Usher Political Economy (Blackwell, 2003)

Table 11.1 Efficient percentage of defective stoves as dependent upon the transaction cost of replacement

[At each transaction cost, the lowest average cost of stoves, inclusive of the expected cost of replacing defective stoves, is indicated by*.]

With no transaction cost, with a transaction cost of $200, and with a transaction cost of $600, the efficient percentages of defective stoves are 7%, 5%, and 1% respectively.

the maker to compensate the buyer for the full cost of replacing a defective stove, then the price of the stove becomes $230.51 for which the maker just covers the full cost of production and replacement. Stove-makers would not enter the business at any lower price, and competition among them stops the price from rising any higher. If the law places the full cost of a defective stove on the buyer, the price of a stove falls to $209 which is just sufficient to induce stove-makers to enter the business. Regardless, the cost of a stove to the buyer is $230.51, paid altogether in one case, and in two distinct parts – one part to the stove-maker and the other part as the assumption of risk or as a premium to the insurance company to cover that risk – in the other.

Second, whatever the law requires, the maker and the buyer can contract around the law. If the law holds the maker responsible for defects, but, contrary to what has been assumed so far, the transaction cost is lower for the buyer than for the maker, a clause exempting the maker from responsibility could be included in the contract of sale. Or if the law holds the buyer responsible for defects, but the transaction cost is lower for the maker than for the buyer, a clause requiring the maker to bear the full cost of defects could be included in the contract of sale. Regardless of the letter of the law, the market would seek out the lowest average cost, all things considered.

This example is useful as a starting point for discussion of the law of liability because it abstracts from the reasons why the law is important, allowing those reasons to be introduced and examined one by one. Before beginning this inquiry, it should be noted the

market does more than assigning responsibility for defects. The market also determines the optimal percentage of defects when a reduction in the percentage of defects is feasible but costly. Optimality in this context is defined unambiguously as whatever serves to minimize the full cost (paid one way or another by the user) of a working stove. There is a unique cost-minimizing percentage of defects, and the market supplies that percentage automatically regardless of who – the maker or the buyer – bears the legal responsibility for defects.

To establish this proposition, it is necessary to give the maker a choice between a larger and a smaller number of defects. The cost of production has to increase as the percentage of defective products declines, for otherwise it would be in nobody’s interest to make products that are less than completely defect free. Suppose the relation between the percentage of defective stoves and the cost of production is as shown in the first two columns of table 11.1. It would cost $244 per stove to make stoves that are entirely defect free. It would cost $199 per stove to make stoves that are 10 percent defective. As shown in the third column, there is a steadily rising cost of reducing the percentage of defective stoves. Stove-makers would never allow more than 9 percent defects because it costs nothing to reduce defects from 10 to 9 percent. Thereafter, the cost of reducing the percentage of defective stoves increases steadily from $1 per stove to reduce the rate of defects from 9 to 8 percent, all the way up to $9 to reduce the rate of defects from 1 percent to nothing. The efficient proportion of defects minimizes the expected average cost of a working stove, inclusive of the cost of production and the expected cost of replacement.

As shown in table 11.1, the efficient rate of defects depends on both the cost of production and the transaction cost of replacement. The last three columns of the table show expected average cost, in accordance with equation (1) above, with no transaction cost, with transaction cost of $200 (as assumed in the example above) and with transaction cost of $600. In each column, the lowest average cost is indicated by . It turns out that the efficient percentage of defects is 7 percent in the absence of transaction cost, 5 percent when the transaction cost is $200, and 1 percent when the transaction cost is as high as $600. Transaction cost could be high if, as might well happen, a defective stove causes an accident, perhaps a fire, that is more costly than the stove itself. In the circumstances of table 11.1, risk is like an ordinary commodity. The market churns out a quantity and price of risk, just as it churns out quantities and prices of bread and cheese.

