ECONOMIC ANALYSIS OF TORT LAW January 23, 2007(Revised)

ECONOMIC ANALYSIS OF TORT LAWJanuary 23, 2007(Revised)

ECONOMIC ANALYSIS OF TORT LAW

Private Bads Torts Intentional Pollution Assault

Fraud

Unintentional Negligence

THEOREM OF COASE

Same efficiency under rival allocation of rights

EXCEPTIONS:High Transaction Costs Asymmetric InformationEmpty Core


• Two Related Motivations For Tort Rules:

• The tort law “problem” is to minimize the social costs of accidents by providing incentives to avoid accidents

• As well the tort law “problem” is to provide compensation to accident victims.

ECONOMIC ANALYSIS OF TORT LAW BILATERAL AGENCY

AGENT 1 AGENT 2

“SUPER”Principal= Judge

TORTS

Its “problem” is to maximize social surplus


• The Court “imposes” a rule that establishes a “standard of care” for legal conduct, breach of which triggers the imposition of damages.


NEGLIGENCE LIABILITY: Product Liability


• A major change did indeed occur, but not until 1934. In 1934 with the landmark House of Lords ruling in Donohue v Stevenson, [1932] A.C. 532 (H.L.)

• This case determined that defendants could be liable to “strangers” when their injury fell within the scope of precaution the defendant was required to adopt as a “reasonable” party


• Perfectly Competitive-Agent • Market – Agents

SS

DP

a1

MC SATC


• Agent 2 - Monopoly

S

DP

a1

PM

Private MC

Social MC

Coasean or Bargained MC

Negligence Rule and MC

• Agent 1 - PC

S

x1

PLR


• Negligence – Defence of Contributory Negligence

a1*

$

Strict Liability Portion Of The Negligence Rule

Precaution Cost Component Of The Negligence Rule

At common law, beyond this point a single Defendant was not liable


• Negligence – Comparative Negligence

a1*

$Under Contributory Negligence statutes, liability or fault is now apportioned (shared) among parties



S

DP

a1

PM

Private MC

Social MC


• Agent 1 - PC

S

x1

PLR



S

DP

a1

PM



• Agent 1 - PC

S

x1

PLR


NEGLIGENCE LIABILITY:Employer and Employee Liability

Torts - History

• Modern Developments• Protecting employers from workers

» Doctrine of Respondeat Superior» Doctrine of Volenti Non Fit Iniuria» Horwitz thesis – Emergence of negligence rules

• Protecting workers from employers» 1830’s – Factory Acts» 1860’s – Fatal Accidents Act» 1880’s – Employer Liability Act» 1910’s – Workers Compensation» 1920’s – Comparative Negligence



S

DP

a1

PM



• Agent 1 - PC

S

x1

PLR


• A mere opportunity to commit a wrongful act does not suffice to show vicarious liability;

• one must consider the job-created power and the nature of an employee's duties as a fundamental component of determining if a particular enterprise increased the risk of particular wrongdoing in relation to a claimant by the employee complained about. (SCC)

• In this case, the employee's limited role and duties "fell short" of what is required to prove vicarious liability.


CATASTROPHIC TORTS


• Between the 1930’s to the 1980’s, thousands of workers who had been in the asbestos industry came down with terrible sicknesses as a result of exposure to asbestos dust

• Question: Did the lawsuits of the 1980’s, which bankrupted many producers, serve as a precautionary deterrent?


• Professor Dewees, who did the Sudbury pollution study we examined in Term I, did another study on the John-Mansville asbestos plant that operated at Port Union from 1948 to 1984


• He found that the tort system in conjunction with workers compensation rules in Ontario were sufficiently clear that liability would be imposed on Johns-Manville for the deaths (p. 310)

• Why did the firm not act?


• The workers’ compensation levies on the plant were not high enough to induce the firm to institute dust controls (p. 317)

• Aerial view of the Johns-Manville asbestos plant (Scarborough)


• Converted use• Residential

Development at Port Union (Scarborough) on top of the site of the Johns-Manville asbestos plant


LIABILITY:Limitation Periods


• Basic limitation periodsOntario’s new Limitations Act, 2002 came into force January 1, 2004.

• The basic limitation (for starting a court action, not for giving notice) is now two years for most claims.

• The new law does not eliminate the various short notice periods, which require that notice be given within a few short days to municipalities for slip and fall on a roadway, for example.


LIABILITY:Duty To Mitigate


• When one party suffers damages at the hands of another, the injured party generally has a duty to act to minimize his or her losses.

