The Welfare Implications of Costly Litigation for the Level of Liability

Abstract

The central concern of the economic theory of liability is how to induce an injurer to take the socially appropriate level of care-the level that minimizes the sum of the cost of taking care and the losses to victims. An important result in this theory is that, assuming litigation is costless, the rule of strict liability with compensatory damages leads the injurer to choose the appropriate level of care. This follows because, under strict liability with compensatory damages, the injurer's problem—minimizing his cost of care plus his cost of liability—is identical to society's problem. The analysis of strict liability with compensatory damages is affected in two ways when litigation costs are taken into account. First, it is no longer true (as was implicitly assumed in the preceding argument) that whenever a victim suffers harm he will sue the injurer; only victims whose losses exceed their cost of litigation will sue. This difference could lead the injurer to take less care (because he will not have to pay for all of the losses he causes) or more care (because, by reducing the harm suffered by victims, he can reduce the number who sue). Second, the social problem now becomes one of minimizing the sum of the cost of care, the losses of victims, and the cost of litigation. With these changes, it may no longer be desirable to set the level of liability equal to the victim's loss. This article analyzes the socially optimal adjustment to compensatory damages when litigation is costly. It will be shown that strict liability with compensatory damages generally results in the injurer choosing an inappropriate level of care and in the parties incurring excessive litigation costs. Thus, it is not socially optimal to use compensatory damages. Whether compensatory damages should be adjusted upward or downward will be seen to depend on the effect of changes in the level of liability on the injurer's incentive to take care and on the victims' incentives to sue. The possibility that the optimal adjustment to compensatory damages is positive can be illustrated by a simple example involving one injurer and one victim. Suppose there are only two levels of care that can be chosen by the injurer—“low care” and “high care.” If the injurer takes low care, the victim's loss is $700, while if the injurer takes high care, the victim's loss is $500. The extra cost to the injurer of taking high care is $100. Thus, ideally, the injurer would take high care. Also, let the victim's cost of litigation be $1,000 and, for simplicity, the injurer's cost of litigation be zero. First consider whether the ideal outcome-high care and zero litigation costs-can be achieved under strict liability with compensatory damages. Regardless of the injurer's care, the victim will not sue because his loss is less than his cost of litigation. Consequently, the injurer will take low care, and the ideal outcome will not be attained. Now consider strict liability with liability equal to compensatory damages plus $301. If the injurer takes low care, the victim will sue because his loss plus the adjustment exceeds his cost of litigation ($700 + $301 > $1,000). But if the injurer takes high care, the victim will not sue (since $500 + $301 < $1,000). The injurer will choose to take high care because the extra cost of taking high care ($100) is less than his liability if he takes low care ($700 + $301). Since there will then not be any litigation, the ideal outcome will be achieved. The possibility that the optimal adjustment to compensatory damages is negative can be shown by modifying the example slightly. Now assume that the injurer's extra cost of taking high care is $600 and that the victim's cost of litigation is $300. Then the ideal outcome is for the injurer to take low care and, as before, for there to be no litigation costs. Under strict liability with compensatory damages, the victim will sue regardless of the injurer's care; this will lead the injurer to take low care. However, if compensatory damages are adjusted downward by $401, the victim will not sue when the injurer takes low care (since $700 - $401 < $300). Thus, the ideal outcome can be attained by an appropriate downward adjustment. These examples illustrate two general principles. With respect to the injurer's choice of care, adjusting damages upward when the injurer's care would otherwise be too low with compensatory damages, or downward when care would be too high, will increase social welfare. And with respect to the cost of litigation, adjusting compensatory damages downward to reduce the victims' incentives to sue will increase social welfare. The optimal adjustment to compensatory damages takes both of these considerations into account and may be positive or negative. The main points of the article are developed in Section II using a model in which there is a single injurer and a group of identical victims, and in Section III using a model with two groups of victims. (The Appendix shows that the results of Sections II and III hold more generally.) In Section IV the same framework is used to study the rule of negligence. Section V contains some concluding remarks.

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