The stove example is intended to be representative of a large class of mishaps including accidents as well as faulty products. Care by one party affects the risk of misfortune to another. The driver of a car is killed when the gas tank of his car explodes in a collision, and the heirs of the driver sue the manufacturer of the car, claiming that extra expenditure on strengthening the gas tank would have prevented the explosion. Producers of asbestos are sued when it is discovered that asbestos insulation of houses causes the occupants to become ill. Tobacco companies are sued by smokers dying of lung cancer. A customer at a restaurant accidentally overturns a cup of coffee, is scalded and sues the restaurant because the coffee was too hot. In these cases, the law must assign the cost of the harm, leaving it with the ultimate victim – the person whose stove has to be replaced, the person burned up in his car, the person whose house is insulated with asbestos, the person dying of lung cancer, the person scalded

by hot coffee – or reassigning the responsibility and the cost of the harm to somebody else who must then compensate the victim.

In the latter case, the law has two principal objectives which sometimes fit together nicely and sometimes conflict. The law is intended to “make the victim whole” and to induce the efficient, cost-minimizing level of care by the perpetrator of the harm. The ultimate objective in making the victim whole is to substitute publicly enforced compensation for private retribution. In ancient times, clans defended themselves from one another, an eye for an eye and a tooth for a tooth because a clan not prepared to reciprocate injury would be victimized and exploited. Such primitive justice might be no worse than contemporary civil law if the parties could agree on the appropriate restitution. Otherwise, private vengeance could escalate into feuding, where each party believes himself to be victimized by the other and the initial harm is multiplied without end. The civil law provides a remedy for harm and, what is more important, a termination to private disputes.

In the stove example, both objectives of the law are obtained simultaneously, regardless of where the legal responsibility for accidents is assigned. The price mechanism can be relied upon to supply the efficient level of care as long as it is clear to everybody either that the stove-maker is obliged to compensate the buyer in the event a purchased stove is defective or that the stove-maker is exempt from responsibility. Making the victim whole is somewhat more complex, for the designation of the buyer as “victim” depends on the original understanding between the buyer and the seller. The buyer of a defective stove becomes a victim if and only if there was an understanding that the stove would be in good working order. The buyer would then need to be made whole (supplied with a new stove) as the law requires. On the other hand, the buyer could hardly be considered a victim if he understood and agreed to bear the risk as part of the sale. The buyer of a stove is no more victimized in that case than is the buyer of a stock which subsequently falls in price.

In practice, the two objectives of the law do not always fit so well together, and the efficiency of the market may be conditional on the assignment between buyer and seller of responsibility for defects. The real purpose of the stove example is as a foil for identifying reasons why one legal regime might be preferable to another. The example is based on simple assumptions, and reasons why the law might assign liability for harm from defective products to the buyer or to the maker as the case may be (and why the principle of caveat emptor has gradually been overturned), emerge as these assumptions are relaxed and as special features of the market for risky products are introduced. These special features may be described under the headings of damages, adjudication, observability and fault, which will be discussed in turn.

Damages

The cost of replacing a defective stove was assumed to be known indisputably by the maker, the buyer and, if necessary, the courts. The world is not always like that. A person is injured by a defective stove, an exploding car, the spilling of an excessively hot cup of coffee, or misinformation by tobacco companies that induced him to smoke when he would not otherwise have done so. Medical expenses can probably be assessed

with tolerable accuracy, though doctors may be inclined to bill generously when they know the patient will be reimbursed. Pain and suffering are immensely more difficult to evaluate. The victim may claim – and the claim may well be true – that no amount of money, however large, would compensate him for his injury or induce him to accept the injury voluntarily. The court must choose a figure if the victim is to be compensated, but the derivation of the figure is often mysterious. Perhaps the appropriate procedure is for the courts to give up trying to make the victim whole, and to concentrate instead on inducing the perpetrator of the harm to exercise optimal care. Regardless, the court’s estimation of harm cannot be other than subjective, varying from one judge to another or upon the whim of the jury.

