Incentive Engineering

The great public service of the law-and-economics movement has been to expose the collateral consequences of policymakers’ actions. In Getting Incentives Right: Improving Torts, Contracts, and Restitution, law-and-economics scholars Robert D. Cooter and Ariel Porat, law professors at the UC Berkeley School of Law and Tel Aviv University, consolidate and complement their past work in a volume of related essays.[1]

The work offers improvements to three areas of law dealing with the conveyance of benefits (if all goes well) or infliction of harm (as often happens when the law interferes with voluntary interactions) between parties. The authors relentlessly pursue a version of economic efficiency that seeks to maximize aggregate wealth—even if it is channeled away from tort victims, nonbreaching contractual parties, or unwilling recipients of unrequested (supposed) benefits.[2]  Their observations are insightful, revealing nuances in the law or its application that one would expect from such experts, and they illustrate them with clear examples.

The authors’ analysis tends strongly toward the Posnerian position that judges (and others) “are capable of collecting and applying substantial amounts of both factual and theoretical knowledge” which they can in turn use to engineer the most efficient relationships between—and impose them on—individuals.[3] This is in contrast to the Hayekian view that the parties’ knowledge of their “particular circumstances of time and place” is better than that of a judge, and that their knowledge will tend to drive them to behave efficiently.[4]

A first glance, the authors’ arguments may appear mismatched. Many arguably fly the Posnerian flag, others are premised on knowledge failures; some carry pleasing libertarian undercurrents, others feel statist; some promote legal consistency, others have an anarchistic flavor. Yet they are ultimately consistent. Given the authors’ singular goal of efficiency, it is not surprising that their outcomes are dispersed along any other spectrum, including that of individual liberty.

In the famous 1947 case of United States v. Carroll Towing Co., Judge Learned Hand advanced the authors’ view when he formalized the standard of care in American negligence law. When determining whether an injury was negligently caused, and therefore whether the injurer must compensate the victim, a court must compare the expected harm from the injurer’s activity with the burden (B) to the injurer of taking “adequate precautions” against the injury. The expected harm is calculated by taking the product of the probability (P) of the activity causing an injury and the “gravity of the resulting injury” (L).[5] If the expected harm is greater than the burden of taking adequate precautions, the injurer did not take the precautions, and an accident happened, the injurer is by definition negligent.

Figure 1 shows the “Hand formula” graphically.

Screenshot (26)

Figure 1

To the left of B*, the burden of taking adequate precautions is lower than the expected harm from not doing so. Under the Hand formula, an injurer who has not taken precautions in such a situation is liable for the harm that he or she caused. To the right of B*, the burden of precautions is greater than the expected harm from not doing so.  In this case, the Hand formula does not require one to take precautions against the harm, and the injured party must absorb the damage.

Cooter and Porat propose to tweak the Hand formula—a staple of tort law and its economic analysis—to modify the incentives of injurers and victims. They also propose importing some of their tweaks into contract and restitution law to modify the incentives of interacting parties. To appreciate their analyses, four features of negligence law, as articulated in the Hand formula, are important to understand.

First, it mercilessly furthers economic efficiency inasmuch as it causes victims to bear the costs of injuries if it would cost the injurer more to prevent it: because there is more wealth in the world, it is acceptable for the victim, rather than the injurer, to bear the cost.

Second, although a strict-liability rule would hold injurers liable for all harm caused by their conduct, it would not lead to greater levels of precaution by would-be injurers, and therefore fewer injuries, than a negligence rule. That’s because rational individual would take precaution only up to the point that it is less costly than compensating for the potential harm—up to B*.  Once the cost of precaution is more expensive than the expected cost of compensation—after B*—one is better off causing the harm and paying for it later.[6] The blue arcs in Figure 1 depict the levels of precaution and harm expected under a simple application of the Hand formula.

Third, the Hand rule does not require a potential injury victim to take any precaution against harms to which he or she might be subjected,[7] even if he or she is able to prevent the harm at lower cost than the injurer.[8]

Fourth, the formula does not consider the risks to the injurer of the injurer’s acts.[9] As Cooter and Porat lucidly demonstrate, these nuances have striking effects on injurer and victim incentives.  Reviewing some of their representative arguments provides a flavor of their work.

The book begins by describing how incentive misalignments in tort law lead to inefficient levels of an activity. “Discontinuities” occur when an injurer is charged with liability that differs from the incremental harm caused by his or her negligence.

The authors employ an example of a doctor and patient who contribute to permanent harm to the patient, resulting in what a court finds to be $10,000 in harm: The doctor prescribes the wrong medicine, causing $6,000 of the harm; the patient drinks alcohol despite warnings not to, causing $2,000; $1,000 was caused by the interaction of the drug and the alcohol; and $1,000 was unpreventable. The authors conclude that the doctor is properly liable for $7,000. ($6,000 that the doctor alone caused plus the $1,000 that his incorrect prescription caused in combination with the patient’s drinking. One might respond that the patient is partly responsible for the $1,000 from the interaction of the drug and the alcohol. This is true, but it also supports the authors’ assertion that precisely attributing damages is very difficult.) Recognizing that 1) it is exceedingly difficult reliably to dissect causation into its components, and 2) matters become worse when there is uncertainty about whether either party’s acts caused any of the harm, Cooter and Porat note that courts (and presumably juries[10]) may tend toward all-or-nothing solutions, awarding either $10,000 or nothing to the patient-plaintiff.

