Internalization of costs, liability and negligence, performance and reliance
The Authors
Demetri Kantarelis, Assumption College, Worcester, Massachusetts, USA
Abstract
Purpose – The purpose of this paper is to discuss incentive mechanisms and procedures for cost internalization by both potential defendants and plaintiffs.
Design/methodology/approach – The approach taken is to rely on the concepts of liability, negligence, precaution and methodologies for estimation of compensatory damages in conjunction with the Coase theorem.
Findings – The paper finds that the decision to internalize and minimize cost depends upon marginal precautionary costs and marginal expected harms.
Research limitations/implications – Research needs to be conducted from a law and economic perspective on developing procedures for estimating precautionary costs and expected harms.
Practical implications – This paper calls upon business firms and their stakeholders (primarily employees and customers) to use and pro-actively manage their precautionary responsibilities and further refine the existing formulas. More specifically, it aims to help law and economics students as well as practitioners in law and regulation to better understand the implications of marginal precautionary costs and marginal expected harms in the process of cost internalization.
Originality/value – In exploring the precautionary responsibilities of firms and their stakeholders, this paper contributes to a better understanding of liability and negligence issues and, as a result, to the important intersection of law and microeconomics.
Article Type:
Research paper
Keyword(s):
Liability; Negligence; Damages; Law; Microeconomics.
Journal:
International Journal of Law and Management
Volume:
50
Number:
6
Year:
2008
pp:
274-284
Copyright ©
Emerald Group Publishing Limited
ISSN:
1754-243X
1. Introduction
According to competitive market principles, allocation efficiency is achieved when costs of products and services offered in markets are born by producing firms and are included, entirely, in selling prices; in other words, maximum efficiency gains are realized when producers internalize all costs. If producers externalize a portion of their costs, they would: be able to produce more (perhaps excessively); withhold incentives for R&D necessary for production process and physical capital innovation; sell at lower prices; encourage wasteful use of their products; discourage recycling; cause pollution, health problems, and wrongful accidents in the work place and in the outside stakeholder community. Needless to say that internalization of costs may be practiced not only by producers but, in a contributory fashion, by their stakeholders as well.
Of course, as it has been demonstrated by Coase (1960) when transaction costs are zero or negligible, the business firm may rely on clearly defined property rights and/or contracts (credible commitments) to deal with the violation of property and safety rights or, in other words, the internalizing of external costs between it and its various stakeholders. (See the Appendix for a description of Coase's invariance theorem.)
When transaction costs are high, the business firm would have to rely on tort liability laws. According to Cooter and Ulen (1996, p. 262), “the economic essence of tort law is its use of liability to internalize externalities created by high transaction costs”. A tort is a “wrong” committed by the firm against its stakeholders (or vice-versa) and it may range from inadvertent to deliberate, from severe to insignificant, from crime to irritation. For more on torts and liability laws see Brown (1973), Calabresi (1970), Posner (2007) and Shavell (1980, 1987) (for definitions and examples see: www.psychservices.psychiatryonline.org/cgi/content/full/51/6/817-a; www.the-injury-lawyer-directory.com/negligence.html; www.contributorynegligence.org/).
In the remainder of this paper, I assume that a business firm is the defendant responsible for precautionary safety in the workplace, and an employee, working for the firm, is the plaintiff. Would the firm (employee) have the incentive to provide (undertake) sufficient precaution? To answer this question, I rely on simple marginalist economics concepts and popular legal rules and compensation formulas. More specifically, I discuss incentive mechanisms for internalization of costs in conjunction with the well-known concepts of liability, negligence, precaution and methodologies for estimation of compensatory damages. The paper's contribution is pedagogical in nature; with torts’ examples and reliance on the Coase theorem it aims to help law and economics students, as well as practitioners in law and regulation, to better understand the implications of various internalization schemes. In section 2, I deal with liability/negligence rules and in section 3 with methodologies for estimation of compensatory damages; a summary/conclusion and an appendix follow thereafter.