Injury resulting in death is especially problematic. Obviously, the victim cannot be made whole. Heirs or dependants may be compensated instead, but the amount of compensation deemed appropriate by the courts may differ from the amount of compensation required to induce optimal care by potential injurers, and there would be nobody to compensate if the deceased had no heirs or dependants at all. The potential victim may not want to be compensated. It was supposed in the stove example that the cost of a defective stove is the original price plus a transaction cost. Suppose instead that there is a tiny risk of a stove blowing up and killing its owners. If the risk is small enough, people might still buy stoves. Not being around to collect compensation, buyers might prefer a legal regime where the manufacturer is not held responsible for defects. Compensation in the event of accidents might add significantly to the price of stoves. Trusting in competition among stove-makers to force the price of stoves down to the average cost (inclusive of the expected cost per stove of compensation in the event of accidents), the buyer may prefer a lower price without compensation for his heirs and dependants to a higher price when the law requires that compensation be paid. The example is not as fanciful as it may appear. Workers in very dangerous jobs, such as extinguishing fires in oil rigs, may prefer to earn high wages if they survive than to be compensated vicariously if they do not. Typically, such workers would be men without dependants trying to build up a stake. For obvious reasons, such workers would have to be knowledgable enough about their business to be sure their employer is taking appropriate precautions for their survival.

Adjudication

Uncertainty about the magnitude of damages generates substantial legal costs over and above the other costs of defects or accidents. My stove explodes, causing some property damage and some injury. If the law exempts the maker from responsibility, I bear the full cost of the accident, whatever it turns out to be. If the law requires the maker to compensate me for the damage, then a dispute typically arises about the magnitude of the harm. I claim damages of $200,000. The maker recognizes damages of only $50,000. Society requires a mechanism for resolving the dispute. That mechanism is the civil law. I, the plaintiff, sue the maker for $200,000. The maker of the stove, as defendant, claims the harm to be no more

than $50,000. A judge or jury has to decide between us, specifying the appropriate award in this case. The maker and I each hire lawyers who, between them, use up a significant proportion of the $150,000 in dispute. The combined cost to us of the two lawyers and to the state for conducting the trial would typically be about half the money in dispute, but could in some circumstances eat up the surplus entirely.

Suppose, for instance, that the gap between claims is $150,000, that each party’s legal fee in the event of a trial is $50,000, and that each party has a 50 percent chance of winning his suit (where, for simplicity, there is assumed to be no chance of an intermediate verdict with, say, two-thirds of the sum under the dispute to me and one-third to the maker of the defective product). The legal fees can be avoided if one party backs off, but neither party does so because there is an expected gain from going to court. Each party’s expected gain from the trial would be $25,000 (50 percent of $150,000 less legal fees of $50,000). In these circumstances, there would be room for a deal. Parties to the dispute may bargain in the shadow of the law. For both parties, the bargain must be preferable to a trial. I must receive something more than $75,000 (the sum of the stove-maker’s initial offer and my expected additional gain from going to trial). The stove-maker must pay me no more than $175,000 (the difference between my initial demand and his expected saving from going to trial). For instance, the stove-maker might agree to pay me $125,000, which is half way between my claim of $200,000 and the maker’s claim of $50,000, to avoid the trial. That would be mutually advantageous, but such a bargain is not always negotiated. The parties may disagree about the division of the surplus. Knowing that the maker will offer to split the difference, I may raise my initial claim for damages above what I know the true damages to be. Or the maker may hang tough, doing whatever he can to raise my cost of litigation to deter future claims. Tobacco companies are alleged to have adopted this “General Patton” strategy to deter claims for compensation for illness associated with smoking. Cases do go to trial, and trials are expensive. By itself, this consideration points to the principle of caveat emptor placing liability for harm upon the buyer rather than upon the maker.

Observability

To demonstrate that the market supplies the “correct” percentage of defective stoves, it was necessary to assume that the buyer of a stove knows how careful the stovemaker has chosen to be. With a transaction cost of $200 and an efficient percentage of defective stoves of 5 percent, the buyer pays an expected $230.51 for a working stove. He pays that all at once if the law or a privately arranged contract requires the stove-maker to cover the full cost of defects. He pays that in stages – $209 for the stove itself and the rest as the expected cost of defects – if the law or a privately arranged contract places responsibility for the replacement of defective stoves upon the buyer rather than upon the maker. In either case, the buyer’s expected cost is the same.

