, Private Taxes, Private Compulsory Services: The Economic Doctrine of Quasi Contracts’, 15 International Review of Law and Economics, 463-487. Bromley, Daniel W. (1978), ‘Property Rules, Liability Rules, and Environmental Economics’, 12 Journal of Economic Issues, 43-60. Buchanan, James M. (1987), ‘Rights, Efficiency, and Exchange: The Irrelevancy of Transactions Cost’, in Economics: Between Predictive Science and Moral Philosophy. Buchanan, James M. and Faith, Roger L. (1981), ‘Entrepreneurship and the Internalization of Externalities’, 24 Journal of Law and Economics, 95-111. Calabresi, Guido and Melamed, A. Douglas (1972), ‘Property Rules, Liability Rules and Inalienability:

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One View of the Cathedral’, 85 Harvard Law Review, 1089-1128. Reprinted in Ackerman, Bruce A. (1975), Economic Foundations of Property Law, Boston, Little Brown, 31-48. Coase, Ronald H. (1960), ‘The Problem of Social Cost’, 3 Journal of Law and Economics, 1-44. Reprinted in Ackermann, Bruce A.(1975),Economic Foundations of Property Law, Boston, Little Brown,17-22. Reprinted in Medema, Steven G. (1995), The Legacy of Ronald Coase in Economic Analysis, Vol.2, Aldershot, Edward Elgar Publishing, 5-48. Reprinted in Coase, Ronald H. (1988), The Firm, the Market and the Law, Chicago, University of Chicago Press. Coleman, Jules L. (1987), ‘Property, Wrongfulness and the Duty to Compensate’, 63 Chicago-Kent Law Review, 451-470. Coleman, Jules L. (1992), ‘Tort Law and the Demands of Corrective Justice’, 67 Indiana Law Journal, 349 ff. Coleman, Jules L. and Kraus, Jody S. (1986), ‘Rethinking the Theory of Legal Rights’, 95 Yale Law Journal, 1335-1371. Cooter, Robert D. (1991), ‘Economic Theories of Legal Liability (Italian Translation: “Le Teorie Economiche della Risponsibilit… Efficenza Produttiva: Alcuni Contributi su noti Argomenti” 379-409)’, 5 Journal of Economic Perspectives, 11-30. Reprinted in Medema, Steven G. (ed.), The Legacy of Ronald Coase in Economic Analysis, Edward Elgar Publishing, Gloucestershire, forthcoming. Italian translation: ‘Le Teorie Economiche Della Risponsabilit Legale’, published in Gianandrea Goisis. Craswell, Richard (1993), ‘Property Rules and Liability Rules in Unconscionability and Related Doctrines’, 60 University of Chicago Law Review, 1-65. Dworkin, Ronald M. (1975), Taking Rights Seriously, Cambridge, MA, Harvard University Press. Epstein, Richard A. (1985), ‘Why Restrain Alienation?’, 85 Columbia Law Review, 970-990. Frank, Robert H. (1987), ‘If Homo Economicus could Choose his Own Utility Function, Would He Want One with a Conscience?’, 77 American Economic Review, 393-394. Frech, H. Edward III (1973), ‘Pricing of Pollution: The Coase Theorem in the Long Run’, 4 Bell Journal of Economics, 316-319. Frech, H. Edward III (1979), ‘The Extended Coase Theorem and Long Run Equilibrium: The Non-Equivalence of Liability Rules and Property Rights’, 27 Economic Inquiry, 254-268. Friedman, David D. (1984), ‘Efficient Institutions for the Private Enforcement of Law’, 13 Journal of Legal Studies, 379-397. Gallo, Paolo (1992), ‘Errore sul Valore, Giustizia Contrattuale e Trasferimenti Ingiustificati di Ricchezza alla Luce dell’Analisi Economica del Diritto (Mistake on Value, Contractual Justice and Unjust Enrichment)’, Quadrimestre, 656-703. Gambaro, Antonio (1996), ‘L’Analisi Economica e la Ricerca della Logica Proprietaria (Economic Analysis and the Search for the Rationality of Ownership)’, 14 Rivista Critica del Diritto Privato, 235-244. Gordon, Wendy J. (1982), ‘Fair Use as Market Failure: A Structural and Economic Analysis of the Betamax Case and its Predecessors’, 82 Columbia Law Review, 1600-1657. Gordon, Wendy J. (1992a), ‘On Owning Information: Intellectual Property and the Restitutionary Impulse’, 78 Virginia Law Review, 149-281. Gordon, Wendy J. (1992b), ‘Of Harms and Benefits: Torts, Restitution, and Intellectual Property’, 21