2. Liability and negligence
Precautionary measures (PC) may range from physical to various services and from medical to procedural. Precaution (undertaken by the firm or its employees) is an input in short supplies and, as such, it carries a cost; it also carries a benefit for all involved because the more of it becomes available the lower the expected harm. Naturally, the more precaution there is, the higher the costs that have to be paid by the provider, the lower the probability of harm and, as a result, the lower the expected harm. Hence, “society” is burdened by two costs: outlays for PC and payments for damages or harms.
Let MPC = marginal precautionary costs, MEH = marginal expected harms and S = level of precaution. Where, MPC = f(S) with f S > 0; and MEH = g(S) with g S < 0. These “f” and “g” functions (which may be linear or non-linear) are graphed in Figure 1. In conjunction with Figure 1, consider the following tort rules:
2.1 Rule of no liability
According to this tort rule, the firm is not liable for accidents in the work place; it has no obligation to offer any precaution over and above S 1, the “costless” minimum possible.
At S 1, the firm's total precautionary costs (TPC) equal zero and the total expected harms (TEH) to employees correspond to the area S 1 e 1 S 2. Hence, under this rule, the expected social cost of torts, E(T), is: (Equation 1)
2.2 Rule of strict liability
According to this tort rule, the firm is strictly liable. Employees have no obligation to pay for any costs associated with accidents in the work place as long as the firm offers no less than S 2, the maximum possible level of precaution, characterized by zero marginal (and total) expected harms.
At S 2, the firm's TPC = S 1 e 2 S 2 and the employees’ TEH equal zero. Hence, under this rule, the expected social cost of torts is: (Equation 2). Comparing (1) to (2) it is obvious that the firm would prefer the rule of “No Liability” and employees the rule of “Strict Liability”. Under “No Liability”, the firm has no incentive to introduce any PC; it passes on the cost – it imposes an externality – to its employees. Under “Strict Liability”, the employee has no incentive to undertake any precaution in the work place, the firm, in this case, internalizes all costs.
2.3 Rule of bilateral liability
Obviously, neither one of the above rules contributes to efficiency. A precaution level such as S* (achieved through a rule of bilateral liability) would be less costly to society; notice that at S*, (Equation 3).
Of course, bilateral liability is easier said than done: neither of the sides would have the incentive for efficient precaution; each, instead, would have the incentive to externalize to the other as much precautionary cost as possible. A possible way out of it is to establish legal standards and then, as explained below, rely on various negligence rules.
2.4 Rule of negligence
Suppose the legal or regulation authorities have determined that the precaution standard is identical to the efficient precaution level of S* in Figure 1. If the firm offers S ≥ S*, it is not liable for any compensation whatsoever; if it offers S A < S* it is liable for the compensation that corresponds to the difference (S* − S A).
If the firm chooses to operate at S A, in other words not to comply with the law, it will save for itself (S*e*A 1 S A) but it would have to pay a compensation of (S*e*A 2 S A); because, in absolute value, the gain is less than the loss, the firm would have the incentive to comply at S*. Naturally, unless the firm derives benefits associated with reputation, altruism and the like, it may not find it rational to expand precaution above S*.
Of course, it is possible that injury in the work place is not due to negligence by the employer but due to lack of precaution by the employee. To minimize this problem, in addition to a precautionary standard imposed on the firm (S*F), authorities may impose a precautionary standard on employees (S*E) as well. Hence, in this case negligence may be modified as follows:
2.5 Rule of contributory negligence
2.6 Rule of comparative negligence
(see equation 6)Whatever each one of the entities pays is determined by the differences between standards and actual levels of precaution. Hence, the negligent firm's proportion of liability is: (Equation 7) the negligent employee's proportion of liability is: (Equation 8)
2.6.1 Hypothetical illustration
Consider the following hypothetical illustration. Suppose a construction firm is building a multi-story structure; the firm is required to construct a canopy to protect the ground workers from falling debris and all workers are required to purchase and wear helmets. (Perhaps the firm does not make such helmets freely available to workers because of union regulations or because it wants its workers to have the incentive to undertake precaution in the work place over and above whatever precaution the firm itself may offer.) The canopy that satisfies the legal standard costs $50,000 but the firm, instead, installs a $30,000 canopy. Therefore, the extent of the firm's negligence is ($50,000 − $30,000) = $20,000.
