The economics of liability

Philippe Gagnepain

Paris School of Economics- Université Paris 1 Panthéon Sorbonne

References

• Deffains, B., & Langlais, E. (2009). Analyse économique du droit: principes, méthodes, résultats. De Boeck.

• Akerlof, G. A., Romer, P. M., Hall, R. E., & Mankiw, N. G. (1993). Looting: the economic underworld of bankruptcy for profit. Brookings papers on economic activity, 1993(2), 1-73.

• Boyer, M., & Laffont, J. J. (1997). Environmental risks and bank liability. European Economic Review, 41(8), 1427-1459.

• Calabresi, G. (2008). The cost of accidents: A legal and economic analysis. Yale University Press.

• Hansmann, H., & Kraakman, R. (1991). Toward unlimited shareholder liability for corporate torts. Yale Law Journal, 1879-1934.

• Landes, W. M., & Posner, R. A. (1987). The economic structure of tort law. Harvard University Press.

• Pitchford, R. (1995). How liable should a lender be? The case of judgment-proof firms and environmental risk. The American Economic Review, 1171-1186.

Introduction

• This Chapter proposes a discussion on how economic tools allow the researcher or the practitioner to compare the effects of different rules implemented with regard to (civil) liability.

• Regulation of risks associated with the production or transportation of dangerous products.

• This theory should be able to correct externalities/damages produced by economic agents (firms).

• Liability can be seen as a mean to promote economic efficiency wich is guaranteed by the minimization of the social cost of accidents (Calabresi, 2008).

• Optimal rules guarantee that the agents are given the right incentives to take decisions that maximize social welfare (and not only private interest).

Liability as an incentive device

• Economists specializing in industrial risk have neglected liability in favor of regulation as the main instrument of prevention.

• Liability acts as a mode of ex post regulation of risky activities.

• The distribution of the damage burden between the parties occurs after the accident.

• The behavior of agents is not controlled a priori, contrary to the logic of ex ante regulation.

• Liability comes into play only if the victim of damage takes legal action against the alleged perpetrator.

• Reduces the cost of monitoring risky activities through the regulatory process.

Liability as an incentive device

• Starting point of the analysis:‒ Identification of the variables influencing the risk of accident: Degree of precaution

and level of activity.

‒ The accident involves a passive behavior of the victim: Unilateral accident.

‒ The accident involves active behavior of the victim: Bilateral accident.

Liability as an incentive device Unilateral accident and exogenous level of activity

• The activity of an agent imposes a risk of accidental damage to third parties.

• The victims suffer a loss of amount D in the event of an accident.

• The probability of an accident depends on the prevention effort x of the risk generating agent : p(x), with p’ < 0 and p’’ > 0.

• The prevention cost is C(x) with C’ > 0 and C’’> 0.

• The socially optimal prevention effort minimizes the social cost:

• First-order condition :

Liability as an incentive deviceUnilateral accident and exogenous level of activity

• In the absence of a mechanism internalizing accident costs, the risk generating agent carries out its activity with the zero precautionary level.

• We analyze now the role of liability as an incentive mechanism for prevention.

• In the absence of a "reasonable" standard of behavior, the agent imposing the risks is responsible for the damage whatever the level of precaution. Its total cost is then:

The agent adopts the optimal level of care.

Liability as an incentive deviceUnilateral accident and exogenous level of activity

• If now a "reasonable" standard is set by the regulator (it is assumed that the standard is efficient and therefore equivalent to x*), the cost borne by the firm is:

The company chooses again the optimal level of effort.

• What is the difference between the two rules?

Liability as an incentive deviceUnilateral accident and endogenous activity

• Taking into account the level of activity q of the risk-generating agent is justified if it is admitted that it influences the risk of an accident.

• Denote as B(q) the benefit obtained from such activity, B’(q) > 0, B’’(q) < 0.

• The social objective becomes:

• First-order conditions:

Liability as an incentive deviceUnilateral accident and endogenous activity

• If no liability, x = 0, and the level of activity is too high.

• In the case of a liability without standard, the private cost of the agent corresponds to the social cost and the social optimum (prevention and activity) is realized.

• In the case of liability with standard (legal standard set at x*), the problem of the agent is given by:

• First-order conditions:

Liability as an incentive deviceUnilateral accident and endogenous activity

• The prevention effort is therefore optimal while the level of activity is excessive.

• Courts generally rule on the degree of precaution only.

Liability as an incentive device Bilateral accident and fixed level of production

• Accident prevention may require the active intervention of the victim.

• The victim takes precautions to reduce the probability of an accident.

• The cost of prevention is A(y) with A’(y) > 0 and A’’(y) > 0.

• The social cost of accidents becomes:

with px < 0, py < 0, px,x > 0, py,y > 0, and px,y > 0.

• First-order conditions :

Liability as an incentive device Bilateral accident and fixed level of production

• We can derive from these conditions optimal reaction functions:

with .

• The social optimum is realized at the intersection of these two functions.

• The question then is to define the rules of liability that lead to the optimum.

‒ If no liability, x = 0 and .

‒ If liability with standard, y = 0 and .

Liability as an incentive device Bilateral accident and fixed level of production

• In the case of liability with standard, the risk generating agent faces the cost function:

• The solution is . The agent just meets the standard.

• The victim is forced to bear the residual damage and hence minimizes the expected losses: .

• Socially optimal behavior:

• Optimum Equilibrium: Charges the accident costs to the victim and incentivizes the other party to select the optimal level of care (and avoid liability).

Liability and contracts

• We assumed so far that the risk generating agent could not sign any complete contract with a third party (the victim).

• We drop now this assumption: Both parties may know each other beforehand.

• Take the case of a producer-seller and a consumer-buyer.

• The damage p(x,y)D is measured per unit of product bought by the consumer.