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Journal of Legal Studies, 449-482. Gordon, Wendy J. (1993), ‘A Property Right in Self- Expression: Equality and Individualism in the Natural Law of Intellectual Property’, 102 Yale Law Journal, 1533-1609. Gordon, Wendy J. (1994), ‘Systemische und Fallbezogene Losungsansatze fur Marktversagen bei Immaterialgutern (Systemic and Case-by-Case Responses to Failures in Markets for Intangible Goods)’, in Ott, Claus and Schäfer, Hans-Bernd (eds), Okonomische Analyse der rechtlichen Organisation von Innovationen, Tübingen, Mohr, 328-367. Gordon, Wendy J. and Gowen, Anne, ‘Mandated Access: Commensurability and the Right to Say ‘No’’, 17 Hastings Communications and Entertainment Law Journal, 46 ff. Haddock, David D., McChesney, Fred S. and Spiegel, Menahem (1990), ‘An Ordinary Economic Rationale for Extraordinary Legal Sanctions’, 78 California Law Review, 1-51. Hasen, Richard L. (1995), ‘The Efficient Duty to Rescue’, 15 International Review of Law and Economics, 141 ff. Kaplow, Louis and Shavell, Steven (1995), ‘Do Liability Rules Facilitate Bargaining? A Reply to Ayres and Talley’, 105 Yale Law Journal, 221 ff. Kaplow, Louis and Shavell, Steven (1996), ‘Property Rules versus Liability Rules: An Economic Analysis’, 109 Harvard Law Review, 713-790. Knetsch, Jack L. (1983), Property Rights and Compensation. Compulsory Acquisitions and Other Losses, Toronto, Butterworths. Krauss, Michael I. (1986), ‘L’Affaire Lapierre: vers une théorie Economique de l’Obligation Quasi-Contractuelle (The Lapierre Case: Toward an Economic Theory of the Quasi-Contractual Obligation)’, 31 McGill Law Journal, 683-721. Krauss, Michael I. (1992), ‘Tort Law and Private Ordering’, 53 St. Louis University Law Journal, 423 ff. Krauss, Michael I. (1994), ‘Regulation vs. Markets in the Development of Standards’, 3 Southern California Interdisciplinary Law Journal, 781-808. Krier, James E. and Schwab, Stewart J. (1995), ‘Property Rules and Liability Rules: The Cathedral in Another Light’, 70 New York University Law Review, 440-483. Kronman, Anthony T. (1978), ‘Specific Performance’, 45 University of Chicago Law Review, 351-382. Reprinted in Kronman, Anthony T. and Posner, Richard A. (eds) (1979), The Economics of Contract Law, Boston, Little Brown, 181-194. Landes, William M. and Posner, Richard A. (1975), ‘The Private Enforcement of Law’, 4 Journal of Legal Studies, 1-46. Levmore, Saul (1985), ‘Explaining Restitution’, 71 Virginia Law Review, 65-124. Levmore, Saul (1994), ‘Obligation or Restitution for Best Efforts’, 67 University of Southern California Law Review, 1411-1449. McChesney, Fred S. (1990), ‘Government as Definer of Property Rights: Indian Land Ownership, Ethnic Externalities, and Bureaucratic Budgets’, 19 Journal of Legal Studies, 297-335. Michelman, Frank I. (1967), ‘Property, Utility and Fairness: Comments on the Ethical Foundations of ‘Just Compensation’ Law’, 80 Harvard Law Review, 1165-1258. Reprinted in Ackerman, Bruce A. (ed.) (1975) Foundations of Property Law, Boston, Little Brown, 100 ff. Pardolesi, Roberto (1977), ‘Azione Reale e Azione di Danni nell Art. 844 C.C. Logica Economica e Logica Giuridica nella Composizione Del Conflitto Tra Usi Incompatibili delle Propriet… Vicine (Property Rule and Liability Rule in Article 844 Codice Civile: Economic Arguments, Legal

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Arguments and Litigation for Inconsistent Uses of Neighbours Lands)’, 1 Foro Italiano, 1144-1154. Polinsky, Mitchell A. (1979), ‘Controlling Externalities and Protecting Entitlements: Property Right, Liability Rule, and Tax-Subsidy Approaches’, 8 Journal of Legal Studies, 1-48. Polinsky, Mitchell A. (1980a), ‘Resolving Nuisance Disputes: The Simple Economics of Injunctive and Damage Remedies’, 32 Stanford Law Review, 1075-1112. Polinsky, Mitchell A. (1980b), ‘On the Choice Between Property Rules and Liability Rules’, 18 Economic Inquiry, 233-246. Polinsky, Mitchell A. and Shavell, Steven (1994), ‘Should Liability be Based on the Harm to the Victim or the Gain to the Injurer?’, 10 Journal of Law, Economics, and Organization, 427-437. Posner, Richard A. (1971), ‘Killing or Wounding to Protect a Property Interest’, 14 Journal of Law and Economics, 201-232. Posner, Richard A. (1972), Economic Analysis of Law, 1st edn, Boston, Little Brown. Radin, Margaret Jane (1987), ‘Market-Inalienability’, 100 Harvard Law Review, 1849-1937. Rose-Ackerman, Susan (1985), ‘Inalienability and the Theory of Property Rights’, 85 Columbia Law Review, 931-969. Reprinted in Coleman, J. and Lange, J (eds) (1992), Law and Economics, Vol. I, New York University Press, 421-459. Rose-Ackerman, Susan (1986), ‘Efficiency, Equity and Inalienability’, in Graf Von Der Schulenburg, J.-Matthias and Skogh, Göran (eds), Law and Economics and The Economics of Legal Regulation, Dordrecht, Kluwer, 11-37. Samuels, Warren J. and Mercuro, Nicholas (1981), ‘The Role of the Compensation Principle in Society’, in Samuels, Warren J. and Schmid, A. Allan (eds), Law and Economics: An Institutional Perspective, Boston, Nijhoff, 210-247. Schap, David (1986), ‘The Nonequivalence of Property Rules and Liability Rules’, 6 International Review of Law and Economics, 125-132. Schwab, Stewart J. (1989), ‘Coase Defends Coase: Why Lawyers Listen and Economists Do Not’, 87 Michigan Law Review, 1171-1198. Schwartz, Alan (1979), ‘The Case for Specific Performance’, 89 Yale Law Journal, 271-306. Schwartz, Gary T. (1994), ‘Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter?’, 42 UCLA Law Review, 377-444. Staaf, Robert J. (1983), ‘Liability Rules, Property Rights, and Taxes’, 5 Research in Law and Economics, 225-231. Stephen, Frank H. (1987), ‘Property Rules and Liability Rules in the Regulation of Land Development: An Analysis of Development Control in Great Britain and Ontario’, 7 International Review of Law and Economics, 33-49. Stout, Lynn A. and Barnes, David D. (1992), Economics of Contract Law, St Paul, West Publishing. Thompson, Barton H. (1975), ‘Injunction Negotiations: An Economic, Moral and Legal Analysis’, 27 Stanford Law Review, 1563-1595. Villa, Gianroberto (1992), ‘Contratto Illecito ed Irripetibilità della Prestazione - Una Analisi Economica (Unlawful Contract and Non Repayable Performance - An economic analysis)’, Quadrimestre, 19-64. Wils, Wouter P.J. (1993), ‘Who Should Bear the Costs of Failed Negotiations? A Functional Inquiry into Precontractual Liability’, 4 Journal des Economistes et des Etudes Humaines, 93-134.