Doctors will provide too few medical services (and patients will, presumably, drink too much) in the former case; and vice versa in the latter. Removing discontinuities increases efficiency without burdening victims. The authors here recognize the proof problems with determining and attributing harm and implicitly caution against imposing uninformed legal solutions.

Notwithstanding their word of caution about the difficulty with objectively determining values,[11] Cooter and Porat make recommendations that rely on external determinations of individuals’ internal preferences. For example, they note that, because negligence law (as defined by the Hand formula) does not consider an injurer’s risk of self-harm when determining whether it is outweighed by the cost of precautions, potential injurers will take less than socially efficient care. Self-risk should therefore, they argue, be added to the calculation of the expected harm. Yet self-risks would seem to involve precisely the sort of internal valuations that judges and jurors are least capable of performing on another’s behalf.

In situations with multiple potential injurers—polluting factories, in the authors’ example—where total harm is observable[12] but an injurer’s individual harm is unverifiable, Cooter and Porat propose making each potential injurer liable for all harm (rather that its pro-rata share) above the optimal level. Their theory is that, despite the unverifiability of individual pollution, no factory will pollute at greater than its optimal level because it (and all others) will have to pay for all of it. If one factory pollutes excessively, the others can “help [it] to correct [its] mistake.”

But what if one malicious polluter can absorb more liability than the others, and it decides to put the others out of business by polluting excessively? If individual harm is indeed unverifiable, the others would not be able to tell who is polluting (and the polluter would not accept the help). The authors respond that “the authorities can extend existing legal remedies” to police “predatory polluting.” They do not explain, however, how the authorities will know who is polluting where individual pollution is unverifiable. Unverifiability and harm potential can be exacerbated if the potential polluters have different harm-versus-abatement cost functions. Nonpolluters would be decidedly less free:  an innocent, unknowing polluter would saddle them with undeserved penalties, and a well-positioned predatory one could bankrupt them.

Contract finds its origins in tort,[13] so it is not surprising that it involves similar incentives. Paralleling their tort analyses, Cooter and Porat argue that incentive efficiency requires that all contracting parties bear the full marginal cost of a breach.[14] Anything less than full liability by each party will cause at least one of the parties to receive partial or no benefit from undertaking a value-creating or -saving action.

The default rule of expectation damages, the authors assert, incents promisees to over-rely on the promisor’s performance and under-assist the promisor in performing. This is because the expected cost to the promisee of limiting contractual reliance in a way that accounts for the risk of the promisor’s nonperformance or assisting the promisor (both nonzero) is greater than the promisee’s expected benefit from doing so (zero, because expectation damages provide the full benefit of the promisee’s bargain). Because most contracts do not limit reliance or mandate assistance, and courts do not consistently[15] require either, the authors believe that contract law is fundamentally inefficient, at least in those situations where the promisee’s unobservable actions can affect performance.

Yet parties are (and ought to remain) free to contract into arrangements that address these concerns. By not requiring promisee assistance, for example, the promisee is effectively paying the promisor to arrange for its own assistance. Implicit in their arrangement is that the parties prefer it to an alternative, including relying on a costly legal process that requires a court to determine the efficient level of (unobservable) precaution. The parties should know best whether it is efficient to require promisee assistance. If they do not, it is fair to assume that the promisor, who is presumably better at performing the promise than the promisee, is better at arranging for its own assistance.

Similar reasoning applies to limiting reliance: Parties can limit reliance liability or decline to contract. Because reliance damages must be foreseeable, the promisor will not be surprised by, and can plan for, a future reliance claim. The authors cogently show that liquidated-damages clauses can solve the over-reliance problem by divorcing the magnitude of compensation for nonperformance from the promisee’s level of reliance, causing the promisee to bear the marginal cost of its reliance. In a nod to freedom of contract, the authors note that to the extent that parties stipulate damages, they are signaling that they are addressing over-reliance, and courts should enforce such agreements.[16]

Cooter and Porat have come up with an ingenious device, which they term “anti-insurance,” via which contractual parties may optimize incentives by voluntarily transferring the promisee’s rights to damages to a third party. Each party bears the full cost of a loss (the promisor by paying damages to the third party, the promisee by suffering the breach), each is incented to minimize it. And both benefit, not just when there is a loss but each time a contract is made, because the third party pays the parties for the right to damages. (In practice, the promisee would sell the liability right to the anti-insurer, the promisor would pay the promisee for its assistance, and the promisee would assist the promisor’s performance. The amounts paid would vary depending on whether and to what extent the parties share the surplus created by the anti-insurance arrangement. Anti-insurance could also incent optimal effort to realize gains by, effectively, bonding the parties to perform.)