These two legal regimes cease to be equivalent when the buyer does not know how much the maker has spent to control the percentage of defects. Nothing changes if

the maker is held responsible for defects because the full expected cost to the maker is entirely independent of what the buyer does or does not know at the moment of sale. As before, the maker has every incentive to choose the percentage of defects to minimize the expected average cost per working stove. But if the maker bears no responsibility for defective stoves and if the buyer cannot tell at the moment of sale how careful the maker has been, then the maker has no incentive to bear any cost over and above the minimum cost of production. Referring to table 11.1 above, the maker spends $199 to produce a stove with a rate of defects of 9 percent. Competition among stove-makers reduces the price to $199 as well. The buyer is now worse off than he would be if the maker were liable for the full cost of replacing defective stoves or if the percentage of defective stoves could be observed at the moment of sale. He pays less for a new stove ($199 rather than $209), but the full cost of a working stove rises from $230.51 to $238.46.

As nobody gains from the buyer’s inability to observe the quality of the product, a maker of stoves will do what he can to supply or compensate for the missing information. He may provide a warranty on his product, in effect converting the regime from one where the buyer bears the cost of defects to one where the seller bears the cost of defects. The maker may “brand” his product so that in time buyers will come to know its quality. He may seek to establish a reputation for quality by advertising which may or may not be mendacious or misleading.

Failure of the buyer to observe the percentage of defects would seem to call for a legal regime where responsibility for defects lies with the maker, but it may not matter very much what the law requires because the maker, in his own interest, has an incentive to supply the missing information or to contract around the law, taking upon himself the obligation to compensate the buyer for defects. On the other hand, when differences in quality among products are more subtle and diverse than the mere percentage of defects, the maker’s strategies for conveying information may be less successful. Problems of identifying damages, adjudication and observability intersect when there is some question about whether a product conforms to any given standard.

Fault

The word “defective” loads the dice against the maker, conveying the impression that he alone is responsible for defects. That was implicit in the example in table 11.1 where the probability of the stove being defective depended entirely on the maker’s expenditure and not at all on how the stove is used by the buyer. Many situations do not conform to that pattern at all. A well-made stove may malfunction if used carelessly. A less-than-perfect stove may or may not cause harm depending on how careful the user turns out to be. Loss of machinery in transit due to the carelessness of the shipper may cause a larger or smaller loss of profit to the manufacturer depending on whether the manufacturer keeps spare parts in inventory. Accidents with ladders typically have more to do with how ladders are used than with how they are made. In general, the risk of harm depends upon how carefully a product is used as well as upon how carefully a product is made. A given accident may not have occurred

if either the maker or the buyer had been “appropriately” careful, where appropriate is whatever combination of care by the maker and care by the user would have been agreed upon as part of the sale if such an agreement could be monitored and enforced.

There is a dilemma here. If the maker’s care were somehow arranged to be appropriate, then the buyer’s care could be rendered appropriate too by requiring the buyer to bear the full cost of accidents or mishaps. Similarly, if the buyer’s care were somehow arranged to be appropriate, then the maker’s care could be rendered appropriate too by requiring the maker to bear the full cost of accidents or mishaps. (The latter case was, in effect, assumed in the numerical example by making the risk of a defective stove dependent on the maker alone.) As long as only one party’s behavior need be influenced, the law can exert that influence by deeming that party to be at fault. When accidents depend on both parties’ behavior, the law could, in principle, be designed to minimize the total cost of accidents including the cost of the accidents themselves and of both parties’ expenditure to avoid accidents, but it is often difficult to tell what the best law on that criterion would be. Fitting the law to each and every product and to each and every case would constitute a major abandonment of clear and simple rules enabling people to predict the full consequences of their actions. Sometimes one party can be identified as at fault. Sometimes not. The cost of adjudication when fault is disputed can be considerable.