A ground worker chooses not to wear a high quality $90 legal standard helmet but, instead, a $50 sub-standard one and, one day, she suffers a “repairable” head injury by falling debris. Suppose, it has been determined, based on historical data, that the high quality $90 helmet reduces the likelihood of “repairable” head injuries by (1/800) which implies that the implicit “standard value of a head injury repair” (V) is V = 90/(1/800) = $72,000. ($72,000 may be the amount needed, more or less, for medical expenses or compensation.) The worker could have purchased the high quality legal standard helmet, or even pay more for one of higher quality; instead, she opted to go (gamble) with a sub-standard helmet with a value of V = 50/(1/800) = $40,000. Therefore, the extent of the worker's negligence is ($72,000 − $40,000) = $32,000. By making the choice to go with a lower value helmet, the worker is negligent against herself. Dividing all numbers by 1,000 and comparing, the negligent firm's proportion of liability is:(see equation 9)the negligent worker's proportion of liability is:(see equation 10)Comparative negligence has been criticized over the difficulty of computing proportions of liability. As the above hypothetical example illustrates, entities and legal authorities may have to rely on probability estimates from experimentation, collection of data without guarantee of certainty and deal with high administration costs. Additionally, if the disputing parties are not engaged in the same activity then it is more difficult to determine exact percentages of fault; litigants, in this case, would have to absorb high transaction costs due to prolonged negotiations, hostility, unreasonable behavior, politics and so on. At the end, the efficiency gains from a correct allocation of fault proportions may be outweighed by administration, transaction and other costs.
2.7 Rule of strict liability with contributory negligence
This rule assigns the cost of unintentional injury to the firm (the injurer), regardless of its level of precaution, unless the employee (the injured) is liable: (Equation 11)
3. Methodologies for estimation of compensatory damages
Although the liability and negligence analysis above centered on the firm and its employees, it was mentioned that similar disputes might arise between the firm and any of its stakeholders. The firm often is subjected to liability or negligence ranging from product and/or service to loss of human life for which an important aspect of litigation is the choice of methodology for estimation of compensatory damages.
For market products with substitutes, firms may rely on the indifference method to compute damages. For this method to work, the “victimized” client must be indifferent between the product/service offered by the “injuring” firm and a similar product/service offered by another firm. Hence, the liable or negligible firm may perfectly compensate the client so that she uses the money to buy a substitute product/service from another firm in the market.
3.1 Optimal commitments to performance and reliance[1]
A deal between entities X and Y may induce both to invest. If X is the promisor and Y the promisee, X may invest in performing and Y in reliance upon the promise. To illustrate, consider a deal for renovation between X (a building construction company) and Y (the owner of a hospital building in need of renovation and extension.) To fulfill the promise, X may have to invest, in advance, in specific construction equipment, which it does not currently possess. In anticipation of the final project, Y may invest, in advance as well, in additional medicine service inputs ranging from human (hiring doctors, nurses and administrators) to physical (purchasing computers and special machinery for medical procedures.) Obviously, X and Y would be fully interdependent upon each other and the possibility of breaching would motivate them to consider possible compensation remedies with different incentive implications for investments in performance and reliance. In the end, the promisor and the promisee should include optimal commitments to performance and reliance. Optimality, of course, requires accurate estimation of damages and it may involve third parties such as private arbitrators, courts or even government representatives.
