The Cato Review of Business & Government
The Cato Review of Business & Government
Paul H. Rubin
Paul H. Rubin is a professor of economics at Emory University and an adjunct scholar at the Cato Institute. Ray Atkins provided research assistance for this article.
The high costs of many goods and services can be traced to misguided attempts by federal regulators and courts to protect the public health and safety. The problems with the courts are especially serious, since they undermine more cost-effective means of achieving that goal.
A principal function of tort law is to deter manufacturers from causing excess harms, or, in the case of medical services, to deter malpractice. But this system has been undermined by unreasonable standards—imposed by the courts—defining parties' liability for damages.
Further, the best alternative means for securing low-cost protection has also been undermined. Before 1960, when parties agreed on an exchange of goods or services, they implicitly, if not explicitly, also agreed on the rules and limitations that would govern any liability for possible injuries. But over the past three and a half decades courts have voided such contracts, reserving for themselves the power to make determinations of liability.
If policymakers wish to lift a burden on the economy as well as provide cost-effective protection for consumers, they must undertake major reforms that restore rational tort law and, most importantly, the rights of contract.
Government intervention in the market is justified only in circumstances where the market can be expected to “fail.” The most common source of market failure is the existence of some externality. An externality is said to exist when a third party, one not directly involved in a transaction, is nonetheless affected by the transaction. The classic example of a negative externality is pollution, where bystanders are harmed by the actions of polluters. Some effort at correction—by establishing or redefining property rights, by internalizing the costs of the externality, or, if all else fails, by direct government regulation—is justified by such externalities.
By this standard, much of modern tort law and much of modern government regulation purporting to protect safety and health cannot be justified, since no externalities exist that must be dealt with. Both forms of government intervention—by the courts and by regulatory agencies—stem from the fact that policymakers are unwilling to rely on private transactions to achieve efficient outcomes.
Undermining Contracts
Much tort law governs accidents between “strangers”—those who have no legal relationship with each other before an accident occurs. Examples include: a car striking a pedestrian; two cars colliding; a passerby on the public domain being struck by a baseball flying from a stadium; a drunk punching someone for no reason in a bar. All of the above are classic tort situations, and all are cases in which there is no prior relation between the parties. In each case there is an externality, and therefore some government intervention, through regulation or through the court system, may be proper.
But many activities now governed by tort law are not of that sort. Instead, in many cases, the parties do have prior relations with each other, and therefore there is no externality and no need for government intervention. The major examples are product liability, where a purchaser of a product may be harmed by that product, and medical malpractice, where a patient may be harmed by some action of a physician that the patient has hired. For technical legal reasons, many workplace illnesses or injuries, such as those associated with asbestos, are governed by product liability law. In such cases there is also a prior relationship, although it is more complex. The worker contracts with his employer, and the employer contracts with the supplier of the product.
Since about 1960, as a result of a New Jersey Supreme Court case, Heningsen v. Bloomfield Motors, involving General Motors (GM), courts have generally been unwilling to enforce contracts between buyers and sellers involving compensation for harms caused by accidents. No matter what terms the parties may want to govern the results of an accident, the court will decide and impose its own terms. For example, the parties may want to agree that if there is an accident, the producer of the product will pay only for lost earnings and medical costs, and will not pay anything for “pain and suffering.” (We will see later that this would be a likely term for parties to agree to.) But if there is an injury, this voluntary agreement will have no effect. The courts will decide what level and type of damage payments from the manufacturer to the consumer are appropriate.
The “Contract of Adhesion” Argument
What is the basis for the courts' intervention? The courts use several related legal concepts to override voluntary contracts. They may say that the parties have “unequal bargaining power,” so the contract is a “contract of adhesion” and therefore “unconscionable” or “against the public interest.”
Although this family of doctrines is pervasive in the legal literature, it makes no sense. Consider price, for example. In a modern retail establishment, a consumer cannot bargain over price; price is a term of “adhesion” just as much as are the terms of the warranty. In a modern market system, in the short run, almost all product characteristics are characteristics of “adhesion.” That is, at any time consumers must take whatever products are offered for sale as given.