Adjudication becomes especially messy when a defective product increases the probability of an event that might occur regardless. Suppose that the probability of contracting lung cancer rises from 10 percent if one does not smoke to 20 percent if one smokes, and that misinformation by tobacco companies or the spiking of cigarettes to make them more addictive has raised the incidence of smoking to twice what it would otherwise be, so that one-quarter of all smokers’ lung cancer can be attributed to the actions of the tobacco companies. A smoker dying of lung cancer has no way of telling whether or not his misfortune is the fault of the tobacco company. It seems unreasonable that he should be compensated by the tobacco company for the full cost of his illness, but neither is it reasonable for the tobacco company to bear no responsibility at all. (Consider a more extreme example. Suppose a drug increases the incidence of fatal heart attacks by one per million users. Though a particular user who dies of a heart attack might not have died but for the use of the drug, one would not want to hold the maker responsible for all fatal heart attacks, especially as the drug may actually reduce mortality from other diseases and as substitute drugs may have even greater impacts on the incidence of fatal heart attacks.) The courts could award a fraction of the estimated harm to each possible victim, but courts have not been inclined to act in that way. Typically, smokers who contracted lung cancer have been awarded the full cost of their illness or nothing at all.

Returning to the original problem and pulling these strands together, the case for caveat emptor (exempting the maker from responsibility for defective products) rests on the considerable complication and expense in employing the courts to identify fault and to determine the appropriate compensation. Balanced against this is the loss of incentive for care by the maker when the buyer cannot identify the quality of what he buys. The decline in this century of the principle of caveat emptor and the considerable willingness of the courts, with the concurrence of the legislature, to

arrange compensation for the injured party, may stem from the ever-greater ignorance of the ordinary person about the composition and qualities of the goods he buys. In the nineteenth century, a buyer of a horse or a wagon from the local merchant might be expected to judge quality for himself. In the twenty-first century, the typical buyer of a car, a computer, or a drug produced by a large international corporation has no idea why products work or what dangers lie in their use. Only the automobile manufacturer knows which safety devices are incorporated in the car and which safety devices have been rejected as too expensive.

Murder

All countries punish murder severely. Some countries impose the death penalty. Others impose long imprisonment instead. The choice between these punishments is less susceptible to precise analysis than the choice among rules for product liability, but we need not fall back on the crude supposition that customs are what they are independently of any assessment of the common good. Choice between punishments can, at least in part, be explained with reference to the utility of the citizen.

Long imprisonment was not a serious option until recent times. The Bible sanctioned the death penalty. The Koran sanctioned the death penalty. Every ancient religion sanctioned the death penalty, or accepted it as inevitable. Throughout the world and throughout history until quite recently, every society imposed the death penalty for murder, and, frequently, for many lesser crimes as well. We cannot rule out a priori the possibility that the teachings of all religions and the practices of all societies were mistaken or, perhaps, a manifestation of class-based law that could have been jettisoned in a more egalitarian society, but there are reasons for supposing that those teachings and practices were warranted. In ancient times, when the standard of living was very much lower than it is today, imprisonment for murder would have been prohibitively costly and would have constituted a poor deterrent to would-be murderers whose standard of living in prison could not have been much below their standard of living on the outside if they were to survive in prison at all. By comparison with the death penalty, imprisonment would have been so costly and would have deterred so few murders that no reasonable person, however squeamish or kind-hearted, could suppose imprisonment to be the better option.

The balance of considerations is different today. A diversity of practice not noticeably connected to differences among countries in the standard of living suggests a diversity of criteria which may be weighted differently by different people. An important aspect of the problem will for the moment be swept under the rug. Not all murders are equal in the eyes of the law, and sentencing is meted out accordingly. When murder is punished by imprisonment, the term may be long or short depending on the circumstances of the crime. When courts may choose between imprisonment and execution, the latter is typically reserved for the most heinous murders. Ignore such considerations. To focus the analysis, suppose all murders are alike and must be punished identically. Society must choose between punishment by execution and punishment by imprisonment for a fixed number of years. The principal criteria for this choice are as follows.