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Cases Kansas Pacific Ry v. Brady (1877), (17 Kan. 380: Kansas Supreme Ct.) LeRoy Fibre Co. v. Chicago, Milwaukee & St. Paul R.R. (1914), (232 U.S. 340: U.S. Supreme Court) Smith v. Staso Milling Co. (1927), (18 F. 2d 736: 2d Cir.) Spur Industries v. Del E. Webb Development Co. (1972), (494 P.2d 700: Arizona Supreme Court)

3900 UNJUST ENRICHMENT AND QUASICONTRACTS Christopher T. Wonnell Professor of Law, University of San Diego School of Law © Copyright 1999 Christopher T. Wonnell

Abstract This chapter presents an economic analysis of some of the most typical cases involving the law of restitution. It questions the economic utility of a generalized theory of unjust enrichment, but defends the economic wisdom of three of the most common categories of relief that have gone under that umbrella term (rescue situations, transfers that were not fully voluntary or informed, and benefit-based remedies for wrongs committed). JEL classification: K19 Keywords: Duty to Rescue, Unjust Enrichment, Restitution, Hypothetical Contracts

1. Scope of the Chapter This chapter presents an economic analysis of some of the most typical cases involving the law of restitution, which is generally defined as the class of all claims grounded in the unjust enrichment of the defendant (Goff and Jones, 1993, p. 3). Actions that seek damages based upon restitutionary principles at law are frequently characterized as quasi-contractual in nature. However, restitutionary remedies are also available in equity, as with the constructive trust that a court can impose on property to avoid the defendant’s unjust enrichment. This article will question the economic utility of a generalized theory of unjust enrichment, but defends the economic wisdom of three of the most common categories of relief that have gone under that umbrella term. The first of these sources of restitutionary or quasi-contractual relief involves plaintiffs who did something that purposely but unofficiously benefitted defendants, such as a physician who provided emergency medical services to an unconscious patient (Cotnam v. Wisdom, 104 S.W. 164 (Ark. 1907); In re Crisan Estate, 107 N.W.2d 907 (Mich. 1961)). An economic rationale could be that the law is seeking to provide an incentive for providers to render services that the recipients value more than their cost but that cannot be negotiated contractually by virtue of high transaction costs. If the rescue is indeed efficient, one question is whether the potential rescuer should be under an affirmative duty to provide the service (Epstein, 795

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1973, p. 190). Thus, this article will explore both restitutionary ‘carrots’ for rescuers and potential tort or criminal ‘sticks’ that might be imposed on nonrescuers. The rescue situation, however, is by no means the only scenario in which restitutionary relief is available. This article will discuss two other broad patterns of cases. One pattern concerns transfers that were not fully voluntary or informed, as with payments of money by mistake or pursuant to a contract that has become impossible to perform. In such situations, plaintiff’s can often recover restitutionary recoveries from defendants, although defendants may be able to interpose defenses such as changed circumstances in reliance on the payments made. The economic theory here is that full divestiture of the plaintiff’s property as a consequence of mistake would encourage excessive care in the avoidance of mistakes or in the contractual transfer of possession. If the social cost of a mistaken or contractual transfer is small, it would not be wise to allow the private cost of the transfer to be large. A third common restitutionary pattern is the benefit-based remedies for wrongs committed. For example, if the defendant converts property belonging to the plaintiff and uses the property to make some profit, the plaintiff may be able to ‘waive the tort and sue in assumpsit’ to recover the gain the defendant has made. The economic theory here is essentially one of deterring a defendant from bypassing market transactions where transaction costs are low enough to make such transactions feasible.