Early in this century, when Henry Ford said that a customer could purchase one of his cars in any color as long as it was black, the color of a car was a “color of adhesion.” But GM offered cars in many colors, thus destroying Ford's claim, as well as its market. In the 1970s when GM failed to make small, energy-efficient cars, one might have said that the size of a car was an adhesion characteristic. Again, however, other sellers, in this case mostly foreign ones, offered the economy cars that consumers demanded.
At one time, retail stores offered goods under terms and prices “of adhesion” until K-Mart and Wal-mart changed those terms and made lots of money in the process. In a market economy, there are powerful incentives for sellers to discover the characteristics preferred by buyers and offer to sell products with those characteristics.
Contract terms are no different than other product characteristics. Firms can compete with respect to warranties and other contract terms, including safety guarantees, just as well as they can compete with respect to any other product characteristic. Indeed, firms do sometimes offer competing warranty terms. Automobile companies often offer a choice of free warranties with car purchases; for example, some companies offer three-year, bumper-to-bumper coverage or a one-year full warranty with an additional four-year limited warranty. Most offer extended warranties for varying prices for different lengths of time. Moreover, it is often possible to buy extended warranties on automobiles or on appliances from third parties, with the warranties unbundled from the product itself.
It may be true that if a particular producer does not offer a warranty that a consumer desires, then the consumer cannot buy the product with that warranty. But if the consumer and enough others do want such a contractual feature, then some other producer will find it in his interest to offer the terms, just as producers compete by offering product characteristics that consumers desire. If consumers do want such terms enough to pay for them, then producers will also find it worthwhile to advertise that they offer the more desirable terms.
Some jurists and policymakers would restrict the rights of parties to set their own terms of contract if the service or product in question is offered by a monopolist. They contend that the consumer has no recourse to another seller if he wants to buy that service or product. But in fact the only real, economically dangerous monopolies are those established by governments and thus not subject to market forces.
The federal government, for example, gives the U.S. Postal Service a monopoly on the delivery of first- and third-class mail. It is a crime for a private company to compete. In this situation, the customer truly has his right to contract restricted, but it is restricted by the government. In any event, monopolists have no incentive to offer products that consumers do not want. If a warranty with certain terms is worth $10 to a consumer and costs less than $10 to provide, then a monopolist, like a competitor, will offer that warranty. If private monopolists charge higher prices for products than would be charged in a competitive market, they will draw in competitors.
It makes no more sense to regulate contractual terms than to regulate any other terms of private transactions. Moreover, although it may appear that no individual consumer has any bargaining power with respect to a producer, if enough consumers desire some feature, contractual or otherwise, then producers can make money by offering that term. That possibility will lure firms into satisfying consumers' desires, independently of bargaining power.
Indeed, the courts have the analysis exactly backwards. Consumers have bargaining power with respect to businesses because they have the power to take their patronage and their money elsewhere. But with respect to the courts themselves, consumers have no such power. They must use the legal system available to them. Thus, if there is unequal bargaining power, it is between consumers and courts, not between consumers and producers. Moreover, since consumers must take as a given the contractual terms established by courts, those terms may be considered the true “contracts of adhesion.” It is the courts' unwillingness to allow free negotiation of terms between buyers and sellers that eliminates consumer freedom and creates true inequality of bargaining power.
Efficient Tort Law
If remedies for injury or damage to property were handled through contract arrangements instead of tort law in those circumstances where parties are in bargaining or contractual relationships, then producers and consumers would be able to devise the most efficient system, as is true in any other free market. Thus, any attempt here to define an efficient system is in one sense redundant. However, it is possible to speculate about the terms that might evolve on the market in such cases. If the system is allowed to develop freely, and actual terms differ from those discussed below, that merely means that this speculation is incorrect. Whatever customers and suppliers decide on will be the best arrangement for them. The problems with the current tort system stem from the attempts of third parties to impose terms on transactors that those parties believe are optimal; no such goals are sought here.
Parties to product liability and medical malpractice injuries are in a pre-accident contractual relationship with each other; in other words, the potential victim is paying money to the potential injurer. If tort law imposes costs on the injurer, then those costs will ultimately be borne by victims of higher prices.
Once parties to contracts learn that the courts will impose payments in the form of accident compensation, then the seller will include the expected cost of that compensation in the price of the product. It is this cost that creates the incentive for consumers, the potential victims of injuries, to desire efficient tort standards.
