How should the level of tort damages be determined in theory and in practice?
Hee Yeon Oh
There are harms that cannot be solved through contracts and property laws. Therefore, victims cannot sue since there are no contracts or properties that have been breached or broken. Thereby, tort law exist and now I am going to discuss various economic theory of tort liability and the how it is implied in practice.
According to Cooter and Ulen(2016), the cost of harm and the cost of avoiding harm is the basic elements of the economic model of tort law. The probability of an accident, p decreases there is an increase in precaution, x which is a deceasing function of x and we show it as p=p(x). Also, if we denote A as the monetary value of the harm from the accident, pA becomes the expected harm. Since p=p(x), expected harm is p(x)A which is also a decreasing function of x.
In order to take precaution it involves losing money, time and convenience. When we say precaution costs $w per unit and it is constant and does not change because of the amount of precaution, x it means that wx is the total amount spent on precaution. These are depicted on the graph below.
The expected social cost, SC is the cost of precaution and expected harm which gives an equation: SC = wx + p(x)A. When we differentiate this equation then only leave w on the left side of the equation, w = -p`(x)A. In other words, when the precaution is efficient, the cost of a little more precaution (marginal cost) will be same as the reduction in the expected cost of harm (marginal benefit). Therefore, we can find the most efficient point of precaution x* and conclude that the efficiency will requires taking more precaution when the marginal cost of precaution is less than marginal social benefit. Vice Versa.
Since now we know the basic of the efficient level of precaution it moves on to incentives for precaution under different liability conditions. Under no liability for accidental injuries, Assume the victim’s precaution level is xv, and the cost for precaution level per unit is wv. At this time, all the damage A caused by the accident will be covered by the victim. That is, under no liability, the victim’s expected loss is p (xv) A. The total cost of the victim, including the expected loss, is wvxv + p (xv) A. The victim will try to minimize the total cost, and thus the attitude level xv *, which minimizes the total cost of the victim, satisfies the following equation.
wv (victim’s marginal cost) = -p ‘(xv *) A (victim’s marginal benefit)
Therefore, under no liability, the victim has an incentive to internalize the marginal cost of marriage and marginal benefits and to choose an effective precaution level.
In case of strict liability Consider the victim’s incentives under the strict liability system where the perpetrator is responsible for all accidents. It is assumed that the victim is fully compensated for the damage of the accident. In other words, the victim has the expected loss p (xv) A, but receives compensation from the offender. Also, D = A is established by the assumption of perfect compensation. Therefore, wvxv + p (xv) A-p (xv) D = wvxv can be derived.
To minimize wvxv, the victim must have xv = 0. Thus, if full compensation is provided by strict liability, the victim has no incentive to pay attention.
In bilateral precaution Both victims and offenders can be cautious, and both victims and perpetrators should take the appropriate level of care in order to obtain effective results. In conclusion, as with unilateralism, under the indemnification system, the perpetrator has no incentive to pay attention. On the contrary, under strict liability systems where full compensation is made, the victim has no incentive to pay attention. This phenomenon is called the paradox of compensation.
IV. Incentives to be cautious under the system of failure (important)
The system of negligence can provide effective incentives for both the offender and the victim. The system of fines provides legal standards to pay a certain amount of attention. If the level of this state is ~ x, then the attention level is divided into those belonging to the allowed area and those belonging to the forbidden area.
In the graph below, we can see that efficient attention is given only to the boundary of the allowed and forbidden areas. (x = x *)
Thus, in the case of a malpractice system in which the perpetrator avoids liability in compliance with legal standards, the victim may have an incentive to choose an efficient level of care.
From all the above paragraphs, in order to discuss economic theory of tort laws and damage, some core assumptions have been simplified. First, Decision makers are rationally self- interested. Second, there are no regulations designed to reduce external costs. Third, there is no insurance. Fourth, All injurers are solvent and pay damages in full. Fifth, litigation costs are zero. (Cooter and Ulen, 2016) However, it is different in practice and from now on I would like to discuss what it like in reality and show the comparison with these assumptions from the theory.
It is important in economic theory to assume that people are self –interested and make rational choices. However, in practice there are people who fail to do so. For example, most of the harm that is less likely to be happen is not frequently mentioned so there are cases where people underestimate the possibility of event occurring close to 0. On the other side, people overestimate the possibility of harms that are talked about through media to occur. Therefore, people fail to calculate the efficiency of precaution and cannot appropriately measure benefit and loss that the economic theory assumes. In order to solve these problems precaution needs to be taken on both sides but in practice, it raise a concern if tort damages are appropriate measured through the liabilities.
Though we assumed that there are no regulations to reduce external cost, in practice, administrators have an authority to stop potential injurer before the harm occurs and the court has a power to make injurer to compensate victim after an accident. Considering the liability and the regulation, sometimes one side is better to be implied to solve the problems depends on the accidents. Therefore, we cannot totally exclude regulations in reality.
In practice, insurance is closely related to tort damages and liability. A person can buy insurance because he is worried about possibility of accidental harm. Generally, insurance company covers the cost or any risks that insured party have. In other words, by transferring the risk, insured party is externalizing the risk. When the risk is externalized the insured precaution level will reduce. This phenomenon is called ‘moral hazard’ by insurance which is contradicting with the theory.
Moreover, Bankruptcy gives a chance to escape from tort liability which is contradicting to the theory on no or strict liability. If the compensation for the victim’s damage exceeds the value of the company’s assets, the company will not have any incentive for precautions because they cannot take responsibility for compensation exceeding the value of the company. There is no perfect solution to losing the incentive for precaution by using the insolvency bankruptcy state. Compulsory insurance, posting bond or discharge liability to prior regulation is existing imperfect solution so far.
One of the important assumptions of economics theory of tort liability is that the litigation cost is zero. If a victim costs a lot in the course of filing a lawsuit, the number of litigation decreases. In the case of a potential victim, if the costs of the litigation exceed the compensation amount, they will not file a lawsuit, so the injurer’s level of precaution will fall below the appropriate level and the frequency and severity of the accidents will increase. On the other hand, high litigation costs have the opposite effect on potential injurers. If the injurer’s litigation costs increase, they increase precaution.Since the effect of high litigation costs is different for potential victims and potential injurers, it is not clear how precaution levels should be defined and shows us that assumption on costless litigation is hard to happen.