2. The Anomaly of Benefit-Based Liability The essence of restitutionary claims is often said to be the focus on the defendant's gain as opposed to the plaintiff’s loss (Dobbs, 1993, Sec. 4.1). From an economic perspective, this is immediately anomalous. Economic analysis generally sees legal intervention as a response to conduct that imposes harm, seeking to sanction or ‘price’ that behavior so as to reduce its incidence to more optimal levels. Barring some argument based upon envy or spite, the presence of a gain as such is not a reason for the law to become concerned (Wonnell, 1996, pp. 177-190). To the contrary, the defendant’s gain is normally a factor that cuts against the wisdom of trying to impose sanctions on the defendant for harms that the defendant may have caused. For example, one imposes sanctions on a contract breacher because of the harm that breach inflicts on the promisee, but one might worry about excessively large sanctions that would deter even efficient breaches where the defendant’s gain from breach exceeded any harm caused (Posner, 1986, p. 882). Similarly, one imposes tort liability on an ultrahazardous activity because of its predictable harms or costs, but one is not led to embrace criminal sanctions, injunctions, or benefit-based liability against the blaster precisely

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because of the gains that the defendants (and their contractual partners) are making from their blasting activity. And, of course, under Learned Hand’s famous test of negligence in the Carroll Towing case, an action can be considered non-negligent and therefore escape liability precisely when the benefits from not taking care were larger than the expected harm (United States v. Carroll Towing Co., 159 F.2d 169, 173 (2d Cir. 1947). Finally, the paradigm case of damnum absque injuria is the losses caused by fair competition, losses which are not compensable precisely because the gains made by defendants and their contracting partners from the ability to compete freely are so large. These facts strongly suggest that ‘unjust enrichment’ is never going to have the unity as a field that might be possessed by other great categories of the law such as tort and contract (Wonnell, 1996). The conclusory label ‘unjust’ hides the nature of the harm that warrants legal intervention. And there must be some special, rather than general reason, to regard ‘enrichment’ as an integral part of the wrong rather than as a factor in complete or partial mitigation of the wrong. This article suggests that ‘unjust enrichment’ is really a shorthand for three essentially different concepts. The first is the theory of rewarding those who intentionally confer positive externalities on others with the fruits that could have been earned by contract had transaction costs been lower. The second is the idea of incomplete divestiture of property. The third is the notion of deterring the conscious bypassing of available market options.

3. Hypothetical Contracts for Rescuers; Duty to Rescue One situation in which the law has awarded ‘restitutionary’ remedies involves the plaintiff who rescued the defendant’s person or property and seeks compensation for costs incurred in the rescue. Physicians are frequently awarded their reasonable fee when they render emergency medical services to unconscious patients. Other situational rescuers are sometimes given compensation for their out-of-pocket costs, although many providers of services are denied compensation for having acting ‘officiously’ (Dawson, 1961). If tort law penalizes the imposition of negative externalities, this branch of restitution law rewards the creation of positive externalities (Epstein, 1994, p. 1377). Dramatic rescues from death or serious bodily injury are not the only example of this class of remedies. In continental countries, a party can recover in ‘negotiorum gestio’ for costs incurred in repairing storm damage to the house of a neighbor who was out of the country. Co-owners of property are often allowed to make necessary repairs or maintenance expenses on the common property and to bring actions against their co-owners for compensation. A party who creates a common fund, such as a class-action plaintiff or her attorney, can often recover in restitution from others benefited by the plaintiff’s action. Although less dramatic than the rescue cases, the

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essential principles of these cases are the same. Transaction costs of a voluntary transaction are high, whether because of unavailability of a party or bilateral monopoly conditions, and the Kaldor-Hicks efficiency of the service is sufficiently obvious that the risk of judicial error appears tolerably low (Bouckaert and De Geest, 1995, p. 485). It is certainly true that not all providers of valued services are entitled to compensation from the enriched recipients. Courts tend to deny recovery to those who ‘intermeddle’ or provide services officiously. When transaction costs are low enough to enable a voluntary transaction, there is no efficiency advantage to allowing parties to provide services without consent and then to demand compensation after the fact. It is somewhat doubtful that the principle involved in the rescue cases is one of benefit-based liability at all (Levmore, 1994, p. 1427). The physician who performs emergency medical services is not really asking for a benefit-based remedy. If the service was ineffective, the plaintiff can recover although the defendant derived no benefit. And if the service was effective, the benefit derived is the value of the defendant’s extended life, which is not awarded. Nor should it be, from the standpoint of efficiency, for such a ‘rescue’ which provided no benefit to the defendant would encourage the defendant, who controls the regular use of herself and her property, to exercise excessive care to avoid the need to be ‘rescued’ (Wittman, 1985, p. 182). The plaintiff’s regular fee is normally a good measure of the defendant’s benefit because it is a reflection of alternatives available to the defendant; if many people are willing to perform a service for a particular fee, any one service provider cannot benefit the defendant by more than the fee she could have paid instead. However, in the rescue context, there may have been no other service providers, so the plaintiff’s regular fee is no longer an indication of the extent of the defendant’s benefit (Wonnell, 1996, pp. 169-171). Instead, the principle of the rescue cases is essentially one of hypothetical contract, imposing on the defendant the contract which would have been consented to had the transaction costs been lower (Long, 1984, pp. 415-416). It is properly denied when the plaintiff had no contractual intent, as when the services were offered with the intention of extending them as a gift. The label ‘quasi-contract’ has a bad reputation with restitution scholars, because the notion of ‘contract’ is so misleading in describing why the defendant is liable in the case of mistaken transfers or in the case of willful conversions (Goff and Jones, 1993, p. 6). In the rescue setting, however, the contract analogy seems apt, as long as one remembers that the consent is hypothetical and indicative only of how the parties would have contracted had the opportunity been available. Rescuers are not always treated well by the courts. Courts may dismiss rescuers as intermeddlers too frequently, leading to an inefficiently low number