Damages, paid by the promisor, may be computed on the basis of:
- Perfect expectations.(These damages leave the promisee indifferent between performance and breach);
- Perfect reliance.(These damages leave the promisee indifferent between no deal and breach);
- Perfect opportunity-cost (OC).These damages leave the promisee indifferent between breach and performance of the best alternative deal. (Similarly for damages paid by the promisee).
For example, consider the builder/hospital entities used for illustration above in conjunction with Figure 2. The builder may deliver a building ranging from dysfunctional (0) to perfectly functional (100 per cent) and damages may be computed subject to three possible indifference curves: perfect expectations (E), perfect reliance (R), or perfect OC. Each indifference curve connects a set of combinations that have the same utility; each combination corresponds to a certain dollar figure on the vertical axis and the corresponding percentage functionality of the building on the horizontal axis.
First, assume that the deal between X and Y requires perfect expectations damages, in other words the possibilities associated with curve E. If the builder delivers a 100 per cent perfectly functional building, the hospital owner would be happy and there would be no basis for remuneration. But if, in the end, the building were only 25 per cent functional, the hospital owner would be equally happy only if, in addition, it receives a $20 million compensation for damages from the builder.
Second, assume that, prior to renovation, the building's functionality is 50 per cent and that the deal between X and Y requires perfect reliance damages, or the possibilities associated with curve R. If the builder delivers a 50 per cent functional building (as it used to be prior to the deal), the hospital owner would be happy and there would be no basis for remuneration. But if, in the end, the building were only 25 per cent functional, the hospital owner would be equally happy only if, in addition, it receives a $9 million compensation for damages from the builder.
Third, assume that the hospital owner, instead, could have hired a competing builder who would have renovated the building for 80 per cent functionality. In this case, the deal between Y and X requires that if X does not deliver at least 80 per cent functionality, Y is entitled to remuneration. Thus, the deal between X and Y requires perfect OC damages, or the possibilities associated with curve OC. If the builder delivers an 80 per cent functional building (as the competing builder would do prior to the deal), the hospital owner would be happy and there would be no basis for remuneration. But if, in the end, the building is only 25 per cent functional, the hospital owner would be equally happy only if, in addition, it receives a $17 million compensation for damages from the builder.
In addition to the above compensation schemes, the dealing parties may consider, among other: restitution (it requires that the promisee receives back what it gave to a breaching promisor for the deal – for example, a down payment); and disgorgement (compensation received by the promisee equal to the profit made by the promisor for misconduct – for example, promisor X promises to deliver a service to promisee Y but instead it delivers the service to someone else.)
3.2 Risk-equivalence
Of course there are “goods” for which there are no markets for substitutes. For example, for injuries involving loss of life or a limb, compensation would be difficult to estimate and most of the time the estimated amounts are far from perfect either in favor or against the plaintiff (defendant.) Despite the difficulties though, legal institutions have to award damages for wrongful death or for grievous personal injuries. A method often used (conceptually easy but practically complex and controversial) is the method of risk-equivalence, which was just used, in the hypothetical illustration, to demonstrate comparative negligence. It takes actual market sales as a guide to how much the client values safety. For example, suppose that a car buyer purchases a car with anti-lock breaks and pays the asking price plus $X to the seller. If the $X extra expense on anti-lock breaks reduces the likelihood of deadly accident by (P A) then the consumer's valuation of safety, which implies an implicit value of life (V Life) is:(see equation 12)For illustration, if $X = $2,000 and P A = (1/7,000), then(see equation 13)
Hence, if after a deadly car accident, in which only the car/driver owner was killed, it is determined that the death was due to the failed anti-lock breaks (and not due to other causes such as excessive speeding, or driving under the influence of alcohol, etc.) that the driver had paid for, the car manufacturer would be found at fault and would have to pay $14,000,000 in damages for wrongful death to the beneficiaries of the victim.
Undoubtedly, easier said than done: Do probabilities like P A exist? How accurate are they? Does value of life involve other things: lost estimated future income of the victim (another estimate!) and the discount rate to be used, hedonic variables such lost pleasures for the remaining of life, and so on[2].
4. Summary and conclusion
Assuming that a firm is the defendant responsible for precautionary safety in the workplace, and an employee, working for the firm, is the plaintiff, I explored under what conditions the firm (employee) would have the incentive to provide (undertake) sufficient precaution for the purpose of cost internalization. By relying on simple marginalist economic concepts, popular legal rules and compensation formulas the main conclusions may be summarized as follows:
- Internalization of costs may be practiced not only by producers but, in a contributory fashion, by their stakeholders as well.
- When transaction costs are zero or negligible (see Coase), the business firm may rely on clearly defined property rights and/or contracts (credible commitments) to deal with the violation of property and safety rights or, in other words, the internalizing of external costs between it and its various stake holders.
- When transaction costs are high, the business firm would have to rely on tort liability laws.
- Neither “No Liability” or “Strict Liability” contributes to efficiency.
- A precaution level achieved through a rule of “Bilateral Liability” would be less costly to society but neither one of the sides would have the incentive for efficient precaution. A possible way out of it is to establish legal standards of precaution for both parties and then rely on various negligence rules such as contributory and comparative.
- Damages may be computed on the basis of perfect expectations, perfect reliance and perfect OC.
- For injuries involving loss of life or a limb, compensation would be difficult to estimate. A method often used is the method of risk-equivalence, which takes actual market sales as a guide to how much the client values safety.
It is hoped that the pedagogical exercise, that this paper is, would prove helpful to law and economics students as well as practitioners in law and regulation as they endeavor to understand the implications of various internalization schemes for more efficient outcomes. Naturally, a follow up to the exercise undertaken in this paper could be a study of real-world legal cases, preferably from around the world, with the objective to empirically validate or refute the strengths and weaknesses of the proposed incentive mechanisms.
Notes
- Sections 3.1, 3.2 and the Appendix draw heavily from Cooter and Ulen (1996); to fit the purpose of this paper, the analysis differs with respect to examples and other modifications.
- Alternatively, compensation may be based on traditional measurements of benefits and costs subject to inflation rates (p) and controversial – due to subjectivity – discount factors (r) (where r stands for OC.) For example, the option of a lawsuit may be feasible only when (PV B /PV C ) > 1 or when (PV B − PV C ) > 0, where PV = present value, B = benefit (from compensation), and C = cost (from, primarily, legal fees.) Such benefits and costs may be measured as explained below.Measurement of benefits and costs B t = benefit, t = 0, 1, … , T; C t = cost, t = 0, 1, … , T; p = inflation rate; r s = social discount rate; b = real dollars benefit; b t = B t /(1 + p) t (see equation 14) c = real dollars cost; c t = C t /(1 + p) t (see equation 15) Determining feasibility (see equation 16)If (PV B /PV C ) > 1, the option is considered feasible.(see equation 17)If (PV B − PV C ) > 0, the option is considered feasible.
Figure 1Marginal expected harms and marginal precautionary costs
Figure 2Damages based on expectations, reliance and opportunity
Figure A1External costs
Equation 1
Equation 2
Equation 3
Equation 4
Equation 5
Equation 6
Equation 7
Equation 8
Equation 9
Equation 10
Equation 11
Equation 12
Equation 13
Equation 14
Equation 15
Equation 16
Equation 17
References
Brown, J. (1973), "Toward an economic theory of liability", Journal of Legal Studies, Vol. 2 pp.323-49.
Calabresi, G. (1970), The Cost of Accidents: A Legal and Economic Analysis, Yale University Press, London, .
Coase, R. (1960), "The problem of social cost", Journal of Law and Economics, Vol. 3 pp.1-44.
Cooter, R., Ulen, T. (1996), Law and Economics, 2nd ed., Addison-Wesley, Reading, MA, .
Posner, R.A. (2007), Economic Analysis of Law, 7th ed., Hardcover, Aspen Publishers, New York, NY, .
Shavell, S. (1980), "Strict liability versus negligence", Journal of Legal Studies, Vol. 9 pp.1-25.
Shavell, S. (1987), Economic Analysis of Accident Law, Harvard University Press, Boston, MA, .
Appendix. Coase's invariance theorem
Coase (1960) suggested that a solution to the problem of negative externalities due to environmental pollution is not necessary. Assuming that economic agents are free to negotiate – pollutees can pay the polluter to reduce pollution or the polluter can bribe the pollutees to accept more pollution – Coase showed that the same amount of output and pollution would be produced, regardless of which side owned the rights to clean air or water or, in general, property affected. If the polluter owned the right to clean property, the pollutee would pay until the marginal benefit from emission reduction equaled the marginal cost (MC). If the pollutee owned the right to clean property, the polluter would pay until the MC equaled the marginal benefit of less emission. Hence, with zero or insignificant obstacles to bargaining (zero or insignificant bargaining-related transaction costs), the parties involved would reach the same Pareto optimal levels of output and emission. The only dissimilarity would be an equity issue: who pays whom for the right to make use of the property.
Assuming zero transaction costs, well-defined property rights and a perfectly competitive market, Coase's invariance prediction may be illustrated with two entities one of which, the polluter, is a firm and the other, the pollutee, is the entire community. In this case, the firm may impose on the community a negative externality equal to the difference between social marginal cost (SMC) and private MC. The cost associated with this negative externality, may be absorbed by the firm (the firm may internalize the externality) or paid by the community (the community may compensate the firm for investing in “green” production technology.) Obviously, if the firm and the community experience no obstacles in possible negotiations with each other (zero transaction costs) they will reach a more or less equitable compromised agreement regardless of how property rights are initially distributed among themselves. If transaction costs are high, the legal system may be used for the generation of reasonable and enforceable property laws, which in turn will affect the distribution of the externality costs.
Consider Figure A1. The firm produces Q and faces demand (D) which is fixed at the ongoing market product price of P (AR = average revenue and MR = marginal revenue).
Suppose the firm may produce Q with or without emissions. If it produces without emissions, it sets MR = MC to maximize profit at Q* for a maximum profit of aP0. When the firm produces with emissions, the emission cost may be paid in full or in part by the firm itself (in which case the firm internalizes the cost) or by the surrounding community (in which case the firm externalizes the cost.) Consider the following settings involving a polluting firm whose emissions are not deadly.
Setting I: the law does not restrict the firm from polluting.
In this setting, the polluting firm will maximize profit subject to its private MC, sell Q* and realize a profit of aP0; because it is free to pollute, the pollution it causes (the negative externality) will be paid by the community. The community will pay P for Q* plus the difference between SMC and MC or, P + ba. For all units up to Q*, the total externality cost is the triangle 0ba. The community, in this case, may alleviate the burden of the externality cost by subsidizing the firm to install “green” production technology, which may reduce SMC to SMCT. At SMCT, for all units up to Q*, the total externality cost is the triangle 0fa which is less than the previous triangle 0ba. Thus, in this setting it pays for the community to subsidize (or bribe) the polluter to pollute less. The firm ends up with the same profit, the community ends up paying less externality costs and, overall, well-being improves.
Setting II: by law, the community has the right to clean environment.
In this setting, the polluting firm has to internalize the emission cost; in other words, its true MC will be the one designated SMC. Thus, subject to SMC, the firm makes a profit of gP0 and the community, although it still pays P it buys Q 1, which is less than Q*, but it experiences no externality costs whatsoever. In this case, the polluting firm has the incentive to invest in “green” producing technology; such investing will rotate the SMC to SMCT (as in setting I above.) With SMCT, the firm's profit will increase to hP0 while consumers will purchase more output at the same price.
Corresponding author
Demetri Kantarelis can be contacted at: dkan@besiweb.com