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UW-Madison ECON 522 - ECON 522 Lecture Notes

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Econ 522 – Lecture 19 (Nov 12 2007)Over the last three lectures…- we introduced the notion of torts, and several possible rules for when an injurer is held liable for the harm he caused- we introduced the notion of precaution – costly actions the injurer (or the victim) could take to reduce the likelihood of an accident – and examined the incentives for precaution created by various liability rules- we introduced the notion of activity level (which can also be thought of as unobservable precaution), and the incentives created by the various liability rules- negligence rules must be accompanied by a legal standard for how much care or precaution is required to avoid negligence; we discussed the rule put forward by Judge Learned Hand, which held that precaution is required as long as it is cost-justified, that is, efficient- and we looked at the effects that errors, both systematic and random, would have on the incentives each liability rule gives- finally, we re-examined the questions of precaution and activity levels in a marketsetting, where expected liability losses would factor into the price of a product, and considered the outcomes when customers had differing abilities to perceive the riskiness of their choicesGiven all the time that we’ve just spent developing a formal economic model and examining its implications, I think it’s fair to step back a bit and ask the question: does the model work? That is, is there any evidence from the real world that a choice of liability rule affects peoples’ behavior in the way the model predicts? The usual assumption we make in economics is that if you make something more costly, people willdo less of it. But when people get in their cars, do they really think about the amount they will have to pay in the event of an accident when deciding how fast and how far to drive? Do people really think about liability rules when deciding whether to get in a bar fight?This is exactly the question (not the bar fight question, the more general question) addressed in the paper by Gary Schwartz, “Reality in the Economic Analysis of Tort Law:Does Tort Law Really Deter?” He reviews a wide range of empirical studies in different areas of tort law, and comes to the following, not that startling conclusion:- Tort law does affect peoples’ behavior in the direction the economic model predicts, but not as much as a literal reading of the model would suggestHe points out that most of the academic work prior to that point was either implicitly assuming that people behaved exactly as in the model; or pointing out various critiques ofthe model, and reasons why liability rules would not impact behavior at all; but that the truth lay somewhere in between.(One of the obvious ways in which the model is “wrong”: the model suggests that, under a negligence rule, injurers will always take the mandated level of care – that is, there will never be any negligence! And yet there are lots of studies showing that negligence is rampant – in auto accidents, in medical malpractice, and in other areas. Nonetheless, studies in a variety of industries show that a greater degree of liability does lead to greateroverall levels of precaution.)Schwartz has a funny line toward the end of the paper, where he argues that since people do not respond as precisely to incentives as the model predicts, we should put aside efforts to “fine-tune” the law to achieve perfection:“Much of the modern economic analysis, then, is a worthwhile endeavor because it provides a stimulating intellectual exercise rather than because it reveals the impact of liability rules on the conduct of real-world actors. Consider, then, thosepublic-policy analysts who, for whatever reason, do not secure enjoyment from a sophisticated economic proof – who care about the economic analysis only because it might show how tort liability rules can actually improve levels of safety in society. These analysts would be largely warranted in ignoring those portions of the law-and-economics literature that aim at fine-tuning.”He also points out, since “fine-tuning” may be impossible, that simple rules start to make more sense. He looks at the example of worker’s compensation in the U.S. Worker’s compensation holds the employer liable (whether or not he was negligent) for the economic costs of on-the-job accidents, while leaving the victim bearing all non-economic costs such as pain and suffering. Schwartz argues:“Analyzed in incentive terms, this regime of “shared strict liability” takes for granted that there are many stpes that employers can take, and also many thigns that employees can do, to reduce the work accident rate. Yet workers’ compensation disavows its ability to manipulate liability rules so as to achieve in each case the precisely efficient result in terms of primary behavior; it accepts as adequate the notion that if the law imposes a significant portion of the accident loss on each set of parties, these parties will have reasonably strong incentives to take many of the steps that might be successful in reducing accident risks.”Next week, we’ll hopefully come back to Schwartz’s assessment of the effects of liability law in various particular areas.Many of the objections Schwartz points out – reasons that people may not respond to liability laws in the way the “standard model” predicts – can be seen as violations of whatCooter and Ulen refer to as the “core assumptions” of the model. Specifically, the model as we’ve explained it so far assumes:1. Decision-makers are rational2. There are no regulations in place beyond the liability rule3. There is no insurance4. Injurers are solvent and pay damages in full5. Litigation costs are zeroWe can relax each of these assumptions in turn, and see what effect this should have.Cooter and Ulen give two examples of ways in which the rationality assumption may be violated.The first is on the basis of a growing literature in behavioral economics that says that many people systematically misperceive the value of probabilistic events. That is, a number of experiments have shown that when people evaluate probabilistic events, they make choices that are not compatible with the usual expected-utility framework.(One clear example of this comes from a classic paper by Daniel Kahneman and Amos Tversky, called “Prospect Theory: An Analysis of Decision under Risk.” They found thatgiven a choice between


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UW-Madison ECON 522 - ECON 522 Lecture Notes

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