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of rescue attempts (Wade, 1966, p. 1212). One situation in which rescuers fare somewhat better is in admiralty, where successful rescuers are often awarded a considerable fee for their efforts. The need for professional rescuers to engage in investments in rescue-related equipment may partially explain the sympathy accorded to such rescuers in admiralty. It has been argued that the structure of compensation for rescuers in admiralty closely approximates the terms of a transaction that the parties would have made with the rescuer had a transaction been possible (Landes and Posner, 1978, pp. 103-104). An interesting question is whether rescues, if they are clearly efficient, should be required rather than left to the law of quasi-contract. An award that was substantial enough to clearly exceed the plaintiff’s costs should be sufficient to inspire rescue. If restitutionary awards are generous, a duty to rescue could be superfluous, but by the same token it would appear to be a harmless supplemental incentive. The most serious problem with penalties (especially when pursued to the exclusion of liberal restitutionary awards) is their indirect effects on incentives. A person who realizes that her talents and properties can be conscripted to help others will not have as much incentive to develop those talents and properties in the first place or have them in a place where they could be useful to others, although the empirical significance of this problem will vary with the circumstances (Levmore, 1986, pp. 889-892). This problem might be quite unimportant where the cost of the rescue was trivial, as with the paradigm case of the person who refused to throw a rope to a drowning swimmer. The incentive problem with mandatory rescue as opposed to restitutionary regimes is essentially a problem of governmental knowledge. To impose an efficient duty to help, one would need to know about the previous choices available to potential rescuers and what effect the prospect of liability might have on those choices. To create a hypothetical contract, one can instead ignore past choices, as a mutually beneficial transaction should not deter others similarly situated from making the choices which would place them in a position to be of service to others. This is not to say that a duty to rescue would always be inefficient. Where one party is both a better avoider of the loss and a better insurer against uncertain outcomes, it may be an express or implied part of a contract that one will provide rescue services when needed by the other. This may explain why the law sometimes imposes a duty to rescue between parties in a ‘special relationship’ with each other such as common carriers or innkeepers and their guests (Prosser and Keeton, 1984, Sec. 56, pp. 376-377). Another possible case for an efficient rescue duty would be a setting in which one was equally likely to be a rescuer or a rescuee. In that case, a party may actually be encouraged to be in a position where she can be of service, as an unintended byproduct of wanting to be somewhere that others would have a duty to rescue if one got into

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trouble (Hasen, 1995, p. 141). Another potential problem with a duty to rescue is that the would-be rescuee loses some of her incentive not to be in a position that would require rescue (Wittman, 1981, p. 89). In principle, this should be accounted for in saying that the duty is truly an efficient one, for if the rescuee is a cheaper cost-avoider, the would-be rescuer’s duty would not be efficient (Calabresi and Hirschoff, 1972, pp. 1060-1061). However, this would once again require considerable knowledge on the part of the state as to the steps that could have been taken by would-be rescuers and rescuees. If knowledge of decisions available in prior periods is unavailable, the safer course may be to try to construct mutually beneficial bargains by generous rewards extended to rescuers, at least where there is no reason to fear that a plaintiff may have induced the demand for her own rescue services (Levmore, 1986, p. 886). It is true that a restitutionary award, by making rescues more likely, will increase the incentive of potential rescuees to act in ways that will require their rescue, but because rescuees will be forced to pay for the service rendered to them, the effect will be considerably smaller than that generated by a duty to rescue. Still another potential problem with the duty to rescue concerns administrative costs. Parallels can be drawn to the great costs of trying to enforce against consensual or victimless crimes, where lack of evidence is a serious problem unless one resorts to very aggressive law enforcement techniques. The person who was not rescued may be deceased and unavailable as a witness, while other witnesses to the nonrescue may be equally culpable as nonrescuers and thus unwilling to bring forward their information (Rubin, 1986, p. 274). And if multiple nonrescuers were involved, there will be difficulties in assessing relative responsibility. There may be some incentive gain from the purely symbolic effect of creating a largely unenforceable legal duty to rescue, although this would have to be traded off against any losses that might occur in the feelings of altruism or heroism that might result from the perception that one was performing only a legal duty (Rubin, 1986, p. 275). The economic argument for a duty to rescue - somewhat uncertain, as noted above, at least for rescues of nontrivial cost - should be distinguished from the broader social or utilitarian argument for redistribution from those with surplus resources to those with greater need for the resources. The economic argument asserts that each rescue is a Kaldor-Hicks efficient transaction, and can add that rescue situations are sufficiently unpredictable that a general duty of rescue might well be in everyone’s ex ante interest to accept. The redistributive argument would assert that people have a duty to do their part for others in dire need even if the economic value of their resources (as contrasted with their utility) is not higher in the rescuee’s hands, and despite the fact that the rescuer may have no reasonable expectation of receiving reciprocal benefits. In normal

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circumstances, a welfare state would be the sensible mechanism for coordinating such a duty, but in rare emergency cases the person who should act might be sufficiently individuated that a private law rescue duty could supplement the system of taxation and public protection. At least some commentators appear to make both the economic and the redistributive arguments for a duty to rescue (Weinrib, 1980, pp. 272, 292). The redistributive argument of course suffers from the more general moral hazard problems of welfare states in altering behavior by shielding people from the consequences of their choices.

4. Incomplete Divestiture Suppose that the plaintiff pays money to the defendant by mistake, perhaps having miscounted the money or misidentified the defendant’s account number. What is the economic rationale for requiring the defendant to return the money? The essential idea is that the plaintiff is in a position to make decisions over her own property, and the law should create an incentive to optimize these decisions. There may be a modest social cost created if the plaintiff is careless in directing her money, as the mistake must then be identified and corrected at some administrative effort. Ideally, the property holder should be liable for these costs in order to ensure that she takes proper care to avoid mistakes. However, it would not be efficient to punish mistakes with full divestiture of the plaintiff’s rights to the value of the money. Such a rule would impose a private cost on the plaintiff much larger than the social cost of correcting a mistake. The plaintiff would be induced to exercise too much care to avoid her mistake (Huber, 1988, p. 99). Moreover, the defendant would have a perverse incentive not to correct, or even potentially to cause, the plaintiff’s mistake. In the case of money, the social cost of the mistake is usually small, although it may be large if the defendant took actions in detrimental reliance on what reasonably appeared to be new wealth. In other situations, the social cost of mistake may be quite substantial. A common pattern involves a plaintiff who constructs a building by mistake on the defendant’s land (Madrid v. Spears, 250 F.2d 51, 54 (10th Cir. 1957); Rzeppa v. Seymour, 203 N.W. 62, 63 (Mich. 1925)). As the defendant did not ask for the building, it may be worth considerably less than the value of the plaintiff’s labor and materials invested in the project (Dickinson, 1985, pp. 62-63). Older cases tended to deny recovery to the plaintiff builder on the theory that the defendant should not be made worse off by being required to pay for an improvement she did not want (Producers Lumber & Supply Co. v. Olney Bldg. Co., 333 S.W.2d 619 (Tex. Civ. App. 1960)). This approach, however, does create an incentive for the plaintiff to exercise excessive care in avoiding mistakes, and for the defendant to exercise insufficient care to avoid such

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mistakes by the plaintiff. Many recent cases have granted a restitutionary recovery for the plaintiff who constructs a building on the defendant’s land by mistake. The problem with this approach is that the social cost of the mistake is difficult to measure. The illiquidity of the newfound wealth imposes different costs on different types of parties, depending upon their overall preferences and financial situation (Kull, 1997). Perhaps the best approach would be for the courts to make generous assumptions about the amount of harm that will be caused by the illiquidity, and to award the plaintiff an amount that one can assert with considerable confidence will not make the defendant worse off from the overall transaction. The essence of the plaintiff’s claim is not that the defendant has been enriched. If for some reason the plaintiff’s building looked particularly good on the defendant’s land, there is no reason to require the defendant to disgorge the gains received in excess of the costs the plaintiff has incurred (Madrid v. Spears, 250 F.2d 51, 54 (10th Cir. 1957); Rzeppa v. Seymour, 203 N.W. 62, 63 (Mich. 1925)). Rather, the plaintiff’s essential claim is harm caused by the incomplete divestiture of property. It would clearly be undesirable to allow the plaintiff to retain formal title to the building while the defendant retained formal title to the underlying land. This would create serious problems of bilateral monopoly and accompanying high transaction costs of breaking the compulsory (Wonnell, 1996, p. 197). Property, however, is a bundle of severable sticks, and the fact that necessity compels the divestiture of the plaintiff’s physical rights to the property does not mean that the plaintiff must also lose her rights to the value of that property. Incomplete divestiture is the counterpart to the more familiar idea of incomplete privilege (Bohlen, 1925). A defendant who is caught in a storm and needs to use the plaintiff’s docking facilities is not confronted with legal rules designed to prevent use of the plaintiff’s property, such as criminal sanctions, injunctions, or benefit-based liability. However, the defendant remains liable for the costs imposed, as an incentive for the defendant to take the potential for such emergencies into account in evaluating how to make use of her own property. (Vincent v. Lake Erie Transportation Co., 124 N.W. 221, 222 (Minn. 1910)). Necessity compels the yielding of exclusive physical rights to the property (and the right to charge any price made possible by free contract) but it does not compel the yielding of the plaintiff’s rights to the value of the property. ‘Restitution’ in these cases is essentially the same principle, but where the plaintiff rather than the defendant is the active party, and accordingly where the law must remain alert to the possible harms caused by the activity in question. Contracts provide the backdrop for many restitutionary remedies. In some circumstances, especially important in losing contracts, the courts may allow a restitutionary recovery as an alternative to standard expectation principles of