• This principle is known as the duty to mitigate. • It generally applies to cases concerning bodily

injury, damages to property and breach of contract, but not to debt collections


LIABILITY:Insurance Contracts – Single Defendant


• The efficient operation of liability insurance markets will indirectly effect the “solution” of the tort problem


AGENT 1

(Insured)

AGENT 2

(Insured)

“SUPER”Principal= Judge

TORTS – Bilateral Agency

Its “problem” is to maximize social surplus

Insurer 1 Insurer 2

CONTRACTS – Principal Agency


• DUTY TO DEFEND• The Supreme Court of

Canada in Jesuit Fathers of Upper Canada v. Guardian Insurance Co. of Canada, 2006 SCC 21 has ruled that an insurer's duty to defend in a claims-made policy covers only those claims actively made (rather than merely discovered by the insured) during the term of the policy.

Garnier Residential School, Spanish, Ontario

http://scc.lexum.umontreal.ca/en/2006/2006scc21/2006scc21.html




• When a single defendant has limited wealth, its insurance decisions are the outcome of a single-agent decision problem.

• This is the familiar “contract” problem reviewed in the first term


• What might persuade a single agent to switch from a full insurance contract to no insurance when the level of activity risk that agent faces increases?

• The defendant, an individual or a corporation, has limited liability because of the option to declare bankruptcy.


• Given a liability rule, a defendant chooses an amount of insurance, I1, to maximize its

expected utility.

• The defendant pays premium p for this insurance, where p = probability that an accident will occur.


• .

w - pI1

w

E

U1

Utility Indifference Curve Of A Single Risk Averse Insured


• The “Insurance” Problem:

• EU = pU(w + I1 – pI1 – D) +

(1-p)U(w – pI1)


• First Order Condition – No limited liability

EU/dp = 0

p(1-p)U’(w + (1-p)I1 – D) = p(1-p)U’(w – pI1)

marginal benefit of insurance = marginal cost of insurance


• First Order Condition – Limited liability

EU/dp = 0

p(1-p)U’(w + (1-p)I1 – D) = p(1-p)U’(w – pI1)

Limited Liability Constraint:

p(1-p)U’(w + (1-p)I1 – D) = 0

up to I1* = (D-w)/(1-p)


• An increase in the probability of an accident, p, decreases the critical damages award level, D.

• So the damages award for the plaintiff is lowered.


• An increase in p will cause some individuals to drop their insurance coverage completely.

• An increase of either damage awards or liability standards can reduce the compensation to accident victims when a defendant abandons liability insurance.


NEGLIGENCE LIABILITY:Insurance Contracts – Multiple Defendants


• Linking insurance decisions to the tort system shows that more liability in tort can lead to less compensation for the accident victim, and less deterrence against accidents.


Bilateral Negative Externalities – Example: Cournot Duopoly

a2 = Output of Agent 2

a1 = Output of Agent 1

NASH EQUILIBRIUM

Iso-Profit Curve For Agent 1

Iso-Profit Curve For Agent 2

PARETO OPTIMAL EQUILIBRIUM


• In the case of only two multiple parties A1 and A2, if both were equally involved in the accident, the parties would split the damages, provided there are no limitations on wealth.


• However, when two agents with limited wealth are subject to the joint and several liability (common law) rule, the agents’ insurance decisions are the outcome of a game of bilateral positive externalities.

• See Winter, Ralph, “Liability Insurance, Joint Tortfeasors and Limited Wealth”, v. 26, Issue 1, International Review of Law and Economics, p. 1 (March, 2006)


• The “Deep-Pockets” Effect:• As Agent A1 buys more insurance, it confers a

positive externality on Agent A2

• Agent A2 believes a plaintiff will go after A1 first because there is a “deeper pocket”

• Why would a plaintiff pursue the “deeper pocket”?

• The plaintiff makes an outlay of transaction costs to its lawyer so it will be seeking a greater return for its outlay


• If Agent A2 believes A1 will be sued before A2, then A2 may reduce its effort towards precaution

• A2 may also reduce the level of its insurance coverage


• The “Cascade” Effect:

• But A1 sees what A2 is doing and decides it will reduce its exposure as well – rationally it does not want to be the “deep pocket”

• A1 instead receives a “positive externality” from A2 being the “deep pocket”


Bilateral Positive Externalities – Example: The “Insurance” Game

I2 = Insurance Purchased By Insured 2

I1 = Insurance Purchased by Insured 1


Utility Curve For Insured 1

Utility Curve For Insured 2NASH EQUILIBRIUM


• It is the combined wealth and insurance that is targeted by a plaintiff or claimant

• A defendant may strategically react by reducing both its insurance coverage (as explained) and its wealth

• Because wealth and insurance are strategic substitutes it would not make any sense for a defendant to simply reduce insurance coverage and leave its wealth exposed


• The potential defendant could very well decide on the following wealth reduction strategies because it believes insurance premiums, although fair, may be too high

• Dissipate the wealth so that it can opt for bankruptcy to limit its liability if sued

• Transfer its wealth to another party or to another jurisdiction in a bid to increase the plaintiff’s transaction costs should the plaintiff choose to pursue the wealth as a judgment creditor


• Rules such as joint-and-several liability, which would appear to broaden the scope of an accident victim to collect damages.