Compensation and Deterrence. Tort law may be viewed as performing two functions. First, tort lawyers in arguing before juries commonly stress the compensation function: injurers should pay to compensate their victims. And second, tort law is expected to deter injuries, giving a producer or service provider an incentive to take reasonable safety precautions. Requiring injurers to pay for the cost of the injuries they cause will deter them from causing more injuries.
But other institutions in society also perform both functions. Tort law need not bear the entire burden of either compensation or deterrence. Most consumers have direct medical insurance and loss-of-wages insurance to compensate them for the cost of injuries.
In any case, the tort law system is not always particularly efficient. Not all of the costs to operate the system go to compensation and deterrence. Of every dollar that passes through the system, 50¢ is taken by transaction costs, including legal fees and court costs. That is a much higher operating cost than is true of other forms of insurance. Thus, tort law is a rather inefficient method of compensating victims of accidents. For this reason, most students of law and economics, including those who view the current tort system favorably, believe that the compensation function of tort law is relatively ineffective.
Tort law provides a deterrent, but so do other forces. The most important such force is reputation. When a firm's product causes an injury, that firm suffers substantial losses in stock value, indicating that the stock market anticipates that consumers will be reluctant to purchase the products of that firm. Thus, in evaluating tort law, it is necessary to remember that it operates in concert with other forces to provide safety and to compensate injured parties.
One caveat is in order. It is not possible or useful to go back to 1960, before courts began negating contract arrangements, and observe the standards of liability in place then to infer what would occur now if they were restored. From 1960 to 1994 per capita real disposable personal income doubled, from $7,264 to $14,924 in 1987 dollars. And as Aaron Wildavsky has told us, “Richer is safer.” Thus, consumers today would be expected to demand greater safety than in the past, and that would imply different liability rules.
With that in mind, it may be useful to speculate about the most efficient form of tort law. It will be helpful to separate the standards of liability from the level of damages.
Liability Standards. Liability standards present some complex issues. The basic distinction is between strict liability and negligence. Under strict liability, the injurer is liable for any harms, no matter what efforts he has made to prevent the harms. Under negligence, the supplier of a good or service is liable only if he did not take the proper amount of care to prevent the accident.
Standards may also differ with respect to the obligations of the victim. In a regime of contributory negligence, any contribution made by the victim to causing the accident—for example, by misusing the product—will release the supplier from liability. In a regime of comparative negligence, which is universal in the United States today, the victim is compensated in proportion to the fraction of the accident caused by the injurer.
Tort analysts find it useful to distinguish between manufacturing defects and design defects. A manufacturing defect occurs when a particular product does not meet its own advertised specifications; for example, when the steering wheel in a new car breaks during normal driving. Most analysts agree that strict liability for manufacturing defects may be appropriate. Under a strict liability standard, the manufacturer is liable for harm associated with the defect. Such defects are relatively rare and therefore do not lead to great costs. There is nothing a consumer can do to avoid such defects, since they occur in the manufacturing process. Manufacturers decide how much to spend on inspection and quality control. The costs of determining that a fault has occurred are relatively small. Thus, a strict liability standard for this class of error would likely evolve in a free market. Indeed, there is evidence that the original proponents of strict liability for product-caused injuries had exactly this class of defects in mind.
On the other hand, design defects are quite different. Design defects are said to occur when the courts rule that it would have been possible for the manufacturer to design the product differently and thus make it safer. For example, a court may decide that an automobile manufacturer should have put the gas tank in a different location. Such defects apply to all units of some product, not merely to faulty units.
The great expansion in product liability (discussed below) occurred when the courts extended strict liability from manufacturing defects to design defects. That extension requires courts and juries to second-guess product designers and determine if there was a safer alternative available when the product was manufactured. Such second-guessing is difficult or impossible, so litigation of such issues is very expensive. It is unreasonable to expect a manufacturer to include on a product a safety feature that literally has not been invented. The major problems identified with the current tort system are due to the extension of strict liability to design defects. It is likely that a contractual solution would lead to little or no liability for such defects.