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damages. This is quite a problematic idea, as it allows the plaintiff to escape the allocation of a risk that the contract may have efficiently placed (Kull, 1994, pp. 1465-1470). It also gives the plaintiff a perverse incentive to induce the defendant to breach a contract, or to jump on breaches of uncertain materiality as excuses for rescission. However, in some situations it seems likely that the parties would have wanted a restitutionary recovery, especially where the defendant completely failed to perform and the plaintiff’s restitutionary interest is much easier to calculate than her expectation (Kull, 1994). Restitution is also granted in many cases to the breaching party to a contract (Restatement of Restitution, 1937, Sec. 108(b)). As a general idea, this is simply a way of ensuring that the non-breaching party receives her expectation interest, but only her expectation interest, upon breach. It is therefore justified by the general economic argument that favors expectation damages and disfavors punitive damages, involving the principle of efficient breach and the desire to avoid high-transaction-cost bargaining over the surpluses from breach between bilateral monopolists (Posner, 1986, pp. 106-107). On the other hand, in some circumstances it may be difficult to calculate the expectation interest, with the result that a restitutionary recovery for the breaching party threatens to undercompensate the nonbreacher and thereby underdeter breach. Parties sometimes provide for forfeitures of down payments without regard to actual damages as an implicit recognition of this phenomenon of restitutionary awards leading to undercompensation of the nonbreaching party. The general argument that contracts are presumed efficient (at least between informed parties) would argue for the enforcement of such bargained for forfeitures. Finally, restitution is often granted in the case of broken contracts, such as those held to be unenforceable under the Statute of Frauds (Boone v. Coe, 153 Ky. 233, 154 S.W. 900 (1913)), or those that become impossible to perform through some intervening condition or statute. Again, we face a case of incomplete divestiture of property. The parties parted with their goods or services on assumptions that have proved to be invalid. If the court were to simply leave the parties where it finds them, the parties would have incentives to strategically and uneconomically delay the transfer of physical possession of resources involved in the contracting process (Bouckaert and De Geest, 1995, p. 475). To induce parties to use optimal timing in contracts, transfers should be undone if no social harm has been caused (by, for example, affixing resources to projects that no longer have value). If harm has been done, the problem is more complex, and might be addressed by asking which of the parties is more efficiently situated to have prevented or insured against that harm (Posner and Rosenfield, 1977, p. 83).

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5. Disgorgement for Bypassing Viable Market Options Another use of the restitutionary idea is as an alternative remedy for wrongs. For example, a person who intentionally converts property belonging to another is liable in tort for the harm caused, but may also be liable in restitution for the benefit received from her own use of the ill-gotten property. It is said that the plaintiff can ‘waive the tort and sue in assumpsit’ to recover gains larger than the plaintiff’s loss (Palmer, 1978, Sec. 2.10). Restitution can be awarded against those who procured the plaintiff’s property ‘through imposition (express or implied), or extortion; or oppression; or an undue advantage taken of the plaintiff’s situation, contrary to laws made for the protection of persons under those circumstances’ (Moses v. Macferlan, 2 Burr. 1005, 97 Eng. Rep. 676 (1760)). Willful takers of intellectual property belonging to the plaintiff have often found themselves affected by this principle (Gordon, 1992). Is this remedy an exemplar of the broader principle that a person should not ‘profit from a wrong’? (Restatement of Restitution, 1937, Sec. 3). From an economic perspective, this depends greatly on how ‘wrong’ is defined. If wrong is confined to well-defined, easily avoidable conduct that unambiguously imposes more harm than benefit, it would certainly be true that efficiency would require that the defendant not be permitted to profit from the wrong. The law needs to deter such conduct, and disgorgement is the minimum sanction sufficient in principle to effectuate such deterrence. Of course, in this case, economic analysis would see no reason for trying to put the defendant on her own indifference curve between right and wrong conduct (Wittman, 1985, p. 182). If the behavior is clearly defined and unambiguously inefficient, punitive damages or criminal sanctions may be in order, or certainly liability for harm caused (by definition larger than the benefit received). Thus the disgorgement principle, while valid, would be properly submerged in the law beneath more severe penalties. On the other hand, if wrong is defined as conduct that the law ought to sanction, it is no longer true that we would want a rule that a person should not ‘profit from a wrong’. In economic theory, sanctions are imposed because the behavior in question might be inefficient, or because the precise behavior involved is inefficient but is difficult to distinguish before the defendant’s action is taken from other behavior, the inefficiency of which is less clear. In such cases the liability needs to be measured by harm caused rather than benefit derived. Harm-based liability gives the defendant the incentive to undertake the activity if and only if her benefits truly exceed the harm caused. Benefit-based liability would make the defendant indifferent to the costs imposed on the plaintiff (as these did not affect remedies) and to the benefits she herself derived (as these would be taken away in any event) (Wittman, 1985, p. 173).

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One should not expect, therefore, any robust general principle of law that involves disgorgement of gains received. Gains in themselves are not objectionable; they serve to mitigate wrongdoing. Gains should be disgorged in cases where the actual remedies are likely to be considerably more severe, so that the disgorgement idea is unnoticed. When other penalties are inappropriate, this is usually because of factors that make the disgorgement idea inappropriate as well. There is one situation, however, where disgorgement is clearly appropriate. This is the conscious bypassing of readily available market alternatives. This behavior is clearly inefficient, because even if the defendant had more valuable uses for the property in question than the plaintiff, she could, by definition, have obtained those efficiencies by consensual means. Moreover, many takings are clearly inefficient, and the litigation costs of distinguishing those that are from those that are not are likely to dwarf the transaction costs of a voluntary move of the property. An interesting question is whether this principle should result in a defendant’s duty to disgorge gains made by a breach of contract (Farnsworth, 1985, p. 1369). The theory would be that a promise constitutes property of the plaintiff, and that the defendant has converted that property by retaining the benefits of refusing to perform. On the other hand, the contract breach setting is one of bilateral monopoly, and the parties might have considerable difficulty agreeing on a voluntary distribution of the gains from breach. Where that situation obtains, a disgorgement rule might threaten to undermine the gains from breach entirely, or result in their dissipation through haggling over their distribution (Posner, 1986, p. 118). The traditional rule disfavoring disgorgement remedies for breach of contract may well be efficient for that reason, although it should certainly yield in the face of evidence that the contracting parties intended a disgorgement remedy to apply.

Acknowledgments I would like to express thanks to my colleagues Larry Alexander, Frank Partnoy and Tom Smith, and to the anonymous reviewers of the piece, for their helpful comments.