• Yet such a rule may reduce the compensation available once the impact on insurance decisions plays out.


• This is why small or gradual increases in liability risk, through changes in tort laws or the liability risk environment (the aftermath of 9-11), can lead to sudden and volatile changes in insurance markets


• Countering the “Insurance Game”: • Many types of insurance coverage are

mandatory • By law

» There is a mandatory minimum of insurance coverage required for motor vehicles

» Professionals such as doctors, lawyers, accountants, engineers, etc are required to carry regulated minimums in malpractice coverage

• By contract» Creditors such as banks requires borrowers such as

mortgagors (homeowners) to carry insurance to at least the value of the property


The “Insurance” Game – Impact of “credible” mandatory insurance minimums

I2 = Insurance Purchased By Insured 2

I1 = Insurance Purchased by Insured 1


Utility Curve For Insured 1

Utility Curve For Insured 2NASH EQUILIBRIUM


• Countering the “Insurance Game” – Limits on Damages Awards:

• Historically, the common law was not entirely oblivious to the “insurance” game

• Rules prevented disclosure of insurance levels to plaintiffs or juries during the conduct of lawsuits

• However, Ontario relaxed some of these rules in 1984 to enable plaintiffs to investigate the liquidity of a potential defendant


• In 1978 the Supreme Court of Canada imposed a ceiling on particular types of damages, such as damages for pain and suffering

• In 2006 the Ontario Court of Appeal rolled back a $500,000.00 award for punitive damages to $100,000.00, explaining this amount was sufficient for deterrence


• Since 1990, Ontario’s Insurance Act limits the recovery of persons injured as a result of a motor vehicle accident.

• The traditional ability to sue at fault drivers or the owner of the vehicle for general damages for pain and suffering or loss of enjoyment of life, is not available, unless a Plaintiff shows serious permanent disfigurement, or a serious permanent limitation of an important bodily function.


• In effect, the “joint and several liability rule” was replaced by a procedure whereby injured parties recovered exclusively from their own insurers provided their injuries fell below a certain threshold

• In theory this would counteract the “insurance game” and provide more compensation to motor vehicle accident victims


• The traditional ability to sue at fault defendants in non-motor vehicle negligence actions for general damages, for pain and suffering or loss of enjoyment of life, is still available.

• Other developments follow


• The Supreme Court had ruled in 1995 that bars, restaurants and other commercial establishments that serve alcohol are legally liable if, for instance, they continue to serve obviously inebriated customers and then do nothing to stop them from getting into their cars.


• ZOE CHILDS• The question is:

should average Canadians have the same legal responsibility?

• May 5, 2006• The Supreme Court

said noZoe Childs


• But a question remains – How credible are such measures?

• Insurance may still run dry especially in the aftermath of such disasters as Hurricane Katrina (2005) or the asbestos catastrophe explained earlier


TORT LIABILITY:Strict Liability Revisited


• The re-imposition of "strict liability“ in contractual and tort situations is being accomplished with the superimposing of fiduciary duties, "implicit agency", which impose strict liability, in an increasing number of cases.


• STRICT LIABILITY – Asymmetric Information

a1*

$

Strict Liability Rule

Cost of Precaution


• Modern Developments• The Horwitz thesis “in reverse” – moving back to

strict liability» 1930’s - Donoghue v. Stevenson » – One owes strangers a duty of care» 1960’s – Hedley Byrne v. Barclay’s Bank» – Words as well as actions can attract liability» 1970’s - Seaway Hotel case » – Damages extended to include loss of profits


• Modern Developments» 1980’s – Central Trust v. Rafuse » – Strict Liability imposed on professionals such as

lawyers» 1980’s – International Corona v. Lac Minerals» – Strict Liability imposed on businesses such as

mines if critical information withheld or exploited» 1990’s – “Historical” tort cases – Strict Liability

imposed on institutions to address historical wrongs:» Incest Cases» Residential Schools» Wrongful Convictions


• How does this “trend” impact on the “insurance game?

• By increasing the potential for higher recovery of damages for plaintiffs, the “insurance game” can arise for some potential defendants who reduce insurance and move their wealth

• The availability of compensation is reduced

Documents

ECONOMIC ANALYSIS OF TORT LAW January 23, 2007(Revised)