Deterrence

Deterrence is forward looking. It is the punishment of crime today as a signal to the would-be criminal that he will be punished for similar crimes tomorrow. A law deters when the crime rate is reduced. On this criterion, the best law is whatever serves to minimize the incidence of crime. If the incidence of crime is not reduced, then punishment would not be warranted at all, as, for instance, when the perpetrator of a crime does not know right from wrong. Throughout history, the minimization of the number of murders has been the overriding objective of the law of murder, but the superiority of the death penalty on this criterion is probably less pronounced now than formerly. As mentioned above, imprisonment has become more affordable and more of a deterrent with the widening of the gap between the quality of life in prison and outside. At the same time, the efficacy of the death penalty in containing the number of murders may diminish because the standard for proof of guilt is higher in practice when the punishment is more severe. Judges and juries are expected to convict the accused if they believe him guilty “beyond reasonable doubt.” Doubt deemed reasonable when punishment is by imprisonment may, in practice, be deemed unreasonable when punishment is by execution, for imprisonment may be reversed if new evidence eventually reveals the verdict to have been mistaken. In the mind of the would-be murderer, the lower probability of conviction may outweigh the higher penalty, reducing, if not eliminating, the extra deterrence of the death penalty over and above imprisonment. Unlikely to have been of great significance in the distant past, this consideration may be of some importance now. It is said that in the early nineteenth century, the death penalty was abolished for minor crimes because juries simply refused to convict. A similar process may be at work today in the law of murder.

Considering deterrence alone, apart from other aspects of the law of murder to be discussed below, the death penalty is preferable to long imprisonment if

where MD is the number of murders committed when murder is punished by execution, and MI is the number of murders committed when murder is punished by long imprisonment.

Punishing the innocent by mistake

Like all human institutions, the legal system works imperfectly. Diligent and honorable scientists cannot guarantee that space probes never fail. Diligent and honorable agents of law enforcement – police, prosecutors, judges, and juries – cannot guarantee that no innocent people are wrongfully convicted of crime. Meticulous care by the police and by the courts reduces the risk of wrongful conviction, but it is beyond the capacity of fallible people to eliminate wrongful conviction altogether. Imprisonment has two advantages over the death penalty: the harm to the innocent is less, and the punishment is reversible if evidence after the trial establishes that a person was convicted by mistake. On the other hand, there may be fewer wrongful convictions with the death penalty

than with long imprisonment. The stronger the deterrent, the lower the incidence of crime and the smaller the number of wrongful convictions as well. Considering wrongful convictions alone and abstracting from all other aspects of the law of murder, the death penalty is preferable to long imprisonment if

where WD is the number of wrongful convictions when murder is punished by execution, WI is the number of wrongful convictions when murder is punished by imprisonment, βD is the “cost” per wrongful conviction when murder is punished by execution, and βI is the cost per wrongful conviction when murder is punished by imprisonment.

The “cost” of wrongful conviction has a family resemblance to the value of life in cost–benefit analysis. Your cost of wrongful conviction is 1,000 times the amount of money you would be prepared to pay to avoid a 1 in 1,000 chance of being wrongfully convicted. Typically, if not invariably, βI < βD, signifying that you would rather be wrongfully imprisoned than wrongfully executed, especially as wrongful imprisonment may be terminated if new evidence comes to light. Ordinarily, WD < WI, signifying that fewer people would be wrongfully convicted under the death penalty than with imprisonment, for fewer murders would be committed. Thus, it is uncertain whether or not βDWD < βIWI. The inequality may have held until recently because the death penalty was a sufficiently greater deterrent, but it may be reversed today.

Punishing the guilty

It is this aspect of the law of murder about which people differ most sharply. Two extreme views can be described as deterrence and vengeance. The discussion of deterrence above took no account of the murderer himself. When the welfare of the murderer is considered, one might define pure deterrence as the minimization of the number of violent deaths, treating murderers and victims equally in the calculation. Ignoring the discomfort of imprisonment as well as the cost of detection and punishment, the sole purpose of the law of murder would be to minimize the number of violent deaths, at the hands of murderers or at the hand of the state. On this criterion, equation (2) above would be transformed into equation (4), indicating that the death penalty is preferable to long imprisonment if and only if

where GD is the number of people found guilty of and executed for murder. Pure deterrence recognizes no distinction between the murderer and his victim; the death of the innocent is neither more nor less undesirable than the death of the guilty. Once again, the criterion could justify the death penalty if the death penalty is very much more efficacious than long imprisonment.

Though vengeance and deterrence interact, pure vengeance is unconcerned about the incidence of crime. Pure vengeance looks to the crime that has been committed yesterday rather than to the prevention of crime tomorrow. It is a cry for justice from