3:06 pm - Friday September 26, 0814

My Tributes to Professor Emeritus Ronald Coase

Ronald Coase, 1991 Nobel Prize Winner for Economic Sciences and an influential economist of our times, passed away at the ripe age of 102. His final book was “How China Became Capitalist” co-written with a former student, Nina Wang and this was published last year.

Through this blog, I would like to share with all a paper presented by me in my previous avatar as a Professor of Finance in an UGC State Level Program for University Professors in November 2005 and pay my tributes.

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TORT system and its economic objectives

Well friends. Before I go into my discussions, I would like to dedicate this speech to Prof Ronald H.Coase, University of Chicago who was awarded the Nobel Prize in Economic Sciences in the year 1991 for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy.

I have gained new insights and higher learning from his thoughts and works on the nature of firm, transaction costs, marginal cost pricing and the problem of social cost. In fact, you would observe there is a very clear influencing role of Prof Coase in my delivery today.

As the topic chosen for discussion today is weaved around tort law system, let us revisit some law basics.

There are two types of law – common law and statutory law. Common law deals with the law that has evolved over a period of time as a result of previous court decisions, logics and rulings. That is the rule of precedent is the source of common law. It has not been enacted by any legislative body.

In contrast, statutory law refers to laws that have been passed by a legislative body, such as a state legislative assembly or by Parliament.

Laws also can be classified as either criminal or civil. Criminal law covers acts against the state and contrary to public interest. Civil law deals with acts that cause losses to another individual.

There are again two branches of civil law – contract law and tort law.

Contract law interprets contractual provisions and resolves disputes between contractual parties, such as when one party is harmed as a result of another party’s failure to fulfill its contractual obligations.

Tort law deals with wrongs done to some one where a contract does not govern the interaction that caused the harm. Parties held liable for injuries under tort law must pay the injured party monetary damages.

For example, if an automobile hits and harms a pedestrian, the driver and the pedestrian do not have a contract to help them determine how the interaction will be handled; therefore tort law handles the issue of who is responsible for the damages.

There are various ways of assigning liability for losses that arise from the interaction among parties who do not have contractual relations. When the law assigns liability for a general type of loss, the law is essentially allocating risk.

Tort liability law allows injured parties to recover damages for losses caused. Courts award two broad types of damages – compensatory and punitive.

As the name implies, compensatory damages are designed to compensate injured parties for loss. There are in turn two main types of compensatory damages – special damages and general damages.

Special damages refer to compensation for monetary loss such as medical expenses, lost wages and the value of lost services from bodily injury, and repair/replacement cost and loss of use. Estimation of special damages can be complex. As an example, it is necessary to estimate the present value of future wage losses and medical expenses over many years.

General damages refers to compensation for non monetary losses such as pain and suffering and loss of consortium with an injured or deceased spouse, and emotional distress from the death. These types of losses are very difficult to measure accurately.

Damages paid to the plaintiff that are not designed to compensate for the plaintiff’s losses but are meant to punish the defendant for the actions that led to the injury and to deter future actions are known as punitive damages. Punitive damages in principle are reserved for situations where the defendant recklessly or willfully disregarded the risk of harm to the plaintiff.

Often situations arise in which the actions of multiple parties combine to cause loss.  Under the doctrine of joint and several liability, each defendant can be held responsible for the entire damage. However, the plaintiff nevertheless can only recover damages once.

From an economic perspective, the tort system has two fundamental objectives:

–      to provide the right incentive for safety

–      to provide the right amount of compensation for accident victims

When trying to achieve these objectives, one must consider the transaction costs of operating the tort system and the costs of alternative methods of achieving these objectives. It is important to realize that the objectives often cannot be achieved simultaneously.

The right amount of compensation for victims may yield the wrong incentives for safety and vice versa. Similarly the transaction costs that would have to be incurred to achieve these objectives may imply that the society should accept less than optimal safety incentives and less than optimal compensation for victims compared to a hypothetical world without transaction costs.

It is rarely optimal to minimize the probability of loss or expected losses suffered by injured parties. Rather than attempting to achieve a zero risk society, the tort system should provide incentives for people to invest in additional safety only if the additional benefits (marginal benefits) exceed the additional costs (marginal costs)

The other objective of the tort system is to optimally compensate victims of accidents. The compensation awarded by tort liability system is in many ways analogous to an insurance mechanism. Just as an insurance company compensates accident victims under certain conditions following a loss.

Just as policy holders pay for insurance in the form of premiums, people pay higher prices for goods and services for the implicit insurance they obtain from the tort system. If the tort liability system awards systematically awards accident victims higher compensation for product related injuries, then the prices of products will increase.

In summary the economic goal of the tort system is to minimize the cost of risk to society. That is, the tort system should provide optimal safety incentives (loss control) and optimal compensation to victims (insurance coverage), taking into account the cost of achieving these objectives. Unfortunately these objectives probably conflict so that the public policy must reflect a choice as to which objective to emphasize.

Of course this assumption is based on the premise that a tort liability system might be needed to improve safety and compensation. Let us now engage to validate this assumption

When will the market place fail to yield the optimal incentive for safety and the optimal amount of compensation to victims? Imperfect information about the risk of harm and the transaction costs only prevent people from achieving efficient outcomes without well defined tort liability rules.

If consumers are fully informed and if they are willing to pay more for safer products, then the manufacturers will spend optimal amount on product safety and produce risk less products.  Therefore if consumers are fully informed about product risk, then the tort system is not needed to induce optimal safety. Therefore full information implies optimal safety.

Now let us suppose consumers are completely uninformed about product safety and the manufacturers also carry no liability. In such an event, the consumers will not pay a higher price for a safer product and therefore the manufacturers will not be motivated to invest in product safety. In addition they (the manufacturers also carry no liability or risk on their shoulders). Here the risky products impost accident costs on consumers. Therefore uninformed people and no liability implies too little safety

In the same breadth, uninformed people and full liability will imply optimal safety. The manufacturers will be forced to spend on product safety and come out with risk less products as the tort system will intervene to protect consumers’ interest

Similarly uninformed people and less than full liability will imply too little safety.

Uninformed people and more than full liability will imply too much safety.

In a nut shell, the price at which the parties transact reflects the perceived risk involved in the exchange. If the parties are well informed, the market place effectively deals with the risky situation

Other scenarios involving tort liability are complicated by the lack of a transaction prior to the potential accident. For example, pedestrians do not transact with all the drivers that could potentially hit them. In these scenarios, the marketplace would require additional transactions to deal effectively with the risk. Due to the costs of arranging these additional transactions, the tort system may be a better mechanism for achieving the goals of optimal safety incentives and optimal compensation than the market place.

An important implication is that it is not always optimal to eliminate risk. The costs of eliminating the risk must be compared to the benefits. Because reasonable people can disagree about the magnitudes of the costs and benefits (unreasonable people are sure to disagree) arguments concerning the optimal amount of pollution are common.

It can be proved that with zero transaction costs, reasonable people will invest the optimal amount in preventing risk regardless of whether they are liable for the losses. Actually this analysis originated in the work of Ronald Coase, who was awarded the Nobel Prize in economics in part for his work on these types of problems.

If the people are liable and responsible for the losses they will obviously consider the costs imposed. If the cost of treating the risk of loss is less than the expected cost of compensating the risk of loss, then they will naturally treat the risk of loss. Thus if the people are responsible, we get the optimal outcome: the risk is treated

In case the people are not liable for the risk of loss, it may appear on the face of it that they will not treat the risk of loss. However this conclusion is incorrect.  Like the earlier discussion, when consumers are fully informed about the risk of harm, they key to finding is that a contractual solution to the risk issue arises. The tort system is not needed to solve the problem. The marketplace handles it optimally.

If the cost of treating the risk is greater than the benefits results in, then this treatment will not be taken up by reasonable people if they are not responsible.  The consumers will not pay the cost of treatment because the cost of treatment is more than the benefits that result in by such treatment.  In case the reasonable people are responsible, they would prefer to compensate the consumers as and when they incur loss rather than treating the risk, because the expected cost of compensating the consumers will be less than the cost of treating the risk. Thus, regardless of whether the reasonable people are liable, the risk will not be treated

When the reasonable people and the consumers can costlessly negotiate a solution to the risk issue, it does not matter who is liable for the losses that occur. When it is optimal to avoid risk (when the cost of treatment is less than the harm prevented), no risk will occur. When it is optimal to have risk (when the cost of treatment exceeds the harm prevented) risk will occur.

Thus, the assignment of liability can affect the distribution of wealth: consumers are better off if the reasonable people are liable.  In order to achieve the optimal level of safety, it does not matter whether the reasonable people are liable or not – optimal safety takes place regardless of the liability rule.

Zero transaction costs is a critical assumption underlying the conclusion that the assignment of liability does not affect whether the risk of harm will be treated.  The liability rule can affect optimal safety incentives if there are positive transaction costs.

Liability rules can improve safety incentives when transaction costs prevent private contracting from providing the right safety incentives. For example, it would be too costly for every driver to privately contract with each other driver to determine how automobile accidents will be handled. Instead of private contracts, society is better off having the tort system govern these transactions. This reasoning suggests that in addition to the case of underestimation of the risk of harm considered earlier, the society should use tort liability when transactions between people can cause harm and transaction costs prevent these people from entering into optimal contracts to deal with the potential harm

This analysis illustrates that uninformed people and transaction costs provide a justification for assigning liability to certain parties. That is uninformed people and transaction costs sometimes cause the marketplace to handle the problems associated with accident risks sub optimally. We should not conclude the tort liability is always the best solution to the problems that arise in the marketplace. Other methods exist for dealing with safety and compensation issues. For example, government regulation with fines for non compliance or taxes can help provide proper safety incentives and social insurance programmes can provide compensation to those who have been harmed.

All of these methods of dealing with safety and compensation issues, however, are costly, which implies that the inefficiencies of the marketplace must be compared to inefficiencies (costs) of the methods used to deal with the shortcomings of the market place.If people are fully informed, private contracting generally will provide the implicit insurance coverage that people desire. However, if people underestimate some risks or if transaction costs prevent optimal contracts, then people may obtain too little insurance. In principle, tort system can improve compensation in these situations

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May His Soul Rest in Peace!

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