Bibliography on Unjust Enrichment and Quasi-Contracts (3900) Bohlen, Francis H. (1925), ‘Incomplete Privilege to Inflict Intentional Invasions of Interests of Property and Personalty’, 39 Harvard Law Review, 307 ff. Bouckaert, Boudewijn and De Geest, Gerrit (1995), ‘Private Takings, Private Taxes, Private

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Compulsory Services: The Economic Doctrine of Quasi Contracts’, 15 International Review of Law and Economics, 463-487. Calabresi, Guido and Hirschoff, Jon T. (1972), ‘Toward a Test for Strict Liability in Torts’, 81 Yale Law Journal, 1055 ff. Dawson, John P. (1961), ‘Negotiorum Gestio: The Altruistic Intermeddler’, 74 Harvard Law Review, 817 ff. Dickinson, Kelvin (1985), ‘Mistaken Improvers of Real Estate’, 64 North Carolina Law Review, 37 ff. Dobbs, Dan B. (1993), Law of Remedies: Damages-equity-restitution (2nd edn). Epstein, Richard A. (1973), ‘A Theory of Strict Liability’, 2 Journal of Legal Studies, 151 ff. Epstein, Richard A. (1994), ‘The Ubiquity of the Benefit Principle’, 67 Southern California Law Review, 1369 ff. Farnsworth, E. Allan (1985), ‘Your Loss or My Gain? The Dilemma of the Disgorgement Principle in Breach of Contract’, 94 Yale Law Journal, 1339 ff. Goff, Lord Robert of Chieveley and Jones, Garety H. (1993), The Law of Restitution (4th edn). Gordon, Wendy (1992), ‘Of Harms and Benefits: Torts, Restitution, and Intellectual Property’, 21 Journal of Legal Studies, 449 ff. Hasen, Richard L. (1995), ‘The Efficient Duty to Rescue’, 15 International Review of Law and Economics, 141 ff. Huber, Peter K. (1988), ‘Mistaken Transfers and Profitable Infringements on Property Rights: An Economic Analysis’, 49 Louisiana Law Review, 71-109. Kull, Andrew (1994), ‘Restitution as a Remedy for Breach of Contract’, 67 Southern California Law Review, 1465 ff. Kull, Andrew (1995), ‘Rationalizing Restitution’, 83 California Law Review, 1491 ff. Kull, Andrew (1997), ‘Restitution and the Non-Contractual Transfer’, 11 Journal of Contract Law, 93 ff. Landes, William M. and Posner, Richard A. (1978), ‘Salvors, Finders, Good Samaritans, and Other Rescuers: An Economic Study of Law and Altruism’, 7 Journal of Legal Studies, 83-128. Levmore, Saul (1986), ‘Waiting for Rescue: An Essay on the Evolution and Incentive Structure of the Law of Affirmative Obligations’, 72 Virginia Law Review, 879-941. Levmore, Saul (1994), ‘Obligation or Restitution for Best Efforts’, 67 Southern California Law Review, 1411 ff. Long, Robert A. (1984), ‘A Theory of Hypothetical Contract’, 94 Yale Law Journal, 415-434. Palmer, George E. (1978), The Law of Restitution. Posner, Richard A. (1986), Economic Analysis of Law (3rd edn), Boston, Little Brown. Posner, Richard A. and Rosenfield, Andrew M. (1977), ‘Impossibility and Related Doctrines in Contract Law: An Economic Analysis’, 6 Journal of Legal Studies, 83 ff. Prosser, William and Keeton, W. (1984), The Law of Torts (5th edn), St. Paul, West Publishing Company. Rubin, Paul H. (1986), ‘Costs and Benefits of a Duty to Rescue’, 6 International Review of Law and Economics, 273 ff. Wade, John W. (1966), ‘Restitution for Benefits Conferred without Request’, 19 Vanderbilt Law Review, 1183 ff.

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Weinrib, Ernest J. (1980), ‘The Case for a Duty to Rescue’, 90 Yale Law Journal, 247 ff. Wittman, Donald (1981), ‘Optimal Pricing of Sequential Inputs: Last Clear Chance, Mitigation of Damages, and Related Doctrines in the Law’, 10 Journal of Legal Studies, 65 ff. Wittman, Donald (1984), ‘Liability for Harm or Restitution for Benefit?’, 13 Journal of Legal Studies, 57 ff. Wittman, Donald (1985), ‘Should Compensation be Based on Costs or Benefits?’, 5 International Review of Law and Economics, 173-185. Wonnell, Christopher T. (1996), ‘Replacing the Unitary Principle of Unjust Enrichment’, 45 Emory Law Journal, 153 ff.

Cases Boone v. Coe, 153 Ky. 233, 154 S.W. 900 (1913). Cotnam v. Wisdom, 104 S.W. 164 (Ark. 1907). In re Crisan Estate, 107 N.W.2d 907 (Mich. 1961). Madrid v. Spears, 250 F.2d 51 (10th Cir. 1957). Moses v. Macferlan, 2 Burr. 1005, 97 Eng. Rep. 676 (1760). Producers Lumber & Supply Co. v. Olney Bldg. Co., 333 S.W.2d 619 (Tex. App. 1960). Rzeppo v. Seymour, 203 N.W. 62 (Mich. 1925). United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947). Vincent v. Lake Erie Transportation Co., 124 N.W. 221 (Minn. 1910). Restatement of Restitution (1937).