Another major class of modern liability cases involves a “failure to warn.” Originally, it was thought that product warnings would insulate manufacturers from liability. However, the opposite has occurred: manufacturers are often found liable for failure to warn, sometimes in circumstances in which consumers have misused products in dangerous and unpredictable ways. In a regime of efficient tort law, one would suspect that some liability for failure to warn would remain, but only for risks that were reasonably foreseeable in normal uses of the product. Liability might also attach to failure to indicate precautions that would allow consumers to avoid injury in normal uses.
Damage Payments. It is useful to divide damage payments into four classes.
Pecuniary damages compensate consumers for actual out-of-pocket expenses, such as medical expenses and lost wages from injuries.
Nonpecuniary damages compensate consumers for other, nonmonetary losses. The most important class of nonpecuniary payments is for pain and suffering.
Payments for hedonic losses, or lost pleasure in life, a relatively new and controversial class of payments in the tort system, are also nonpecuniary payments.
Punitive damages are for extremely reckless or grossly negligent behavior, where the goal, in addition to compensating the injured consumer, is to punish the injurer.
Keeping in mind that consumers are paying for whatever damage payments they ultimately receive in the form of higher prices for goods and services, some principles are apparent. Damage payments are like insurance: consumers pay “premiums” in the form of higher prices for products and receive a payment if injured. Since consumers do find it worthwhile to purchase insurance against medical costs and lost wages, it is appropriate that those responsible for injuries should also compensate for such losses, although some coordination between payments from injurers and payments from direct insurers may be useful.
If given a choice, consumers never buy insurance against pain and suffering. There are sound theoretical explanations for this fact. However, without analyzing this decision, evidence suggests that such insurance is not purchased when consumers have a choice. That means that the value of such insurance is below its cost, and since the cost of operating the tort system is higher than the cost of operating any other insurance system, consumers would be even less willing to pay for compensation for pain and suffering through the tort system than in any other form of insurance. Thus, it is likely that a voluntary, contractual system would not provide compensation for nonpecuniary losses.
Punitive damages are a more difficult issue. There are some behaviors of firms that normal tort damages will not adequately deter, such as behaviors that may approach criminality. Moreover, firms will sometimes make efforts to hide their behavior. Thus, in some limited circumstances, punitive damages might be in the interest of consumers. A reasonable approach might be to require a higher standard of proof for punitive damages than for other damages. For example, the standard might be the same as that in criminal law, proof “beyond a reasonable doubt.” That would allow some punitive damages, but only in limited circumstances. The higher standard of proof would eliminate many of the extreme cases observed today.
In sum: if contracts were allowed, consumers would probably want strict liability for manufacturing defects. They would probably want to be compensated for pecuniary damages, but not for nonpecuniary damages. In certain limited circumstances, they might also want punitive damages.
If warranties, that is, liability contracts, were allowed, then the terms outlined above are the terms that would likely be agreed upon by buyers and sellers. The terms would be in the warranty. Manufacturers would have the option of allowing different terms and advertising those terms. For example, a manufacturer stressing the safety of its product might agree to pay nonpecuniary damages, and perhaps advertise, “Our product is so safe that if a court ever rules that we have negligently caused a death, we will pay $1,000,000 in additional insurance to survivors.”
Magnitude of the U.S. Liability System
We do not have the efficient system described above. Rather, we have an extremely inefficient and expensive tort system. The U.S. liability system costs much more than the system of any other country, and much more than the U.S. system itself cost 30 years ago. As of 1991, total costs of the tort system in the United States were estimated by the international consulting firm Tillinghast at $132 billion, 2.3 percent of Gross Domestic Product (GDP). For the other countries in the Tillinghast sample (Denmark, the United Kingdom, Japan, Canada, France, Switzerland, Spain, Belgium, West Germany, and Italy) the average cost was 0.9 percent of GDP. No other country even approaches our level of spending. The highest country outside the United States is Italy, with tort system costs of 1.3 percent of GDP.
How much of the $132 billion spent on tort liability in the United States is waste? Suppose that the other countries on average provide about the right amount of insurance and deterrence through the tort system; then the difference between U.S. tort costs and this average would be a measure of waste in the system. U.S. tort costs in 1990 were 1.4 percent of GDP higher than costs in the rest of the developed world. Based on a U.S. GDP of $5.546 trillion, the waste in the system was then $82 billion in 1990. That comes to about $900 for each household in the United States. That $900 is paid in higher prices for goods and services and in higher insura