• Total number of units is q.

• The social objective is represented by the program:

Liability and contracts

• The optimum is obtained when the following conditions are satisfied:

• What are the liability rules that allow reaching this optimum?

• What is the role of the market in the internalization of the cost of the accidents?

Liability and contracts

• We assume that firms are price takers. There are no transaction costs.

• Liability is captured by a parameter which represents the share of damages beard by the consumer.

• The price r of the product is given.

• The consumer chooses Q = nq and y that maximize the expected utility

• Note that , , and .

• The first order conditions are given by:

Liability and contracts

• Simultaneously, the producer chooses q and x in order to maximize its profit :

• The first order conditions are given by:

• Finally, we can add a last condition which states that free entry entails that the long-run profit is nil:

Liability and contracts

• Combining these different conditions yields:

• This result is similar to the one on production at the optimum.

• It is independent from s: Regardless of how liability is shared across producers and consumers, the quantity produced by each firm and the total number of firms are always socially optimum.

• Indeed: when there is complete information on the nature of the risk, the price perceived by the consumer allows internalizing the damages of the accident.

Liability and contracts

• If s = 0, the equilibrium price internalizes the expected damage and the consumer reduces the quantity purchased accordingly.

• If s = 1, the price equals the production cost but the consumer purchases a quantity that’s corresponds to the total cost of the product:

• The quantities exchanged are therefore not affected by the risk sharing rule.

• Is this conclusion also valid for prevention efforts x and y?

• Yes if producers and consumers are able to sign a contract that establishes a link between the effort levels and the price of the good sold. Social optimum is obtained in this case (Landes and Posner, 1987).

• Both parties need to have perfect information about the risk of accident.

Liability and contracts: In a nutshell

• It is not possible to use one single rule that works in all situations in order to reach a social optimum.

• Unilateral accidents: Liability always guarantees the optimum.

• Bilateral accidents: Liability with standards works best.

• Code civil (mai 1998) on defective products: The producer is fully responsible (production, design, and information).

• In this case, the producer is incentivized to choose an optimal effort of prevention, which increases the price of the good and sends positive signal to the consumer on the quality of the product.

Risk and liability: Insolvency (judgment proofness)

• Liability rules allow the central planner to minimize social costs as long as the agent who produce the damages are incentivized to include in their objective function the costs of these damages.

• The producer of the damage must be able to compensate the victims for the damages.

• Difficultie arise in case of small to medium size firms and/or in the case of major risks (Asbestos, nuclear, chemistry, petrol, chemical products, etc).

• “Judgment proofness”: Firms are not able to pay compensation and do not internalize the cost of their actions in their production activities.

• Three main consequences:

(i) Prevention effort too low, (ii) Production too high, and (iii) Insurance policies are inadequate.

Risk and liability: Insolvency (judgment proofness)

• Define L as the solvability limit of the agent.

• In the case of a unilateral accident, the “no-standard” cost faced by the producer is

If L < D, .

• If a “standard” is applied, the cost expression becomes

In this case, the producer is incentivized to exert the optimal effort even if it is insolvent.

• Applying a “standard” seems to be best as long as solvency high enough.

Risk and liability: Liability evasion strategy

• “Judgment proof” is a strong opportunity. Insolvency may become an endogenous decision. Several strategies are possible:

‒ Industrial disaggregation: The financial compensation is usually based on the value of the firm.

Firms may then prefer to subcontract risky activities. Ex: Gas and oil companies do not operate transportation themselves. Small firms may replace large drug companies for the development and initial marketing of pharmaceuticals (Hansmann and Kraakman, 1991).

‒ Financial substitution: The activity of a firm often depends on the funds paid by financial institutions.

Debt is a potential strategy for the firm to reduce its financial value. Debt-own capital substitution. The external creditor not responsible.

‒ Looting: The shareholders proceed to a liquidation of the firm before condemnation to reimburse damages. Akerloff and Romer (1993).

Liability extension

• More and more in the U.S. and in Europe, the central planner attempts to diversify risk among different stakeholders in order to reach economic efficiency.

• Joint liability: Sharing risk may allow reducing it and/or implement very risky industrial activities.

• In case of insolvency, four types of solutions are possible:

‒ Regulating firms’ behavior. The regulator needs to have perfect information on the firms’ activity.

‒ To impose a mean obligation onto risky firms through the obligation of a minimum social capital. Once again, strong informational requirements.

‒ Compulsory insurance (Laffont, 1998): But very few policies are available due to important moral hazard. Collusion (through non-satisfied clauses) is also possible.

Liability extension

‒ Extend liability to external economic partners (the principal):

oConcept of deep pocket on the principal’s side.

o The principal may be able to monitor the risky behavior of the agent responsible for the damage.

o Industrial partners: In case of subcontracting, the principal is the payer. The capital stock involved is higher in this case.

oCreditors: In Europe, the Lugano convention envisions the possibility that banks may be liable in case of damages produced by firms in which they have a financial participation. • Optimal contract between a bank and a firm in a context of asymmetric

information may guarantee that the incentive effects of the liability work.

• Potential adverse effects (next slide).

Liability extensionCreditors: Adverse effects

• An extension of the liability toward banks may have adverse effects.

• Increases the cost of financial loans and hence reduces the number of realizations of viable projects.

• Trade-off between equity and efficiency (Pitchford, 1995): The liability extension increases indeed the probability that the victims get fully reimbursed, but it also increases the probability of accident.

• Firms are less incentivized to exert effort.

• The bank should not be fully liable (Boyer and Laffont, 1997).

• Potential solution: Full liability of shareholders. If the assets of a firm are insufficient to satisfy its liabilities, victims should be entitled to enforce their judgement against the assets of shareholders (Hansmann and Kraakman, 1991).