ECO320H1 Chapter Notes - Chapter 7: Indifference Curve, Strict Liability, Damages
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Chapter 7: Topics in the Economics of Tort Liability
•Implicit assumptions in the last chapter:
oDecision makers are rationally self-interested
oThere are no regulations designed to reduce external costs
oThere is no insurance
oAll injurers are solvent and pay damages in full
oLitigation costs are zero
•Rationality suggests that decision makers can calculate the costs/benefits of the
alternatives available to them and that they choose to follow the alternative that
offers the greatest net benefit.
oTort liability sends signals to potential injurers/victims on how they ought
to behave (assuming rationality).
•Evidence has been provided that people make predictable errors in calculations of
the sort that tort liability encourages them to make.
oTwo common errors:
Most people cannot accurately estimate low probability events
assumption is that “low probability” = 0 (it is actually > 0).
For some well-publicized, potentially catastrophic outcomes, most
people systematically exaggerate the probability of an accident’s
occurring (regardless of information to the contrary).
•I.e. nuclear power plant accidents.
oThe cause of the two above problems deals with the frequency and
vividness with which people are reminded of these risks.
More frequent and vivid
overestimation of risk,
Less frequent and vivid
underestimation of risk,
•The tort liability system may not induce people to minimize the social costs of our
oIf people inaccurately set
when calculating expected costs,
they will take too little precaution (if any at all).
Leads to too many or too severe accidents.
oIf people overestimate
when calculating expected costs, they will
take too much precaution.
•If there is evidence that consumers consistently under-estimate risk,
manufacturer’s should be held liable for failing to design a product that would
prevent foreseeable misuse by less than fully rational consumers.
•Lapses: occasional acts whereby accidents occur due to clumsiness, inattention,
misjudgement, misperception, or weakness of will.
oIn cases where a person aims for a given level of precaution but fails to
achieve it because of a lapse, the courts may find the person liable under
negligence if it falls below the standard.
oSince people will want to avoid liability, they take excessive precaution in
order to build a margin of error where, if they lapse from their intended
level of precaution, they will not be liable.
oTo the left of
(legal standard), the person is liable so they take
precaution x and have a margin of error equal to the space between it and
This is not efficient since
results in too
much cost to society.
•If a rule of intentional negligence was
adopted instead, the potential injurer can
simply intend to meet the standard and they won’t be liable
or take excessive precaution.
oLack of information would cause this method to
result in too few prosecutions since it would be hard
to prove the injurer intended to take precaution
•Why have regulation and liability imposed on injurers when, assuming the theory
of tort liability holds, the injurer will take the necessary precautions outlined in
the regulation without the regulation?
oRegulation is ex ante (pre-accident) enforcement by administrators and
liability is ex post (post-accident) enforcement by victims.
oAdministrators can generally impose more effective standards than courts
can (courts have trouble accumulating technical knowledge about
In these cases, courts will likely use safety regulation as the
standard of care for determining liability.
•Potential injurers will conform to the standard to avoid
fines from administrators and liability from courts.
oProblems of information or motivation can cause a court to distrust the
legal standard imposed by a safety regulation.
Courts may obtain better information from an accident through a
trial than administrators can predict.
•Courts may decide that the standard was set too low by the
administrators and thus set a higher legal standard in
oPotential injurer’s will conform to the higher legal
standard in order to avoid liability.
There may be political motives in the standards set by
•Standards may be set by regulators so high as to reduce
competition and thus courts may set a lower legal standard
in determining liability.
oPotential injurers will conform to the higher
administratively set standard to avoid fines.
•Officials in some countries may want stiff regulations to
guarantee that bribing an official is cheaper than
conforming to the regulation.
oCourts are better off determining their own standard
that more closely reflects the efficient level of
precaution a potential injurer should take.
•Some risky activities attract undercapitalized firms that can escape liability
oRegulation should step in to collect fines and force undercapitalized firms
to comply with safety standards that it would otherwise violate if the only
sanction were liability.
•Generally, safety regulation is more effective in cases where small harm is
imposed on a large number of people.
oDue to the fact that liability law would require aggregating all the claims
in a class action lawsuit.
oInstead, the aggregation can be done cheaper administratively.
•Goal of tort law is to minimize the sum of the costs of precaution, accidental
harm, and administrative costs.
•Subrogation: the insurance company of an insured person stands in place of that
person in the tort suit for harm covered in the insurance claim.
oThe insured person claims from the insurance company and thus gives up
their right to claim from the injurer.
•Insurance is a private system of liability law that reallocates the costs of accidents
according to contracts between insurer and insured.
oComplete insurance results in injurers/victims dealing directly with their
insurance company and not with each other.
The people will then begin to care more about their premium rates
and terms of coverage rather than the underlying law of accidents.
•In a system of universal insurance and competitive insurance markets, the goal of
tort law can be described as minimizing the total cost of insurance to
•A rule of no liability causes victims to buy relatively more insurance.
•A rule of strict liability causes injurers to buy relatively more insurance.
•Insurance externalizes risk by moving the risk from the insured party to the
oMoral hazard: the reduction in precaution taken by the insured as a result
of externalizing the risks.
Ways to combat moral hazard: