Encyclopedia of Law & Economics - 3500 TORT DAMAGES

3500

TORT DAMAGES

Jennifer Arlen

Ivadelle and Theodore Johnson Professor of Law and Business University ofSouthern California Law School

© Copyright 1998 Jennifer Arlen

Contents

Abstract
1. Introduction
A. Replaceable Goods: Basic Analysis
2. Damages, Efficiency Criteria and Initial Endowments
3. Optimal Deterrence Damages Under Strict Liability
4. Optimal Deterrence Damages Under Negligence Liability
5. Comparison With Existing Law
6. Efficient Risk Spreading
7. Accidents in a Market Setting
8. Automobile Accidents and Other Bilateral Risks
9. Factors Affecting Liability
B. Damages for Death and Serious Physical Injury
10. Actual Awards for Death and Physical Injury
11. What Is Optimal Full Compensation for Death or Injury?
12. Inducing Efficient Deterrence and Risk-spreading
13. Deterrence Awards: Willingness-to-Pay vs.Willingness-to-Accept
14. Efficiency of Existing Tort Law
C. Special Topics
15. Damages for Corporate Defendants
16. Economic and Nonpecuniary Losses
17. Role of Defendants' Wealth
18. Sharing Losses Among Multiple Tortfeasors
19. Calculation of and Timing of Damage Awards
20. Conclusion
Acknowledgements
Bibliography on Tort Damages (3500)
Other References


Abstract

This article surveys the literature on tort damages, including damages for seriousphysical injury and death. Section A presents the basic analysis of tort damagesfor injuries to replaceable commodities, focusing on the relationship betweenliability rules and optimal damage rules. Section B discusses damages forphysical injury and death, examining, among other issues, the deterrence andinsurance values of life. Section C examines special topics, such as optimalliability when corporations are defendants, whether recovery should depend ondefendants' wealth, economic and nonpecuniary losses, and the calculation ofdamages. An exhaustive bibliography is attached at the end.

JEL classification: K13

Keywords: Tort Damages, Pain and Suffering, Tort Compensation, WrongfulDeath, Physical Injury, Nonpecuniary Losses, Value of Life.

1. Introduction

Efficient damages awards are critical to the optimal functioning of the tortsystem. A rich literature now exists on the subject of efficient damage awards.This analysis has shown that no one damage rule is optimal in every situation,and that, contrary to common wisdom, damage awards need not necessarily fullycompensate victims. Rather, the optimal damage award depends on: (1) thenature of the injury (harm to replaceable versus irreplaceable commodities); (2)the relationship of the parties and type of risk (unilateral, bilateral or marketrisks); (3) the liability rule (strict liability or negligence); (4) whether liability isindividual or vicarious; and (5) any existing imperfections, such as informationcosts, uncertainty, and judgment proof problems. This analysis reveals thatcurrent rules governing recovery for replaceable losses may be optimal, butthose governing recovery for death and physical injury generally are not.


A. Replaceable Goods: Basic Analysis

This section considers efficient tort damages for purely replaceable commodities.A commodity is replaceable if its owner believes that equivalent commodities areavailable on the market (Cook and Graham, 1977: 144-46). A person can be fullycompensated for the loss of a replaceable commodity if he is paid the marketprice of the good since he can use this money to buy a perfect substitute. Itemssuch as cars, clothing, money generally are replaceable.

2. Efficiency Criteria and Initial Endowments

Although the essential goal of economics is to maximize social welfare, law andeconomics scholars employ a number of different efficiency criteria to determinewhen this goal is satisfied. Some employ the Pareto Criterion: A state of theworld is Pareto Efficient if no one's utility can be increased without decreasingsomeone else's utility. Others employ social utility maximization: Under thiscriterion a tort rule is efficient if it maximizes the total utility of society, even ifsome people are made worse off by the change. Finally, others employ theKaldor-Hicks criterion under which a change is an improvement if those whobenefit from the change could compensate the losers monetarily for their lossesand still come out ahead. A state of the world is Kaldor-Hicks efficient whenthere is no way to increase anyone's utility in such a way that the winners couldcompensate the losers.

Under any efficiency criterion, tort liability must minimize the joint costs ofaccidents and accident prevention. This in turn implies that tort liability anddamage rules must induce optimal care-taking (defined as the efforts individualsundertake to avoid an accident given that they are engaged in the risky activity)and induce optimal activity levels (defined as the frequency with whichindividuals engage in the risky activity). In addition, a tort regime should induceoptimal risk-spreading by any risk averse parties by ensuring that they areoptimally insured against risk, either through the insurance system or the tortsystem, whichever is most effective.

The Pareto Criterion imposes an additional requirement: to be Pareto efficientinjurers' risk-taking must make no one worse off than they would be otherwise,in the status quo ante. This requires that damage awards ensure that potentialvictims are left no worse off than they would have been "otherwise." What thatstatus quo ante is depends on the initial allocation of entitlements (seediscussion infra).

3. Optimal Deterrence Damages Under Strict Liability

Under the traditional economic model of accidents, the efficient tort damage rulefor injury to replaceable commodities is simple: fully compensate victims for theirlosses. Specifically, victims should be awarded the market price of the gooddestroyed.

Under a strict liability regime, this damage rule will optimally deterwrongdoing, ensure efficient risk-spreading by victims, and -- depending on theliability rule and initial endowments -- may satisfy the requirements for ParetoEfficiency that no one be left no worse off than he would be otherwise. Riskaverse injurers will not optimally spread their risk, however, unless they are ableto purchase first-party insurance (Shavell, 1980; Shavell, 1987).

In the standard economic model of accidents injurers impose risk on victimswho are "strangers" to them (i.e., not in a market relationship with them) (J.P.Brown, 1973). The injurer can reduce the risk imposed on the victim both bytaking "care" in the manner in which he undertakes his activity and also bycontrolling the frequency with which he engages in the risky activity (Shavell,1980). For simplicity, this section will assume that all parties are risk neutral (seeinfra Part 6, discussing risk-spreading). Initially, we will take the social goal tobe maximizing total social welfare which is the benefit of the injurers' activityminus total accident costs (defined as cost of care plus expected accidentlosses). Injurers' behaviour is efficient when they employ the level of care andengage in the acticity at the frequency that maximizes social welfare (Shavell,1987: 21).

Consider now what damage rule induces optimal deterrence when injurers areheld strictly liable for any harms they cause. Under a strict liability rule, injurerswill take the level of care that minimizes the joint social costs of care-taking andaccidents if the expected cost to them of risk-taking -- e.g., their expected liability-- equals the cost to society of their risk-taking. This implies that damagesshould equal the cost to society of the accident, which implies victims shallrecover their losses (Brown, 1973; Shavell, 1980). This damage rule also generallywill induce injurers to engage in the optimal amount of the activity because theinjurers' cost of engaging in another unit of the activity -- the resulting increasein his expect liability -- will equal the cost to society of his decision -- theresulting increase in expected accident costs (Shavell, 1980). Yet this rule will notinduce optimal activity levels if each injurer's probability of being in an accidentdepends on the number of people engaged in the activity. In this case, evenunder strict liability, injurers will over-engage in the activity because they willnot take into account the effect of their actions on other injurers' probabilities ofbeing in an accident (Hindley and Bishop, 1983: 60-61).

When potential victims' care levels and activity levels affect expectedaccident costs, tort liability rules also must induce victims to take optimal careand engage in the efficient amount of the activity. Strict liability with fullcompensation damage awards may undermine this effort, however. Whenvictims are fully compensated for their injuries, a pure strict liability rule will notinduce victims to take either efficient care or efficient activity levels becausevictims do not bear the cost of any injuries they suffer; thus they have noreason to spend resources to avoid the harm (Shavell, 1980). Victims will takedue care, however, when strict liability is supplemented with the defense ofcontributory negligence, because in this situation victims bear the full cost ofany failure to take due care. Nevertheless, they still will not engage in theefficient amount of the activity because a victim who has taken due care will befully compensated for any injuries he suffers (Id.).

Under the Pareto Criterion victims often must be fully compensated for theirlosses in order to ensure that the injurers' risk-taking leaves potential victims noworse off than they would be otherwise. If victims' possess the initial entitlementto the property in question, then they must be fully compensated in order toensure that they are not made any worse off (See Part 3 infra discussing theentitlement issue).

4. Optimal Deterrence Damages Under Negligence Liability

Under a negligence rule, full ex post compensation of purely pecuniary lossesis an optimal damage rule, although it is not the minimum optimal rule. Fullcompensation for property losses will induce injurers to take optimal care undera negligence rule, provided courts correctly set the standard of care (Brown,1973; Shavell, 1980). However, a lesser award also may suffice. Cooter hasshown that negligence liability can induce injurers to take due care usingless-than-full-compensation damage awards because an injurer's expectedliability increases dramatically from zero to the expected damage award if hereduces his care-taking from due care to less than due care. This dramaticincrease provides a strong incentive to take due care (Cooter, 1984). This resultdoes not hold, however, if the application of "but for" causation effectivelyeliminates the discontinuity in the injurer's expected liability function. In thiscase, injurers will not take due care unless damages fully compensate victims(Grady, 1983; Kahan, 1989). In all events, under a perfectly functioningnegligence rule, injurers will take due care if damages fully compensated victimsforcing injurers to bear the full costs of their risk-taking (Shavell, 1980; Cooter,1984). Negligence liability will not induce injurers to engage in efficient activitylevels, however, because non-negligent injurers are not liable and thus do notbear the social costs of their activity level choices. Their activity levels thereforewill be too high (Shavell, 1980).

Negligence liability will induce victims to take efficient care and engage inefficient activity levels, however. Under this regime, injurers will take due careand thus will not be liable for the risks they impose. Victims, therefore, will bearthe full cost of their injuries and will have the requisite incentive to take due careand reduce their activities to the optimal level (Shavell, 1980).

Negligence liability thus will optimal deter to the extent it can, when damageawards fully compensate victims for their losses. Yet the question remainswhether this regime is Pareto Efficient. Whether this regime satisfies the Paretocriterion depends on the initial allocation of entitlements. Negligence liabilityimplicitly grants to the injurer the right to impose reasonable risks on the victim,yet entitles the victim to freedom from harms from unreasonable risks. When thisdescribes the victim's initial endowment, then forcing injurers to fullycompensate victims for injuries resulting from unreasonable risks satisfies therequirement for Pareto efficiency that victims be no worse off than they wouldbe in the status quo ante. Negligence liability is not Pareto Efficient, however,if the victim's initial endowment is to be free from any risk of harm created by theinjurer. In this situation, victims are made worse off by a rule that allows injurersto impose reasonable risks on victims without compensating them and onlyforces injurers to fully compensate victims for any unreasonable risks theyimpose [Arlen, 1985; see Calabresi and Melamed, 1972 (discussing theintersection of entitlements and liability rules)].

5. Comparison With Existing Law

The preceding analysis suggests that in the case of injury to replaceablecommodities, damage awards generally should fully compensate victims for theirlosses. Thus tort law should force injurers to pay for any damage they cause.This implies that the "thin skull plaintiff rule" -- which holds injurers liable for avictim's injuries even if the victim is unusually sensitive -- is efficient becauseit forces the injurer to take into account all expected costs of his care-taking andactivity levels. By contrast, the use of the proximate cause doctrine to eliminateliability for foreseeable but excessive losses is not efficient (Shavell, 1987:128-131).

To induce efficient behavior, however, "full compensation" should be basedon the optimal loss caused by the injurer. After an accident occurs victims oftencan take steps to mitigate the harm -- for example, by seeking medical treatmentfor an injury. To encourage optimal mitigation, victims' recovery should belimited to optimally mitigated losses plus mitigation costs (Shavell, 1987: 144-146;Wittman, 1981). Recovery also should be reduced -- or set off -- by thoseamounts the victim would have spent anyway had the loss not occurred(Shavell, 1987: 140).

6. Efficient Risk Spreading

The preceding analysis assumes that injurers and victims are risk neutral -- thatthey care only about the expected value of losses and not their magnitude. Thisassumption may accurately describes many corporations. Thus, injurers inproducts liability cases may be risk neutral [But see Arlen, 1992: 419-420(discussing when corporations should be treated as being risk averse)].Individuals, however, generally are risk averse: most individuals would prefer thecertain loss of $10 to a 10 percent chance of losing $100, even though theexpected value of these losses is the same. A risk averse individual facing apotential loss, thus, would be better off if he could purchase actuarially fairinsurance that fully compensates him for the loss. See generally Shavell (1987,

Chapter 8).

6.1. Insurance is Available

If both injurers and victims are risk averse and both parties can buy actuariallyfair first- and third-party insurance, then people will optimally spread risk bypurchasing insurance; tort liability rules need only be concerned with optimaldeterrence (Shavell, 1987: 210-212). Indeed, in this situation tort liability probablyshould not be used as an insurance mechanism: the administrative costs of tortliability far exceed the administrative costs of either first or third-party insurance(Weiler, 1993b: 926-927). Tort liability should be imposed to optimally deterrisk-taking, however. In this situation, full compensation damages are optimal.This conclusion holds even if there is moral hazard in the sale of liabilityinsurance because insurers cannot observe the injurers' precautions (Shavell,1982; Shavell, 1987: 211-212).

6.2. Insurance is Not Available

By contrast, if insurance is not available, then tort rules should not only induceoptimal deterrence but also optimal risk-spreading by risk averse parties. In thecase of replaceable losses, the optimal amount of insurance is full compensation(Shavell, 1987: Chap. 8; see also the entry on Insurance) Thus, victims'risk-spreading will be optimal if they are fully compensated for any losses theymay suffer. This implies that a full compensation damage rule will ensure thatvictims optimally spread risks when the injurers' activity is governed by a ruleof strict liability. (Shavell, 1982; Shavell, 1987: 210-227).

Victims' risk-spreading will not be optimal under a negligence regime,however, because a perfectly functioning negligence regime will induce injurersto take due care, in which case victims will not be compensated for their losses(Shavell, 1982; Shavell, 1987: 210-227). If the regime does not function perfectly,however, and injurers are deemed to be negligent (for example, because of courterror or principal's inability to induce their agents to take due care), then a fullcompensation damage rule will induce efficient risk-spreading by victims(Shavell, 1982).

If insurance is not available and injurers also are risk averse, then the verydamage and liability rules that yield efficient risk-spreading by victims willproduce inefficient risk-spreading by injurers, and vice versa. Strict liabilityforces injurers to bear any injuries they cause; by contrast, under a negligencerule injurers' risk-spreading is efficient because they can avoid all losses bytaking due care (Shavell, 1987: 208-209).

Moreover, the presence of risk averse injurers who cannot purchaseinsurance also alters optimal damage rules. To induce due care and optimalactivity levels under a strict liability rule when injurers are risk averse anduninsured, injurers must be liable for an amount that is less than the victims'losses. This is because the injurer will view both the loss itself and the risk asa cost. Yet, if damage awards do not fully compensate victims, then victims'risk-spreading will not be optimal. A full compensation damage rule will induceinjurers to take due care when they are subject to a negligence liability rule,however, because they can avoid all risk by taking due care. As previouslyexplained, however, neither injurers' activity levels nor victims' risk-spreadingwill be optimal under such a regime (Shavell, 1982; Shavell, 1987: 209-210).

7. Accidents in a Market Setting

When victims and injurers are in a consensual or market relationship and victimsare fully informed about any risks imposed on them by injurers, market forces willensure that injurers take optimal care and engage in the optimal level of theactivity. This is because victims will treat the risk of harm as a cost of buying theproduct (or service), thus giving the potential injurer the incentive to minimizethe joint cost of accident losses and his care-taking. Activity levels will beefficient because victims will only buy the commodity if the benefit to themexceeds the total cost, including expected accident costs (Polinsky, 1980;Shavell, 1980; Shavell, 1987: Chap. 3; Spence, 1977). In this situation, therefore,the only function for the tort system, if any, is to induce optimal risk-spreadingin those situations where individuals cannot purchase insurance. As explainedabove, when it is appropriate to use the tort system to provide insurance tovictims, then damages should fully compensate victims for their losses (SeeEpstein, 1985 and the entry on Products Liability for a complete discussion ofthe use of the tort system to provide insurance to victims).

Victims are not necessarily fully informed about risks, however. If victims donot accurately estimate the risk of loss, then market forces alone may not induceoptimal care-taking and activity levels (Spence, 1977; see A. Schwartz, 1988,Shavell, 1987: Chap. 3). Consumers may fail to accurately estimate risks as aresult of either imperfect information or cognitive "imperfections" that causepeople's attitudes towards risk to deviate from that predicted by expected utilitytheory. For example, evidence suggests that consumers are likely tounder-estimate hidden product risks; they also tend of underestimate known butlarge risks, such as the risk of dying of cancer, and risks that are substantiallywithin the individual's control (Viscusi, 1991: 64-65).

When consumers under-estimate risks, injurers will take insufficient care andengage in too much of the activity, unless they are liable for the injuries theycause or unless the problem can be corrected with warranties (Polinsky &Rogerson 1983; Shavell, 1980; Shavell, 1987: 52-53; Spence, 1977; see Schwartz& Wilde, 1985). Producers will not necessarily respond to markets withimperfectly informed consumers by offering full warranties, and the availabilityof warranties will not necessarily induce optimal product quality (Cooper &Ross, 1985; Grossman, 1981; Polinsky & Rogerson, 1983; Salop, 1977; Schwartz& Wilde, 1985; see Priest, 1981).

Tort liability may be able to induce optimal care taking and activity levels inthose circumstances when market forces alone cannot do so. When consumersunder-estimate risks, injurers can be induced to take due care and engage inoptimal activity levels if they are held strictly liable for consumers losses andsubject to a full compensation damage rule. When injurers bear all expectedaccident costs, they will directly bear the full cost to society of their products.Thus, in their effort to minimize their own costs, they also will select the carelevels that minimize social costs. Product prices thus will equal the social costof producing the goods, provided product markets are competitive. Consumers,therefore, will purchase the optimal amount of the product, leading to optimalactivity levels [Shavell, 1987: 67-68; see Polinsky & Rogerson, 1983 (modifyingthis conclusion when producers have market power)]. (For a more completediscussion of this topic, see the entry on products liability).

Of course, consumers do not necessarily under-estimate all risks. Indeed,evidence suggests consumers over-estimate small but known risks that havereceived substantial publicity, as well risks that are vivid or dramatic (such as therisk of dying in a plane crash) (Viscusi, 1991, p.64-65; see Arlen, 1998). In thissituation, market focus may cause injurers to take excessive care and engage intoo little of the activity. Tort liability will only exacerbate this problem (Viscusi,1991, p.64-65; see Arlen, 1998, A. Schwartz, 1988).

8. Automobile Accidents and Other Bilateral Risks

The preceding analysis assumes that individuals are either injurers and victimsbut not both -- in other words that accidents result from "unilateral risk"activities. Many common accidents, however, result from "bilateral risk"activities -- situations where both potential parties to the accident risk beinginjured should an accident occur. For example, automobile collisions, the largestsingle source of tort cases, are bilateral risk accidents.

In the bilateral risk context, a full compensation damage award will induceoptimal care-taking by both parties to the accident if the activity is governed bya duty-based liability rule: such as negligence (with or without contributorynegligence) or strict liability with contributory negligence. Each party will takedue care because he is best off taking due care whether or not the other takesdue care [Arlen, 1990a; Arlen, 1990b; Arlen, 1992a; compare with Diamond, 1974:117 (concluding that pure negligence is not efficient)].

In fact, duty-based liability rules can induce efficient care-taking employinga less-than-full-compensation damage rule. People will take efficient careprovided that damage awards are sufficiently large that each is better off takingdue care and getting the resulting reduction in liability than he is not taking duecare and paying the additional cost. The damage award that induces efficientcare-taking is less than the amount that fully compensates victims for theirlosses (Arlen, 1990a; Arlen, 1990b; Arlen, 1992a).

When people are risk averse, the three duty-based liability rules will notinduce optimal risk-spreading, however, even when combined with a fullcompensation damage award. Under these regimes, each party will take due care.Thus, under negligence (with and without contributory negligence) each partywill take due care and thus will bear his own losses. Accordingly, negligence isconsistent with efficient risk spreading only if parties can purchase first-partyinsurance. Under strict liability with contributory negligence each party will takedue care and thus will bear the other parties' losses but not his own. Thus thisregime is consistent with efficient risk-spreading only if parties can purchasethird-party insurance (Arlen, 1990b).

Regardless of the damage rule, however, pure strict liability will not induceefficient care-taking. To see why, assume both people suffer the same injurywhenever an accident occurs. In this case, each person's expected damagesequals his expected recovery. Thus, pure strict liability is equivalent to a NoLiability regime: neither is efficient because neither risk-imposer bears the costto the other person of his risk-taking (Arlen, 1990a; Arlen, 1990b; Arlen, 1992a).

9. Factors Affecting Liability

Of course, even in the standard "unilateral risk" case, determining the optimaldamage award may be more complicated than it might at first appear. This partconsiders several factors that may affect the magnitude of liability, focusing onthe traditional model of accidents in which parties to the accident are strangersand are either potential victims or injurers, but not both.

9.1. Litigation Costs

The standard analysis of tort law assumes that there are no litigation costs. Yetlitigation costs are substantial. This raises the issue of whether damages shouldequal the victims' actual losses plus their litigation costs.

(a) Pareto Criterion

Under the Pareto Criterion, damage rules must include the victims' litigationcosts because a damage rule that limits compensation to harm suffered withoutincluding the victims' litigation costs does not leave the victim no worse off thanhe would be otherwise, at least in those cases where the victim originallypossessed the entitlement the injured property.

(b) Strict Liability

Under strict liability injurers should compensate victims for their litigation costsin some circumstances but not in others. According to Polinsky and Rubinfeld(1988) optimal deterrence requires that injurers compensate victims for theirlitigation costs. Injurers must compensate victims for two reasons. First, ifvictims bear their own litigation costs, some victims with good claims will notfind it worthwhile to sue because litigation costs exceed their expected recovery.Thus, injurers will not bear the full expected cost of the harms they imposebecause not all victims will sue. Second, even if all victims sue, injurers will notbear the full social cost of their actions because, properly defined, the social costof the injurers' risk-taking is the sum of the victims' losses and the cost oflitigation. Thus under a rule of strict liability with compensatory damagesinjurers will not take efficient care or engage in efficient activity levels. Litigationcosts also will be excessive (Polinsky and Rubinfeld, 1988).

Yet, Polinsky and Rubinfeld argue, deterrence is not the only objective of thetort system. A full analysis reveals that in some circumstances victims shouldnot be compensated for their litigation costs. In addition to inducing due care,an optimal regime must minimize litigation costs. Whether compensatorydamages should be adjusted upwards or downwards depends on the effect ofchanges in damages on the injurers' incentives to take care and the victims'incentives to sue. Specifically, if the injurers' care-taking affects not only theprobability of an accident but the magnitude of the harm, it may be optimal toenable the victim to recover some but not all of his litigation costs: enough sothat it is worthwhile for the victim to sue when an injurer takes less than optimalcare and the victims' harm is large, but not enough so that it is worthwhile for avictim to sue if the injurer takes optimal care, thereby reducing the amount ofharm suffered (and thus the amount of recover) (Polinsky and Rubinfeld, 1988).This would induce optimal care-taking and minimize on litigation costs byeffectively transforming the strict liability rule into a negligence rule. As with anynegligence rule, such a regime would not induce injurers to undertake theoptimal amount of the activity.

Victims should recover less than their compensatory damages, Polinsky andRubinfeld argue, in those situations where injurers' care-taking is not productive,and thus optimal care is to take none at all. In this case, a strict liability regimeis optimal if it reduces the victims' recovery to ensure that will not sue (Polinskyand Rubinfeld, 1988). Again, this will not produce optimal activity levels,however.

(c) Negligence Liability

Under a negligence rule, a damage rule limiting defendants' liability to victims'losses will either result in optimal care or too little care. Thus, when needed, anyadjustment to compensatory damages should always be positive (Polinsky andRubinfeld, 1988). Under a negligence rule, injurers will invariably take due careif victims' litigation costs are not so high as to discourage suit. This results infirst-best efficiency because once injurers take due care, victims have no reasonto sue. If, however, litigation costs are high enough to discourage many suits,injurers will not take due care. This also will lead to excessive litigation costs ifsome victims nevertheless find it worthwhile to sue. Increasing damages toensure that victims sue will induce optimal care-taking and minimize litigationcosts, since once injurers take due care victims no longer have a reason to sue(Polinsky and Rubinfeld, 1988: 161-162).

(d) Fees Imposed on Plaintiffs and Defendants

The previous analysis assumes that the state cannot impose fees on eitherplaintiffs or defendants. Shavell (1997) and Shavell (1996) show that once oneallows for such fees, optimal damages imposed on defendants equals the harmto plaintiff plus plaintiff's litigation costs plus the state's litigation costs. Thisensures that each injurer's total expected costs equals the total cost to societyof his risk-taking activities. In order to ensure that plaintiffs have the optimalincentive to sue, the state can impose fees for bringing a suit when plaintiffswould otherwise have excessive incentives to sue or subsidies when plaintiff'sincentives are inadequate. Shavell argues that a plaintiff's incentives areexcessive if the social benefit of the suit -- measured by its deterrence impact,not the plaintiff's injury -- are less than the costs of bringing the suit (Shavell,1997: 575-581; 584-585).

Shavell explains that this system is superior to one in which plaintiffs mustpay the state's litigation costs. He notes that in this situation one should notalways force plaintiffs to pay the state's costs because often a plaintiff's suitprovides an external benefit -- deterrence -- that exceeds his private benefit.Thus, even when the fee is not imposed plaintiff may not have sufficientincentives to sue since he does not reap the full gains from his suit (Shavell,1997; Shavell, 1996: 587). Similarly, Shavell rejects a simple loser-pays fee shiftingarrangement noting that under such a regime victims with good suits will alwayssue. Yet whether the victim will prevail does not determine whether, fromsociety's standpoint, the suit should be brought. This, he argues, depends onthe deterrence impact of the suit.

Shavell's analysis raises an interesting question about how to measure thedeterrence value of a suit. Shavell argues that deterrence value should not bemeasured ex post. Rather liability will not have a deterrence value if, ex ante, theinjurer does not expect to cause this type of accident (Shavell, 1987: 129-130).Such a suit would have deterrence value, however, if the finding of liability --separate from the occurrence of the accident -- would be likely to educate otherpotential injurers (or victims) about the risk (see Arlen, 1993: 1124 n. 110; Rubin,1993: 50).

9.2. Uncertainty and Court Error

Optimal damage awards also are affected by whether the legal process is plaguedby error.

(a) Court Error in Determining Negligence

The possibility of court error in determining whether the injurer is liable undera negligence rule also may affect the optimal damage rule. Specifically, if courtsare likely to err in determining whether the injurer took due care, negligenceliability rule with full compensation damages will not necessarily induce injurersto take due care. Even when courts are likely to err in either direction -- to finda non-negligent injurer liable and a negligent injurer not liable -- under plausibleconditions, care-taking will be excessive if damage awards fully compensatevictims for their losses. When courts err, the cost to the injurer to deciding totake due care rather than excessive care is significant -- the resulting increasedlikelihood being found negligent. This will exceed the additional cost to him oftaking excessive care, under plausible assumptions. In contrast, the possibilityof error in his favor will not induce him to take less than due care. Doing so onlysaves him the additional cost of taking due care but subjects him to a significantrisk of being found liable when he otherwise would not have been. Thus, evenwhen courts are as likely to err in the injurers favor and against him, the cost ofan error going against the injurer will exceed the benefit of an erroneous findingin his favor. Thus injurers will respond to uncertainty by taking excessive care-- provided that there is a positive probability of the court under-estimatinginjurers' care levels and the distribution of errors is not too dispersed (Calfee andCraswell, 1984; Craswell and Calfee, 1986; Shavell, 1987: 79-83, 93-97; cf.Diamond, 1974).

This problem can be addressed in a couple of ways. The state can retainnegligence liability but implement a less-than-full compensation damage awards(Calfee and Craswell, 1984) or it can switch to a strict liability regime (if courtscan correctly determine damage awards) (Cooter, 1984).

(b) Role of Causation Rules

Uncertainty in the determination of negligence will not induce excessivecare-taking if on average courts get the due care standard right and causationrules function perfectly, thus eliminating the discontinuity in the injurer'sexpected liability. Causation rules may eliminate this discontinuity because anegligent injurer is liable only if his negligence caused the harm. Thus, if courtserr in determining due care but not in assessing causation, an injurer falselyjudged to be negligent still will not be liable because the court will recognize thatit is not more likely then not that the accident would not have occurred but forthe injurer's negligence (Grady, 1983; Kahan, 1989: 437-39).

Should causation rules eliminate the "discontinuity" produced by negligenceliability, then the risk of court error in determining whether an injurer is negligentgenerally will result in injurers taking less than due care -- not excessive care -because uncertainty over care-taking may lead courts to hold, incorrectly, thatnegligent injurers took due care, whereas correct application of causation ruleswill ensure that non-negligent injurers incorrectly found to be negligent willescape liability (Kahan, 1989: 437-39). In this situation, inducing efficient caremay require super-compensatory damage awards.

(c) Error in Determining Plaintiffs' Losses

Courts also may err in assessing plaintiffs' losses. Cooter has argued that whencourts are subject to this type of error the solution is to employ a negligenceliability rule. He argues that injurers' risk-taking is less sensitive to errors indetermining the damage award under a negligence regime than under strictliability because under a negligence rule the injurer's expected liability increasesdramatically if he fails to take due care. Cooter argues that this implies thatnegligence is the superior rule when courts cannot accurately determinedamages (Cooter, 1984).

Shavell argues that possible court error in the calculation of losses does notnecessarily imply that strict liability will be inefficient. Strict liability will providecorrect incentives if courts' estimates of losses are correct on average (Shavell,1987: 131-32).

Moreover, even when courts err on average, Kaplow and Shavell argue thatnegligence is not superior to strict liability (Kaplow and Shavell, 1996). Kaplowand Shavell show that, in order to determine due care, courts must be able tocalculate victims' losses. Thus, if courts cannot accurately determine damageawards under a strict liability rule, they also will be unable to determine due care

under a negligence rule, and injurers' care-taking under a negligence regime willnot be optimal. It has been suggested that due care might nevertheless be easierto determine because courts can rely on custom and other sources ofinformation on due care. Yet in order to determine whether the custom is efficientcourts still will need to be able to estimate harm [Kaplow and Shavell, 1996,compare with Arlen & Kraakman, 1997 (discussing strict versus duty-basedvicarious liability rules)].

Thus, any difficulty the court faces in assessing damages should afflictnegligence liability as well as strict liability (Kaplow & Shavell, 1996). The choicebetween the regimes therefore will likely depend on relative administrative costs.Kaplow and Shavell argue that since determining due care requires moreinformation than determining damages, the risk of error and administrative costsare higher under a negligence regime and thus strict liability is superior (Kaplow& Shavell, 1996). Nevertheless, negligence may produce lower administrativecosts because fewer suits will be brought (See generally Shavell, 1987: 264-265).

9.3. Injurers' Ability to Escape Liability for Losses

Other imperfections also can affect optimal damage awards. For example, ifinjurers are not necessarily liable for their wrongs -- for example, because tortsgo undetected -- full compensation damage awards will not optimally deterwrongdoing.

Empirical evidence suggests that injurers are not liable for many of the tortsthey cause. For example, empirical evidence suggests that a tiny portion (lessthan 6%) of victims of medical negligence will obtain compensation (Danzon,1985: 22-25; Weiler et. al. 1993a:74-75). Indeed, even the probability of detectingthe source of a substantial oil spill is only 60 percent (Cohen, 1987).

When wrongdoers may escape liability, optimal deterrence of a risk neutraltortfeasor appears to require a damage award equal to the victim's loss dividedby the injurer's probability of detection (specifically, the injurer's probability ofbeing formal liable) (h/p) because this rule ensures that an injurers' expectedliability equals the social cost of the harm (Becker, 1968; Cooter, 1989b; Landesand Posner, 1981; Polinsky & Shavell, 1998; see Arlen, 1994). This could beimplemented using a regime of compensatory damages coupled with punitivedamages or compensatory tort liability coupled with government-imposed civilor criminal penalties.

This damage rule is not necessarily optimal, however. As previouslyexplained, under a negligence regime expected damages need not equal victims'losses if the injurer's expected liability function increases substantially (anddiscontinuously) if he takes less than due care. Moreover, even under strictliability reasons exist why the damage multiplier should not necessarily equalone over the probability of detection (See, e.g., Becker, 1968: 178; Craswell, 1996;Karpoff and Lott, 1993; Kaplow, 1992). (See the entry on punitive damages fora more detailed discussion of this issue). Finally, this rule must be modified forcorporate defendant's held liable for torts (or crimes) committed by their agents(Arlen, 1994; Arlen and Kraakman, 1997; see infra Section C discussingvicarious liability).

9.4. Intentional Torts

Optimal compensation for intentional torts also may exceed the victim's actuallosses even if injurers are invariably found liable. Intentional torts generally arethose which require the injurer to expend resources in order to commit. It wouldappear that holding injurers fully and strictly liable for such torts wouldoptimally deter them. But, as Landes and Posner initially observed, this assumesthat there are "optimal" intentional torts. Many intentional torts involve lowtransactions costs; thus, market transactions are possible. All else equal, markettransactions are preferable to the involuntary taking of another's property,particularly once one considers victims' costs of avoiding non-market takings.To force such transactions into the market, expected damages should exceed theinjurer's gain from the transaction. This may exceed the victims' losses (Landesand Posner, 1987:160-163; see Haddock, McChesney and Spiegel, 1990; see alsothe following articles on benefit-based damages Epstein, 1994; Levmore, 1994;Polinsky and Shavell, 1994; Wittman, 1984; Wittman, 1985).

9.5. Supercompensatory Damage Awards and Decoupling

Although super-compensatory damage awards are necessary to solve someproblems, they may create others. For example, excess compensation may reducevictims' incentives to take care, unless a victim's right to recovery is governedby contributory negligence. Excess compensation also may preclude victimsfrom optimally spreading losses, because the marginal utility of wealth of victimswho receive excess compensation will be less than their pre-accident marginalutility of wealth (Polinsky and Che, 1991; see Arlen, 1990b).

Excess compensation creates problems less often than might at first appear,

however. As Rubinfeld observes, whether victim compensation is excessivedepends on a victim's compensation net of attorneys fees and litigation costs,not the gross compensation paid. Litigation costs and attorneys' fees aresufficiently high that defendants' liability can exceed victims' losses by aconsiderable amount without victims being over-compensated (Rubinfeld, 1984:553-555).

Nevertheless, when injurers may escape liability, the optimal deterrenceaward net of other costs often will exceed victim's losses. This creates twopotential problems. First, if victims can influence the probability or magnitudeof the accident super-compensatory awards may cause victims to engage in veryexcessive activity levels (victims will take due care, however, provided they aresubject a contributory negligence defense). In addition, victims' risk-spreadingwill not be optimal because the optimal amount of insurance is fullcompensation, not excessive compensation. One potential solution to theproblem of excessive victim compensation is to decouple injurers' liability fromvictims' compensation, with victims being fully compensated for their losses(including litigation costs) and any liability in excess of full compensation beingpaid to the state (Polinsky and Che, 1991; see Danzon, 1984; Spence, 1977). Thispossibility is discussed later in this entry.


B. Damages for Death and Serious Physical Injury

Economic analysis of damages for death and serious permanent physical injurydiffers substantially from the standard analysis of property damage becausethese injuries include harm to irreplaceable commodities. A commodity isirreplaceable if its owner does not perceive any equivalent commodities availableon the market (Cook and Graham, 1977: 144-46). Loss of this commodity resultsin a "nonpecuniary loss." Health is generally considered an irreplaceablecommodity.

Under current law, victims are not compensated for their total losses arisingfrom an accident that results in death or serious permanent injury. Rather,victims are compensated for the pecuniary losses associated with the injury plusan award for the "pain and suffering" occasioned by the loss. In some cases,victims also may receive punitive damages.

This section first examines evidence on the actual operation of the tortsystem: how much are victims compensated and how much do defendants pay?It then addresses the issue of what are optimal awards for death and physicalinjury.

10. Actual Awards for Death and Physical Injury

In a 1991 study, Hensler et. al. concluded that liability payments total $15.7billion annually. Three-quarters of this amount went to victims of automobileaccidents, even though this group constituted only 59 percent of the pool ofvictims who received compensation. Compensation net of legal fees andproperty damage totaled $12.9 billion (Hensler et. al., 1991: 100-101).

This study found that the average compensation paid to victims was $11,173.The average net compensation for personal economic cost -- net of damages forpain and suffering, property damage, and attorneys fees -- was $5,432. Theaverage liability payment for automobile accidents was $14,444. In bothsituations, the distribution of payments was highly skewed, with most victimsreceiving substantially less than the average. The median payment for all caseswas only $2,500; the median for automobile accidents was $4,000 (Hensler et. al.1991: 102-103).

Evidence suggests that victims of nonfatal accidents generally are notcompensated for all the losses they suffer. Hensler et. al. found that nonfatalaccidents impose direct and work-loss costs of $175.9 billion annually. Victimsgenerally bear 38 percent of the monetary loss directly; they only recover 62percent from other sources (including the tort system and insurance). The studyfound that the recovery rate for direct costs is 75 percent, but for work loss isonly 34 percent. Tort liability payments, net of attorneys fees, comprise only 7percent of the total compensation victims receive (Hensler et. al. 1991: 102-107).

Similarly, Viscusi's study of product liability claims paid in 1977 found that theaverage bodily injury loss, $27,446 (1990 dollars) exceeded the average bodilyinjury payment of $19,990 (1990 dollars) (Viscusi, 1991: 102). Other studies alsoconclude that seriously injured victims are likely to be under-compensated(Galanter, 1996: 1117-1119).

This finding that seriously injured victims are under-compensated holdseven though most victims receive awards for pain and suffering. Viscusi foundthat 62.5 percent of the cases with positive awards for bodily injury includedawards for pain and suffering. There was considerable variation in the amountpaid, however. The mean value of pain and suffering awards over all cases wheresuch damages were awarded is $200,000 (1990 dollars) in cases involving braindamage and paraplegia. However, in 14 of the 18 injury categories for which painand suffering was awarded, mean awards are below $60,000. On average, painand suffering awards constitute a two-thirds of the total compensation awardedin those cases where pain and suffering damages are awarded (Viscusi, 1991:103-107).

Leebron analyzed cases involving pain and suffering before death and foundthat the mean award was $83,700 and the median award was $28,500 (in 1987dollars). In general, pain and suffering awards averaged about 23% of the totalaward and almost 76% of the wrongful death amount. Leebron also foundconsiderable variation in the awards, however, not only in absolute terms but inthe per minute payment for suffering. Differences in the manner of death explainssome, but not all, of this variation (Leebron, 1989).

The previous discussion of whether damages under-compensate victimscompares victims' compensation with actual ex post losses suffered. It also isinstructive to compare compensation to the value the individuals place on theirlife and health, as determined by the amount that workers require to compensatethem for additional risk of death or injury. Examining workers' preferences,Viscusi concluded that their behavior yields an ex ante compensation demandvalue of life of $6.4 million. There is considerable variation, however. Workersin high risk jobs appear to place an implicit value on their lives of $1 million orless, whereas workers in very low risk jobs may value their lives at $10 million ormore (Viscusi, 1991: 108). Valuations of nonfatal injuries yield estimates of$12,000 (1984 dollars) to $50,000 (1987 dollars) per injury. Approximately half ofthis amount is for noneconomic loss (Viscusi, 1991: 109-110).

11. What Is Optimal Full Compensation for Death or Injury?

The preceding discussion suggests that actual damage awards, therefore, do notfully compensate victims of serious injuries for their losses. This raises theissues: what is full compensation for death or permanent injury and should thetort system try to fully compensate victims of these injuries?

The answer to the first question depends on what efficiency criterion isemployed. Under the Pareto criterion, tort liability must ensure that the injurers'risk-taking leaves no one worse off than he would be otherwise. This criterionwould seem to require that victims be fully compensated for their losses. Butwhether, and to what extent, victims must be compensated depends on the initialallocation of entitlements.

This part discusses the damage rule that satisfies the Pareto Criterion'srequirement that no one be made worse off than otherwise. The next partexamines the tort regimes that minimize the joint costs of accidents and accidentprevention.

11.1. Injurers Are Entitled to Impose Risks At Will

Society may grant to potential injurers an entitlement to impose certain risks onothers. In this case, the Pareto optimal solution to the accident problem isdetermined -- as in Shavell (1987: 247-254) -- by maximizing the utility of thepotential victim subject to the constraint that injurer be made no worse off thanotherwise. Tort damage awards thus need not compensate victims for theirlosses because, in essence, they have nothing to lose (see Shavell, 1987:247-254).

11.2. Victims Possess Initial Entitlement to Their Health

Alternatively, victims may possess the right to be completely free from certaintypes of risks. In this context, the Pareto optimal solution to the accidentproblem is determined by maximizing the utility of the injurer subject to theconstraint that the victim be no worse off than if the injurer does not engage inthe risky activity. This would seem to imply that tort damage awards must fullycompensate the victim for his losses by awarding his sufficient compensationto return the victim to his pre-accident (healthy) level of utility. But this is notnecessarily the case.

(a) Ex Ante Compensation and Complete Insurance Markets

The standard accident of economic models of tort law assumes that accidentsoccur as the result of injurers imposing risks on victims, without either partyimposing any risk of harm on the injurer. In this situation, fully compensating the

victim apparently requires that the award leave the injured victim no worse offthan when he was healthy. (See, for example, Arlen, 1985; Friedman, 1982). Aproblem arises, however, because many serious permanent injuries dramaticallyeffect the victim's marginal utility of wealth. For example, a victim of a fatalaccident may not derive any utility from wealth paid to her after the accident.Thus full ex post compensation for such injuries would seem to be impossible(alternatively, it is sometimes said that ex post full compensation award isinfinite) (See, e.g., Buchanan and Faith, 1979: 245-46; Friedman, 1982; Mishan,1971: 693).

Yet, as David Friedman observes, the reason injurers cannot fullycompensate victims for such injuries is not that life has infinite value, but ratherthat money paid to a dead person has no value (Friedman, 1982). The fullcompensation amount would be finite -- and perhaps quite small -- if it weredetermined ex ante: if those who impose risk compensated all potential victimsex ante, before any one is injured. Because the money would be paid to healthypeople who value it, only a finite amount of compensation would be required(Friedman, 1982: 83; see Graham and Peirce, 1984).

Implementing a system of ex ante damage awards probably is unworkable,however, because it would require courts to calculate, in advance, the risksimposed by an enormous variety of activities and to oversee constant cashpayments to millions of people (Friedman, 1982: 83). Yet, Friedman argues, it maybe possible to implement a system which awards damages only ex post basedon the ex ante value of life. Friedman notes that victims could be fullycompensated for their losses with substantially smaller awards than at presentif mechanisms exist that enable potential victims to obtain the benefit of thecompensation while healthy -- when the money is valuable. If victims couldbenefit from the compensation while healthy, then the proper measure of fullcompensation is the amount paid to the victim once injured that fullycompensates her for her loss given that she will get the benefit of some (or all)of this money while healthy (Friedman, 1982: 83-85, 89-90; compare with Fraser,1984a). This solution would be possible if insurance markets were complete, inthat victims could sell insurance on themselves (Friedman, 1982). Alternatively,the state could allow a market in unmatured tort claims, where healthy victims

could sell their potential claims to others [Cooter, 1989a; see Shukaitis, 1987(discussing the merits of a market in matured tort claims)].

Currently, however, victims cannot sell unmatured tort claims and there arereasons to doubt the feasibility of either such a market or of "reverse insurance"(Arlen, 1990b: 61 n. 90). Yet even so tort damage awards need not necessarilyfully compensate victims ex post in order to ensure that potential victims are noworse off than otherwise.

(b) Bilateral Risk Accidents

First, most accidents result from bilateral risk -- not unilateral risk -- activities.Bilateral risk activities are those where both parties to the accident risk beinginjured should an accident occur. Car crashes are an example of a bilateral riskaccident.

In many cases, each potential victim of a bilateral risk accident risks injuryonly if he also is engaging in a risky activity. Each person thus can avoid beingsubject to the risk in question -- thereby ensuring his initial level of utility -- byrefraining from imposing risk on others. In turn, each assumes a risk of injury tohimself in return for the ability to impose risk on others. In this situation, tortliability rules are Pareto Efficient if they maximize the utility to individuals ofengaging in the risky activity by minimizing the joints costs of accidents andaccident prevention. There is no additional requirement that injured victims becompensated for their losses. The system compensates each person ex ante forany risk imposed on him by allowing him to engage in a risky activity, imposingrisks on others which they would otherwise be entitled to be free from.Moreover, individuals would not want damage awards to be higher than thatnecessary to achieve optimal deterrence and risk spreading because this wouldrequire each person to expend greater resources while healthy in return for theright to receive additional compensation if injured, which necessarily is worthless to the person if risk spreading is optimal (Arlen, 1990b: 63-65).

This analysis may extend, with some modifications, to the tort systemgenerally, if we view it as a general set of rules that allow us to impose certainrisks on others in return for the right of others to impose risk (perhaps differentrisks) on us. In this situation, the measure of compensation afforded by the tortsystem to each potential victim should include the benefit to him of imposingrisks on others under this rule. People thus might generally prefer damageawards which do not fully compensate victims ex post if in return for notreceiving full compensation if injured (when the money may have less value)each party has to pay less to injure others (thus reducing their expected liabilitywhich they often must pay while healthy, when the money is more valuable). Inthis case, properly defined, a "full compensation" damage rule - which ensuresthat no one is worse off than in the status quo ante where no risks are imposed-- would set ex post recovery at less than the amount that returns an injuredvictim to his pre-accident utility (See Arlen, 1990b; Arlen, 1985: 1136).

(c) Products Liability

Damage awards also need not fully compensate victims ex post in productliability cases if fully informed customers can avoid product-related injuries bynot buying the product. Customers will purchase the product only if its purchase-- including the resulting risk -- leaves them no worse off than they would beotherwise. Thus, regardless of the damage award, customers are never madeworse off. (Shavell, 1980) This analysis assumes, however, that customers arefully informed. If customers under-estimate the risk in question, then they willnot be as well off as they would be otherwise unless tort damages fullycompensate them for any harm they suffer (see Section B.14 supra).

11.3. Injurers Are Entitled to Impose Reasonable Risks

Victims may only be entitled to be free from unreasonable risks of harm imposedby injurers (Graham and Peirce, 1984). In this situation, under a system of ex antedamage awards, victims will be as well off as they would be otherwise if they arecompensated only for the cost to them of any risks imposed on them over the"reasonable" level -- for example, the level that results if the injurer takes optimalcare. If, by contrast, compensation is only paid ex post, then to be as well off asthey would be otherwise, victims must be paid the full ex post compensationdemand value of the risk imposed.

12. Inducing Efficient Deterrence and Risk-spreading

To minimize the joint costs of accidents and their prevention, tort rules mustoptimally deter injurers' risk-taking (and, where relevant, victims' risk-taking) andbe consistent with optimal risk-spreading by risk averse victims and injurers. Thepresent analysis examines what tort liability and damage rules governing seriouspermanent injuries induce injurers to undertake efficient care and activity levels,while being consistent with efficient risk-spreading by victims. The question ofwhat rules will also induce victims to undertake optimal care and activity levelsis addressed earlier in this entry and in the entry on Tort Liability Rules. Theissue of how to induce injurers to efficiently spread risk is addressed both in theentry on Insurance and in the entry on Tort Liability Rules.

12.1. The Potential Conflict Between Deterrence and Risk-Spreading

When accidents result in death or serious physical injury, it may be difficult toinduce both optimal deterrence and optimal risk-spreading. Optimal deterrencerequires that injurers bear the full social cost of their risk-taking activities,including nonpecuniary losses. Yet were the tort system to award damages tovictims that fully compensated them, ex post, for death or serious permanentinjury, the award would preclude victims from engaging in optimalrisk-spreading, because, assuming that health is a normal good, full ex postcompensation for death or serious permanent injury exceeds the amount thatinduces efficient risk spreading.

Victims efficiently spread the risk of loss when they derive that samemarginal benefit from a unit of wealth whether healthy or injured. If health is anormal good, then the optimal amount of insurance is less than the amountneeded to fully compensate the victim for his full loss. In other words, apotential victim's marginal utility of wealth will be the same, whether healthy orinjured, if he is paid an amount if injured which fails to return him to hispreaccident level of utility (Arrow, 1974; Cook and Graham, 1977; Spence, 1977).To take an extreme example, a person with no heirs would prefer to have morewealth when alive than when dead, because money has no value to him once heis dead. Thus, he will not purchase life insurance. And, absent deterrenceconcerns, he would prefer to receive even a small amount of money whilehealthy to receiving millions of dollars after his death. Thus, any compensationpaid to him after he dies would produce greater social utility if given to someonewho is healthy.

Similarly, in the case of serious permanent injuries, if health is a normal goodthen individuals would not fully insure against the risk of a serious permanentphysical injury (Arrow, 1974; Cook and Graham, 1977; Spence, 1977). Thus,damage awards which fully compensate a victim for serious physical injuries -in the sense of returning him to his preaccident level of utility - overcompensatevictims in that they exceed the efficient amount of insurance coverage (Cook andGraham, 1977; Spence, 1977).

12.2. Does the Conflict Exist?

The preceding analysis suggests there is an apparent conflict betweendeterrence and risk-spreading. In order to be efficient, a tort regime must takethis conflict into account.

Yet in order to address this conflict, we must understand exactly when itarises, and when it does not. For example, the conflict between deterrence andrisk-spreading may be overstated in the case of negligence liability. Indeed,under a perfectly functioning negligence rule, there is no conflict betweendeterrence and risk-spreading, provided victims can purchase first-partyinsurance. Under a perfectly functioning negligence rule with optimal(deterrence-based) damage rules, injurers will take due care and thus will not beliable. Thus, tort liability will deter without compensating, and damage awardswill not distort victims' ability to spread risks using first-party insurance (Arlen,1990b; Calfee and Rubin, 1992: 403). Of course, negligence liability does noteliminate the conflict between deterrence and risk-spreading if injurers are foundnegligent, for example because courts err or because principals are unable toinduce agents to take due care.

In addition, even the activity is governed by a strict liability regime (or ifinjurers risk liability under a negligence regime) employing deterrence-baseddamage awards will not necessarily interfere with victims' ability to optimallyspread risks. Although it is true that in order to induce optimal deterrenceinjurers must bear the full cost of any harms they cause, this does not imply thatinjurers' liability must equal the amount that leaves the victim as well off after theserious injury as before -- i.e., equal to the full ex post compensation demandvalue of the injury. From society's standpoint, the cost of an injurer's risk-takingactivities is better measured by the cost of the risk he imposed on all potentialvictims than by the ex post compensation value of the actual injuries sufferedby any victims. In other words, the deterrence award should be based on the exante compensation demand value of the injury: on the amount individuals wouldrequire to accept the risk the injurer imposed, divided by the expected numberof accidents (Arlen, 1990b; Arlen, 1993; Viscusi 1991: 108).

While this amount may be large, in the case of very serious injuries itgenerally will be less than the amount needed to compensate injured victims expost. Ex ante compensation is based what amount must be awarded to healthyindividuals to compensate them for bearing a risk of a harm that may nevermaterialize. People often accept relatively less when compensated ex ante,because they are receiving the money when they are healthy and can enjoy itmore; indeed, individuals often are willing to accept relatively small sums ofcompensation for relatively small risks of quite serious injuries. The sum of allthe compensation required generally is much less than the ex post compensationdemand value of the injury. By contrast, the ex post value is based on theamount needed to compensate a seriously injured person for his loss. If theinjury eliminates, or dramatically reduces, any utility to the victim of money, thenthis amount might be astronomical. Indeed, in the case of death, no such amountmay exist [or, the amount may be infinite (Mishan, 1971)], even though a healthyperson might require a relatively small amount ex ante to induce him to accepta risk of such loss (Arlen, 1993: 1097-98; Danzon, 1984; Viscusi, 1991: 89-91; seeGeistfeld, 1995: 804-810).

Thus, in order to optimally deter injurers it is not necessary that the awardfully compensate victims for their actual losses. The award must simply equal thecost to society of the risk imposed. Should this amount equal -- or, if there isfirst-party insurance, should it be less than -- the victim's optimal insurancecoverage, then even under a strict liability rule, setting damage awards equal tothe amount necessary to optimally deter injurers will not preclude victims fromengaging in efficient risk spreading.

Moreover, even if the ex ante deterrence award exceeds the optimal amountof insurance, holding injurers liable for this amount will not necessary result invictims being over-compensated. While injurers' behavior is based on the grossaward paid -- including injurers' litigation costs and any part of the award thatgoes to victims' litigation costs -- victims' compensation depends on the netaward. A victim's compensation is excessive only if the net award -- net ofattorneys' fees and litigation costs -- exceeds the efficient amount of insurance.Thus, even if an injurers' liability equals the full deterrence award, the net awardto the victim may be less than or equal to the optimal amount of insurance(Geistfeld, 1995: 800-802; Rubinfeld, 1984: 553-555).

Evidence suggests that if damage awards were set equal to optimaldeterrence levels, litigation costs would substantially reduce the risk of excesscompensation. For example, currently pain and suffering awards appear toroughly equal the standard lawyers' contingency fee (Viscusi, 1991: 114). Thus,the victim's net award may be roughly equal to pecuniary losses. Providedvictims can purchase first-party insurance against nonpecuniary losses, this netaward will be consistent with optimal risk-spreading by victims. Similarly,Geistfeld argues that on net victims will not be over-compensated if victims arenot compensated for all tortuously caused injuries; any over-insurance for someinjuries may offset under-insurance for others (Geistfeld, 1995: 800).

Yet while for some injuries the net deterrence award may be less than orequal to the optimal amount of insurance, for many it still will exceed the optimalinsurance award. Scholars have estimated the ex ante value of life to beapproximately $3-6 million (Viscusi, 1991: 108; see Danzon, 1984: 527, placing thevalue at approximately $1.4 million (1980 dollars), citing Arthur, 1981; seegenerally, Kornhauser, 1990). Even net of litigation costs, this ex ante deterrencedamage award likely exceeds the efficient amount of insurance -- particularly if,as some have suggested, individuals would only insure against pecuniarylosses, (Danzon, 1984: 522-524; Priest, 1987: 1547; A. Schwartz, 1988: 364-367;Leebron, 1989: 274; see also Viscusi, 1991: 110; Viscusi and Evans, 1990).

12.3. Measure of Optimal Insurance

The magnitude of the gap between the optimal deterrence award and the optimalinsurance award depends critically on what is the optimal amount ofcompensation to pay to victims. A number of scholars have argued thatindividuals only insurance against pecuniary losses, even when faced with a riskof a serious nonpecuniary loss, such as is occasioned by death or seriouspermanent physical injury (Danzon, 1984: 522-524; Priest, 1987: 1547; A.Schwartz, 1988: 364-367; Leebron, 1989: 274).

Yet whether optimal insurance for such injuries is indeed limited to purelypecuniary losses remains an open question. As a theoretical matter, optimalinsurance can exceed pecuniary losses: optimal insurance for injuries thatincrease the victims' marginal utility of wealth exceeds the victims' pecuniarylosses. Individuals will insure against nonpecuniary losses if the injury increasesthe marginal utility of wealth: implying that the individual derives more utility outof a dollar spent if injured than he did if healthy. This might occur if an injuredperson would be using the wealth to enable him to get essentials, like mobility,whereas when healthy he would only be using the money to purchase luxuries.Individuals will not insure against nonpecuniary losses (and will not even insureagainst all their pecuniary losses), however, if the injury decreases the marginalutility of wealth, as occurs with wrongful death (Calfee and Rubin, 1992; Cooter,1989a: 388-91; Viscusi, 1991: 90).

Empirical evidence suggests that serious on-the-job injuries may reduce thevictim's marginal utility of wealth (see Viscusi and Evans, 1990). In this case, thenet optimal deterrence award will exceed the optimal amount of compensationbecause the former generally exceeds the victim's pecuniary losses. Yet there issome evidence to suggest that some injuries do increase the marginal utility ofwealth -- or at least that individuals anticipate that it will. For example, peoplecurrently insure against nonpecuniary losses -- purchasing, for example,uninsured motorist coverage. This suggests that such insurance may be optimalin some circumstances (Arlen, 1990b: 73-74 n. 149; Croley and Hanson, 1995;Geistfeld, 1995: 795-796).

However, even when optimal insurance includes some nonpecuniary losses,individuals do not fully insure against nonpecuniary losses, and optimalinsurance often (indeed generally) will be less than the net optimal deterrencevalue of the injury. Thus, even when optimal insurance includes insurance fornonpecuniary losses, the optimal insurance damage award neverthelessgenerally will be lower than the (net) optimal damage award, thus presenting aconflict between risk-spreading and deterrence.

12.4. Eliminating the Conflict Between Risk-Spreading and Deterrence

Thus, in the standard model of accidents -- where accidents occur between"injurers" and "victims" who are strangers to each other -- if injurers must payvictims an award based on the deterrence value of the risk, victims'risk-spreading generally will be suboptimal.

(a) Decoupling

The state may be able to eliminate this conflict between deterrence andrisk-spreading by decoupling the injurer's liability from the victim's recovery. Inother words, the state can require the injurer to pay the victim an amount thatensures that the victim's net recovery equals the insurance value of the harm,and then, where necessary, impose a deterrence surcharge on the injurer payableto the state to ensure that the injurer's total liability equals the ex ante cost ofthe risk he imposed (Danzon, 1984; Shavell, 1987: 233-235; Spence, 1977).

It has been suggested that this solution may not be feasible because amajority of cases settle out of court, enabling the injurer to avoid paying the fineto the state (Geistfeld, 1995: 799-800; Rubinfeld, 1984: 553-557). Yet Polinsky andChe argue that decoupling may enhance efficiency even if cases settle (Polinskyand Che, 1991: 566-67). Kahan and Tuckman argue, however, that Polinsky andChe's result does not necessarily hold, and that the requisite levies may beineffective if agency problems affect the plaintiff-lawyer relationship (Kahan andTuckman, 1995). Yet Shavell shows that settlements will not undermine thestate's ability to collect fines if the state refuses to enforce any settlements thatare not registered with the court, with the injurer being required to pay a levywhen he registers. This would ensure that injurers are not tempted to settlesecretly because plaintiffs on the receiving end of secret settlements could turnaround and sue the injurer. The only way for the injurer to get the benefit ofsettling would be to register and pay the fine (Shavell, 1996; Shavell, 1997).

(b) Bilateral Risks

Even without decoupling, most standard torts resulting in serious permanentinjury or death may not produce a conflict between deterrence andrisk-spreading. Most tortuous injuries result from bilateral risk accidents -- thosein which both potential parties to the accident risk being injured. Indeed, mosttort cases are automobile accidents -- which are single activity accidents whereboth parties to the accident are engaged in the same activity and impose riskson each other. In this situation, the tort system operates more effectively as amechanism for deterring risk-taking than for compensating victims, and tortdamage awards may not interfere with victims ability to engage in optimalrisk-spreading through the purchase of first-party insurance.

Consider the most extreme type of bilateral risk accident: single activityaccidents where both parties will be injured should an accident occur and willsuffer identical losses. In this situation, neither party will receive any netcompensation under any of the standard liability rules. Under negligenceliability, each party will take due care and will not be liable. Under strict liabilitywith contributory negligence, each will take due care and will be liable to theother, but because the accidents are symmetrical, damages paid will equaldamages received with the result that on net neither receives or pays anycompensation. Tort liability thus does not result in victims receiving netcompensation and thus does not interfere with each parties' ability to employfirst-party insurance to optimally spread the risk of loss. Rather it serves a purelydeterrent function: it will induce due care if the state employs a duty-basedliability rule -- i.e., negligence liability or strict liability with contributorynegligence -- because each party takes due care in order to avoid net liability forthe other's losses [Arlen, 1990b; see Diamond, 1974 (discussing deterrence butnot insurance)].

The state also can induce optimal care-taking and promote optimalrisk-spreading when parties to bilateral risk accidents do not suffer the identicallosses. Under any negligence-based liability rule (e.g., pure negligence,negligence with contributory negligence, and strict liability with contributorynegligence) each injurer will take optimal care if damages are set such that theinjurer is better off taking due care than bearing net liability for the accident(Arlen, 1992a; see Arlen 1990b; compare with Diamond, 1974). If damages arebased on "deterrence values" -- i.e., on the amount necessary to induce efficientcare-taking -- then under either negligence liability rule recovery also will beconsistent with efficient risk-spreading by victims, provided victims canpurchase first-party insurance. Under both negligence and negligence withcontributory negligence, each risk-taker will take due care and thus neither willbe liable. Thus, tort damages only affect potential injurers' care levels and do notaffect parties' ability to spread the risk of loss efficient. Each will do so bypurchasing first-party insurance (Arlen, 1992a).

Under strict liability with contributory negligence, each will take due care andthus will be liable. Because each is liable for the other's losses, the defendantwho suffered the larger injury will receive an award greater than his liability; theother party will not receive any net compensation. Thus, the party who faces netliability invariably can spread his risk of loss, provided that he can purchaseinsurance, because there is no risk of his being over-compensated. The partywho will receive net compensation should an injury occur also may be able tooptimally spread the risk of loss, if he can purchase insurance and if his netrecovery (net of fees, costs, and the liability to the other ) is less than theamount needed to induce optimal risk spreading. Alternatively, the state canguarantee that risk-spreading is efficient by arbitrarily ruling that both parties toa bilateral risk accident will pay the same damages, with the amount of the awardequaling that minimum award necessary to make each party take due care. In thiscase, even under strict liability with contributory negligence neither receives anynet compensation when each takes due care, and damage awards do not interferewith victims' ability to spread risks optimally by purchasing first party insurance(Arlen, 1992a). For a more detailed discussion of efficient insurance, see theentry on insurance.

(c) Products Liability

Products liability cases also may not involve a conflict between deterrence andrisk-spreading. If consumers are perfectly informed about product risks, themarket will induce producers to take optimal care and produce the optimalamount of the product. Thus, damage awards need only induce optimalrisk-spreading by victims. Awards thus should be based on "insurance" values,not deterrence values (A. Schwartz, 1988; Priest, 1987; see Shavell, 1980).

Many argue, however, that tort liability must promote optimal deterrence ifconsumers underestimate the risk of harm (see supra Section B.14). Thus,injurers' liability should equal the optimal deterrence award, which may exceedoptimal compensation to victims (E.g., Danzon, 1984; Geistfeld, 1995: 798-799; A.Schwartz, 1988; Spence, 1977). Yet, as previously discussed, a victim often willbe over-compensated -- from an insurance standpoint-- if his recovery equals theinjurers' liability. As before, it may be possible to solve this problem bydecoupling victims' recovery from the injurers' liability (Polinsky and Che, 1991;Spence, 1977). (See discussion supra)

Of course, this raises the issue of whether consumers do indeedunderestimate the risks of being injured by a product. Alan Schwartz disputesthe claim that consumers generally underestimate product risks sufficiently toproduce inefficient equilibria (A. Schwartz, 1988: 378-384). However, Viscusi andothers have shown that consumers do underestimate some risks (Viscusi, 1991:134-139; see generally Sunstein, 1997: 1183 (discussing self-serving biases)). Yet,Viscusi also has shown that consumers over-estimate other product risks, suchas risks that are called to their attention (for example, by product warnings) andrisks of certain low-probability events (like cancer) (Viscusi, 1991: 134-139).When consumers over-estimate risks, products liability may lead toover-deterrence.

Moreover, some scholars argue that even if victims are imperfectly informed,damages in some products liability cases need not equal the "deterrence" valueof the injury. Calfee and Rubin claim that imperfect information does notnecessarily justify products liability for products, like vaccines, which overallserve to reduce the risk of harm. If consumers underestimate both the risk ofharm from the product (e.g., the risk of side effects) and the background risk theproduct reduces (the risk of disease), the consumer demand for the product maybe suboptimal. In this situation, employing deterrence-based damage awardsmay reduce efficiency by deterring consumers from purchasing a product theyshould purchase (Calfee and Rubin, 1992; but see Geistfeld, 1995: 798 n. 99).Similarly, Knoll argues that stiff penalties for products liability may have theperverse result of encouraging firms to keep dangerous products on the market[Knoll, 1996b; see Arlen, 1994 (examining the impact of strict liability on firm'swillingness to monitor to determine it has done something which is likely to leadto liability)].

Finally, the government may be able to better solve imperfect informationproblems by giving consumers information on risk than by imposing tortliability. This depends in part on consumers' ability to rationally interpretinformation about their own risk of being injured (See, e.g., Sunstein, 1997).

13. Deterrence Awards: Willingness-to-Pay vs. Willingness-to-Accept

The optimal deterrence damage award for a particular injury is not the same inevery case. First, a populations' ex ante evaluation of the cost of a particular riskwill depend not only on the magnitude of the risk but also on the backgroundrisk affecting the population, assuming, as is likely, that preferences arenonlinear in risk (Arlen, 1985: 1132-34; Kornhauser, 1990: 215; see Linnerooth,1979: 57-58). In addition, it will depend whether the optimal award is properlybased on potential victims' willingness-to-pay to avoid the risk or the amountthey must be compensated to accept the risk.

Willingness-to-pay and willingness-to-accept produce very differentestimates of the deterrence value of life (Hoffman and Spitzer, 1993; Geistfeld,1995: 822-825; Knetch, 1984; Kornhauser, 1990). The willingness-to-accept (orcompensation demand) measure is most appropriate for accidents betweenstrangers governed by a strict liability rule because strict liability implicitlygrants the victim the entitlement to his health (Arlen, 1985).

Under social welfare maximization or Kaldor-Hicks efficiency, thedetermination of due care and damages under a negligence rule also should bebased on the willingness-to-accept risk if the presumption is that people possessthe right to their health and reasonable risks are those which create benefitswhich equal or exceed the amount victims would require to compensate them forthose risks (Arlen, 1985).

Willingness-to-pay may be the appropriate measure of damages for accidentsresulting from bilateral risks (Geistfeld, 1995: 826-828). Willingness-to-pay alsomay be the proper measure of damages in products liability cases becausepotential victims are in fact paying for safety through higher product prices. YetGeistfeld argues against using this measure on the grounds that it would beunfair: rich and poor consumers would pay the same product prices and yet therich would be entitled to more compensation because they would have a higherwillingness-to-pay (Geistfeld, 1995: 805-806 n. 123). This problem disappears,however, if injurers' liability is based on ex ante deterrence value of the risk - i.e.,on the aggregate willingness-to-pay of all consumers who purchase the productdivided by the expected number of accidents. In this case, all victims wouldreceive the same amount. Where this award conflicts with risk-spreading goals,the state could decouple victims' recovery from injurers' liability by forcinginjurers to pay a fine to the state (see discussion supra).

When implementing any damage rule, however, it is important to recognizethat actual damages awarded by courts may also be affected by how the issueis "framed." Specifically, both cognitive decision theory and experimentalevidence suggests that juries' and judges' determination of the value of life islikely to depend on whether the judge or jury views tort damages as a gain to aninjured victim or as making up a loss to a previously healthy person: whetherthey are told to consider the amount needed to make the victim whole or theamount she would have to be paid to subject herself to the injury in the firstplace (McCaffery, Kahneman, Spitzer, 1995).

14. Efficiency of Existing Tort Law

The present review of the literature on efficient tort damage rules for death andinjury reveals that the existing rules governing recovery for wrongful death andphysical injury are not efficient.

Under current law, recovery from wrongful death and physical injury is basedon the victim's lost wages and medical expenses plus an award for "pain andsuffering." Current measures of pain and suffering generally are designed tomeasure just that -- the pain of death or injury -- and generally are not an attemptto measure the lost quality of life. Moreover, and more important, pain andsuffering is victim specific, and thus is not tied to total cost of the risk the injurerimposed on the entire population. Thus existing damage awards do not equaleither the ex post value of the victim's loss or the ex ante cost of the risk theinjurer imposed (the efficient ex ante damage award). Thus, injurers' total liabilityfor wrongful death and serious physical injury is not based on the social costof the harms they cause. Accordingly, the tort system is unlikely to be providingthe correct incentives for injurers to take due care and limit their activity levels(Arlen, 1985; Arlen, 1993).

Indeed, actual damage awards for wrongful death or serious permanent injuryrarely exceed the efficient ex ante deterrence award of approximately $3-6 million(Viscusi, 1991: 108). This suggests that the tort system may not induceindividuals to reduce the risks they impose to efficient levels. But, from thestandpoint of inducing optimal risk-spreading, the compensation victims actuallyreceive may be higher than is efficient -- although this is unclear given that muchof the award will go to attorneys fees and other costs.

Finally, in the unilateral risk context, damage awards do not satisfy therequirement for Pareto efficiency that injurers' risk-taking leave victims no worseoff than they would be otherwise if victims are initially entitled to be free fromrisks imposed by others.


C. Special Topics

15. Damages for Corporate Defendants

The standard analysis of optimal damages assumes that liability falls on theactual injurer. In other words, the standard analysis assumes that the defendantis the actual injurer, and that both people are natural persons. Yet often thedefendant is a corporation which is being held liable for wrongdoing of itsmanagers or other employees. Indeed, most of the famous tort cases involvecorporate defendants - e.g., U.S. v. Carroll Towing Co., 159 F.2d 169 (2d Cir.1947); The T.J. Hooper, 53F.2d 107 (S.D.N.Y. 1931); Palsgraf v. Long Island R.R.,162 N.E. 99 (N.Y. 1928). Analysis of corporate liability for torts of managers orother employees reveals that the standard analysis of individual injurers doesnot necessarily apply to corporate liability. Holding firms liable for theiremployees' torts induces employees to take optimal care and firms to engage inoptimal activity levels if firms either can directly control employees' care levelsor can use wages to force employees to bear the full social cost of wrongdoing.This regime does not induce optimal care, however, if firms cannot directlycontrol employees' care levels and employees cannot pay the optimal damageaward (Kornhauser, 1982; Shavell, 1987: 170-175; Sykes, 1984).

In this situation, optimal deterrence requires that corporate tort liabilityinduce firms to optimally deter their employees' wrongdoing. To do this,however, one must do more than simply force firms to pay for any harms caused.

When employees are insolvent and firms cannot directly control their employees'care-taking, to optimally deter wrongdoing it may be necessary to induce firmsto implement measures which increase employees' expected liability byincreasing the probability that they will be liable for their torts. These measures-- hereinafter called policing measures -- include monitoring employees,conducting self-evaluative audits of the firm's compliance with the law,investigating suspected wrongdoing, and reporting wrongdoing. In addition, tooptimally deter wrongdoing firms may need to undertake preventive measures- such as screening employees - and also adjust activity levels to reflect the fullsocial cost of wrongdoing (Arlen and Kraakman, 1997).

The current civil corporate liability regime is best described as being a regimeof traditional strict vicarious liability, under which firms are liable for every harmcaused by their employees' in the course of their employees' employment andsubject to a fixed damage award equal to the harm caused, with no mitigation ifthe firm took steps to avoid the harm (Arlen, 1994). This regime is not in and ofitself efficient. First, if the probability of detection is less than one, the firm willnot undertake optimal prevention measures or activity levels unless the firm'sliability equals the social cost of the harm divided by the probability of detection(h/p) - an amount which may be many times higher than actual harm (Arlen &Kraakman, 1997; see Kornhauser, 1982; Polinsky & Shavell, 1993; Polinsky &Shavell, 1998; Sykes, 1984).

Second, in order to induce optimal policing measures -- specifically measuresthat affect the probability that the firm will be found liable -- traditional strictliability generally should be replaced with a partial duty-based regime("composite regime"). Under this regime firms would be subject to a legal dutyto monitor, audit, investigate and report optimally. In order to induce optimalprevention measures and activity levels, the firm would be subject to a sanctionof h/p* -- where p* is the optimal probability of detection -- if it satisfied itspolicing duties but would be subject to a much higher sanction of h/po if it didnot - where po is the probability of detection if the firm does not undertake anypolicing (Arlen & Kraakman, 1997). Strict liability will not induce firms toundertake optimal policing, unless the sanction is h/p, where p depends on theactual probability of detection (Arlen, 1994; Arlen & Kraakman, 1997). Fullanalysis of corporate tort liability also would require examination of the impactof criminal laws and also market-based sanctions.

The present analysis reveals that one cannot simply apply the findings of thestandard economic models of torts to cases involving corporate defendants.This suggests that we need to develop a better understanding of whycorporations commit torts and how firms respond to liability, and that we shouldbe circumspect about basing policing decisions governing corporate liability oneconomic models of how individuals behave. This topic is discussed in moredetail in the entry on Vicarious Liability.

16. Economic and Nonpecuniary Losses

Even where full compensation is efficient, concern for efficiency suggests thatvictims should not necessarily be compensated for their economic losses.Economic loss usually refers to foregone profits or earnings. Scholars argue thatvictims should not necessarily be compensated for economic losses becauseonly some economic losses are social costs. For example, assume that a firmloses business to a competitor selling the same product at a lower price as aresult of the tortuous activity of the latter. In this case, from the perspective of"static" efficiency, the "victim's" lost profits are not a measure of social loss butare actually a measure of social gain. Similarly, when an accident halts a firm'sproduction of a good, the firm's lost profits on foregone sales are not socialcosts if other firms produce perfect substitutes at the same cost (Shavell, 1987:135-140).

Nevertheless, in other cases economic losses may also be social losses. Forexample, an accident that interferes with production will cause social losses ifalternative goods are manufactured at higher cost. This cost difference is themeasure of the social loss and is a proper component of damages. This amountwill be less than economic losses, however, if the price of the good does notchange. Social costs may exceed economic losses if no alternative sale is made,because the social costs equal the lost consumer surplus which necessarilyequals or exceeds the producer's economic loss (Bishop, 1982; Shavell, 1987:135-140). For additional discussions of tort liability for economic losses see(Goldberg, 1994; Landes and Posner, 1987: 251-255; Rabin, 1985; Rizzo, 1982; G.Schwartz, 1986; G. Schwartz, 1996).

In contrast to economic losses, which often should not be included indamage awards, nonpecuniary losses generally should be included.Nonpecuniary loss generally refers to the loss of an "irreplaceable" commodity-- a commodity which cannot be purchased on the market. Irreplaceable goodsinclude the sentimental value a person attaches to a family photo or otherpersonal possessions. Health is another irreplaceable good (see discussionsupra). Nonpecuniary losses are social costs: the cost is the reduction in thevictims' utility. In order to ensure that injurers take into account the full socialcost of their actions, injurers must be liable for both pecuniary and nonpecuniarylosses (Bishop and Sutton, 1986; Shavell, 1987: 133-135). The one exception tothis is where nonpecuniary loss is small enough that the benefit of holdinginjurers liable for this nonpecuniary loss is less than the administrative cost ofestimating them (Shavell, 1987: 133-135). This condition is satisfied only if thebenefit of including such losses measured by the effect of including them on allinjurers who impose risks to such commodities (whether injury results or not)exceeds the administrative cost of calculating them in the (relatively fewer) caseswhere the commodity is actually injured. Additional issues concerning recoveryfor nonpecuniary losses are discussed in Section C supra.

17. Role of Defendants' Wealth

The standard analysis generally assumes that potential injurers are identical. Thequestion arises, however, what if potential injurers have different wealth? Shouldthis affect the damage award?

Under the Pareto Efficiency criterion, defendants' wealth should be irrelevantto the determination of damages (see Shavell, 1987: 215-227; Miceli andSegerson, 1995). This result also holds under the total social utility maximizationcriterion if each individual has the identical marginal utility of wealth for all levelsof wealth -- i.e., if individuals are identical and are risk neutral (Arlen, 1992;Abraham and Jeffries, 1989).

When social welfare is measured by maximizing total social utility, thenemploying a simple model in which individuals are risk averse but are otherwiseidentical it can be shown that total social utility is maximized if wealthier peoplespend more on care; which can be achieved by forcing them to pay higherdamages. The reason is that in this situation defendants have declining marginalutility of wealth. Thus, the wealthier the defendant the less impact anexpenditure of a dollar has on his welfare. Thus, optimal due care for wealthierindividuals exceeds optimal due care for poorer defendants, because, all elseequal, the marginal cost of care for a wealthier defendant is lower. It is possibleto induce greater care-taking by wealthier defendants by having damages varywith defendants' wealth (Arlen, 1992).

This conclusion results from the fact that under the social welfaremaximization criterion transfers of wealth can increase social welfare -- as definedas maximizing total social utility. The fact that when the total social utilitycriterion is employed it is possible to increase "social welfare" through purelydistributional changes is a reason that many economists prefer other measuressuch as the Pareto Criterion or Kaldor-Hicks criterion (Arlen, 1990b).

Moreover, Miceli and Segerson question the conclusion that havingdefendants' damages vary with wealth maximizes total social utility. They agreethat the efficient standard of care and damage awards vary with defendants'wealth when a negligence liability rule is employed and tort liability rules are theonly instrument employed to increase social utility (Miceli and Segerson, 1995:202, 204-205). However, they conclude that under strict liability care levels anddamage awards should be independent of defendants' wealth (Miceli andSegerson, 1995: 204-205).

Furthermore, there are additional reasons to question whether wealthdifferences should affect damages, Arlen argues that we should not necessarilybase damages on defendants' wealth -- even where static analysis might suggestthat basing damages on defendants' wealth would maximize total social utility --because basing damages on defendants' wealth would have negative affects onwillingness to accumulate wealth. In addition, it would entail substantialadministrative costs. (Arlen, 1992:427-29; see Polinsky & Shavell, 1998: 910-913).Moreover, it is far from clear that society should design tort rules to maximizetotal social utility, instead of rules that are Pareto or Kaldor-Hicks Efficient (seeArlen, 1985; Arlen, 1990b).

Finally, this analysis only examines one method of achieving redistribution.Other instruments, such as the tax system, might be superior for affecting theredistribution of wealth potentially required for social utility maximization(Kaplow and Shavell, 1994). Indeed, Kaplow and Shavell argue that income taxesare superior to liability rules for redistributing wealth because while bothinstruments distort people's choice between labor and leisure, redistributionthrough legal rules imposes an additional cost: it distorts the behavior the legalrule was meant to regulate. They, therefore, conclude that legal rules shouldfocus on efficiency alone (Shavell, 1981; Kaplow and Shavell, 1994).

Recently, Sanchirico (1997) has challenged this conclusion that legal rulesneed only focus on efficiency because equity concerns are better addressedthrough the tax system. He argues that even if income taxes are optimal, tortrules may need to take considerations other than efficiency into account ifpeople with different wealth levels respond to in different ways to the tortsystem -- e.g., if the wealthy are more cautious. In addition, equityconsiderations may be relevant if wealth differences are explained primarily byincome differences and high income individuals tend to be more accident prone.Moreover, complete analysis of the issue of whether taxes or legal rules shouldbe used to serve equity concerns would require analysis of the politicaleconomy of legislatures versus judges - of which institution is more likely toadopt an optimal, or second-best efficient, regime (Sanchirico, 1997).

Christine Jolls argues that the case for using legal rules to achieveredistribution is strengthened once one takes into account well known featuresof human behavior that depart from the rational choice model. She argues thatif -- as experimental research suggests -- people are overly-optimistic aboutuncertain events, exhibit risk-seeking behavior towards losses, and engage inmental accounting, then redistrubtion through tort liability may distort workincentives less than an income tax. This conclusion undermines a centralargument against using tort liability to achieve redistrubtional goals. Moreresearch is needed to determine whether behavioral economic analysis arguesin favor of using tort liability to achieve redistribution, however (Jolls, 1998).

18. Sharing Losses Among Multiple Tortfeasors

Many torts involve multiple tortfeasors. Under current law, generally jointtortfeasors are jointly and severally liable for a plaintiffs' losses. This rule holdseach defendant potentially liable for the full amount of the plaintiffs' losses.Apportionment rules, by contrast, apportion tort liability between defendantsin relation to their responsibility for the harm. This raises the issue of how toapportion damages amount multiple tortsfeasors. This issue is discussed atlength in the entry on Joint and Several Liability and thus will only beconsidered briefly in this entry.

The standard legal regime holds multiple defendants jointly and severallyliable for any losses they cause. This implies that each defendant is potentiallyliable for the full amount of the victim's losses. Alternative regimes apportionthis liability between the defendants.

Under a negligence liability regime, joint and several liability will inducepotential injurers to take due care if they are fully solvent (Kornhauser andRevesz, 1989; Landes and Posner, 1980; Landes and Posner, 1987: 190-227; seeShavell, 1987: 164-167). By contrast, if each injurer is only liable for the amountof damage attributable to his own negligence -- e.g., in a pollution case each isnot liable for damage caused by the other person's dumping --, then injurers willfail to take due care (Kornhauser and Revesz, 1998: 372; Kornhauser and Revesz,1989).

Kornhauser and Revesz argue that the result is different under strict liability,however. They conclude that neither joint liability nor non-joint liability willcause injurers to take due care (Kornhauser and Revesz, 1998; Kornhauser andRevesz, 1989). By contrast, Shavell concluded that under strict liability anapportionment rule will result in injurers taking due care if they act in concert,but not if they act independently (Shavell, 1987: 164-167, 177-179). For adiscussion of apportionment rules when injurers are insolvent see Kornhauserand Revesz (1990). For a discussion of the effect of joint and several liability onsettlement see Kornhauser and Revesz (1994a) and Kornhauser and Revesz(1994b).

19. Calculation of and Timing of Damage Awards

19.1. Accuracy in the Assessment of Damages

Litigants often devote substantial effort to establishing the level of harm. The

question is, are the costs of increased accuracy socially optimal? Kaplow andShavell argue that if injurers know the harms they will cause, accurate damageawards will lead potential injurers to internalize the true cost of the risks theyimpose, leading to optimal care-taking and activity levels (Kaplow and Shavell,1996). But if injurers do not know the harms they will cause, then simplyknowing that damages are accurate will not induce injurers to engage in optimalbehavior. In this situation, expenditures on accuracy are wasteful, if all we areconcerned about is optimally deterring injurers' behavior. Injurers can beoptimally deterred by basing damages on the average harm caused. Yet thisconclusion does not hold if courts' efforts to assess harms correctly causesinjurers to learn more about the expected harms they may cause. At present,however, both parties are likely to have excessive incentives to provideinformation to courts about harm because litigants have ex post incentives toprovide information about harm if actual harm is differs from estimated harm,even if this information has no social value (Kaplow and Shavell, 1996).

19.2. Individualized Versus Scheduled Awards

Danzon (1984) argues that in products liability cases, the current system ofindividualized awards should be replaced by a system of scheduled awards,under which a victim's recovery for a particular injury is pre-determined, basedon the average cost of such an injury. Rubinfeld (1984) suggests that scheduledawards will not necessarily reduce administrative costs and that the varianceassociated with individual awards may produce some benefits.

Arlen (1990b), Arlen (1993) and Viscusi (1991) also argue for scheduledawards and against basing awards on victims' actual losses. They argue thatoptimal damages for physical injury should be based on ex ante cost to societyof the risk the injurers imposed, and not on the actual victim's ex post losses.This proposal differs from Danzon's in that damage awards would depend on themagnitude and nature of the risk imposed -- not just on the harm. Thus aninjurer's liability for a given loss -- e.g., wrongful death -- would not be a fixedamount but rather would depend on the magnitude of the risk imposed and the

nature of the risk (say fire versus being crushed). It might well be, however, thatvictim's recovery could be decoupled from the injurer's liability, so that victimswho suffer a particular type of harm - say loss of an arm - would receive the sameamount. Those who would prefer to receive more could purchase insurance.

19.3. Lump-Sum Versus Periodic Damages

Compensatory damages often must cover not only past losses but also futurelosses, for example future lost wages associated with a serious permanentphysical injury. The question arises whether this system of lump-sum awardsshould be replaced by a system under which awards are made periodically,contingent on the actual amount of the future loss.

Those who support periodic contingent awards argue that contingentawards reduces the calculation problems associated with the uncertain natureof future losses. Rea (1981) argues, however, that the case for lump-sum awardsis stronger than it might seem because periodic awards can add substantially toaccident costs. First, Rea notes that ex ante victims will never be made better offby switching to periodic awards because a victim who would prefer periodicawards can always transfer a lump-sum award into a periodic award bypurchasing insurance. Second, he notes that defendants may be risk averse. Arisk averse defendant will prefer a certain lump-sum payment to uncertaincontingent payments with the same expected value. The defendant thus subjectto a contingent award will likely purchase insurance. Rea suggests that a systemunder which the victim obtains a lump-sum award and purchases insurance ispreferable to one under which the defendant is subject to a periodic award andpurchases insurance (Rea, 1981); see also (Schuck, 1990).

19.4. Prejudgment Interest

Because it often takes many years from the time of an injury for a successfulplaintiff to receive an enforceable judgment, courts award prejudgment interest.A proper award of prejudgment interest is necessary both to ensure that theplaintiff is fully compensated and that the defendant pays the full cost of theinjury. The question is, what is the appropriate rate of prejudgment interest?

Michael Knoll argues that economic and finance theory implies that when theparties have ready access to the capital markets (as publicly traded corporationsdo) prejudgment interest should be awarded at the defendant's cost ofunsecured borrowing. A defendant who is assessed a judgment has in effectborrowed the judgment amount from the plaintiff. As with other loans, theplaintiff is compensated if he receives interest at the defendant's borrowing rate.Because judgment creditors are treated along with other unsecured creditors inbankruptcy, awarding prejudgment interest at the defendant's cost of unsecuredborrowing will both compensate the plaintiff and prevent the defendant frombeing unjustly enriched (Knoll, 1996a). For other articles discussing this topicsee Fisher & Romaine (1990), Patell et. al. (1982).

20. Conclusion

Economic analysis has greatly enriched our understanding of damage rules. Itreveals that damages serve a complex and multi-faceted role: deterringrisk-takers, helping victims spread risks, and compensating them for their losses.Economic analysis reveals how to design tort liability and damage rules to servethese goals. This analysis can guide legislators and courts as they design tortliability and damage rules.

Existing research suggests that at present damage awards for seriouspersonal injury and death generally are not sufficiently large to induce potentialinjurers to take due care and engage in optimal activity levels. Yet economicanalysis also suggests that victims of physical injuries may be receiving toomuch compensation. This suggests that states should consider decouplingdefendants' liability from victims' compensation.

Economic analysis also suggests that the fact that tort liability for certainaccidents is too low does not imply that all damages awards should beincreased. Although defendants' liability is too low in some circumstances,existing research suggests that it may be too high in others. A defendants' fullcosts of risk creation includes litigation costs, any market penalties thedefendant bears as a result of either the harm or being held liable, and anyadditional government imposed sanctions, such as civil penalties imposed byan administrative agency or criminal penalties. These costs must be included inany assessment of whether tort damage rules are adequate. Moreover, moreempirical evidence is needed on the questions of what is the optimal ex antedeterrence award for different risks, and what are potential victims' preferencesfor spreading the risk of various losses.

Economic analysis of tort damages also would benefit from additionalanalysis on why accidents happen in the first place -- particularly, why arepeople negligent? Simple economic models predict that if damages and liabilityrules are set correctly, no one will be negligent. Yet there is considerableanecdotal evidence -- and some empirical evidence -- that people are indeednegligent (see Weiler, 1993a: 72-73 showing that doctors are negligent in asubstantial portion of cases). The question is why? Is it that damages are toolow? Is it that optimal care is set incorrectly? Or are there other forces at work -perhaps informational or institutional problems - that result in the tort system notcreating adequate incentives for people to take due care. Economists haveexplored some of the possible reasons: such as the risk of court error; thepossibility injurers' will not be liable for their torts; and the fact that many tortdefendants are business organizations, not individuals. These and otherpossible explanations warrant additional analysis.

Acknowledgments

I would like to thank Linda Cohen, Bob Cooter, Lewis Kornhauser, MitchellPolinsky, Chris Sanchirico, Gary Schwartz, Steven Shavell, Matthew Spitzer, EricTalley, and two anonymous referees for their helpful comments.

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© Copyright 1998 Jennifer Arlen