The strength of anti-insurance lies in its voluntary nature. The parties know better than an external observer—like a court—where it is most sensible to place the risk of loss. One need not anti-insure if a loss would deplete too large a portion of his or her wealth. Problems arising from unverifiability, like collusion and nonreporting of losses by the promisee, are lessened because parties will opt into anti-insurance only when they trust their counterparties (as with repeat transactions) or if the promisee is given a cut of the anti-insurer’s payment.

The authors’ stand on the expansion of restitution law, however, will make libertarians bridle. They argue that restitutions should be expanded into circumstances in which “benefactors” are compensated for providing others with unrequested benefits. This would allow benefactors to internalize the benefits that they create, incenting them to be more altruistic, and would overcome coordination problems that make advance agreement impractical. Their argument for a “market in unrequested benefits” feels oxymoronic—a market implies willing parties—and, indeed, they maintain that the law should “force transactions on their beneficiaries” via “involuntary exchanges.”

The authors’ quintessential example is that of a homeowner converting his front yard into a rose garden: The cost of conversion is 20; the homeowner’s property value increases by 15; his neighbors’ values increase by 10 each. They would use the law to force the neighbors not only to pay for their share of the benefits, but to provide the homeowner with a profit to incent other homeowners to be similarly altruistic. They would only do this in the case of Pareto improvements involving “indisputable benefits,”[17] which benefits would presumably be determined objectively.

The authors here again show a willingness to allow courts to override individuals’ decisions. What if the neighbor, despite theoretically benefiting from an increase in property value, is cash poor and unable to pay for the rose garden? Cooter and Porat reply that a lien should be placed onto his property. What if, despite a buyer’s potentially valuing the neighbor’s property more highly, the neighbor has no interest in selling and hates roses? And how can a neighbor’s assertion to this effect be disproved?  Only death (not even taxes) is indisputable. In addition, providing the homeowner with a profit to incent the other homeowners to plant rose gardens (or install bird feeders, or what have you) seems to ignore the law of diminishing marginal returns.  Incenting further behavior of a similar type devalues the initial investment by providing more of the same.

The authors go even further: They believe that it would be good for private individuals to provide unrequested benefits for the purpose of securing a right to restitution. Sensing that this proposition carries a risk of abuse, they offer two potential solutions:  government licensing of benefactors and voting by potential beneficiaries. Yet the former option is likely to lessen efficiency and make people less free by subjecting them to a government bureaucracy, and the latter implies that enough coordination among the potential parties is possible to determine whether the project in question should be undertaken.

Professors Cooter and Porat have done a service to the field of law and economics by providing fresh efficiency-seeking analyses of tort, contract, and their cousin, restitution. But their zeal for efficiency, while creating wealth—if in fact judges are able to determine what does and does not create value—could destroy liberty.

[1] The author wishes to thank Daniel D. Barnhizer, Edward Dawson, Nicholas J. Johnson, Jeremy Kidd, Andrew Pardieck, William A. Schroeder, and Angela Upchurch for their insights and comments.

[2] This is a common starting point in economic analysis. The efficient outcome is said to be superior to all others. When wealth, in dollar terms, has been maximized, it can transferred among individuals according to one’s moral sensibilities. See Steven E. Landsburg, The Armchair Economist: Economics and Everyday Life (Free Press, revised edition 2012), pp. 73-87. See generally R. H. Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (1960). But it is impossible to attach dollar values to outcomes when individuals’ subjective valuations cannot be discerned. And the argument for the primacy of efficiency “works only when the definition of efficiency is couched in terms of dollars” because outcomes not valued in dollars cannot be transferred. (Landsburg, p. 78.) The authors tend strongly to convert all harms into dollars. It is questionable whether all benefits and harms can be monetized, and therefore whether this simplification is warranted, but the practice is ubiquitous enough, and has been discussed enough, that there is little sense in critiquing it here. To the extent that courts almost universally award money damages, perhaps it serves its purpose.

[3] Todd J. Zywicki and Anthony B. Sanders, “Posner, Hayek and the Economic Analysis of Law,” Iowa Law Review 93 (2008), 559, 561-62.

[4] Ibid. p. 568, quoting F.A. Hayek, “The Use of Knowledge in Society,” American Economic Review 35 (1945), 519, 521.

[5] 159 F.2d 169, 173 (2d Cir. 1947). Judge Hand presumably used “L” as the shorthand for the injury because he considered it a loss.

[6] For example, imagine that a contractor has been hired to install a new sewer line, and that the installation requires the blasting of trenches in which the sewer lines will sit. Because blasting is an “ultrahazardous” activity, it subjects the blaster to strict liability for all harms. For example, Vecellio and Grogan, Inc. v. Piedmont Drilling & Blasting, Inc., 644 S.E.2d 16 (N.C. Ct. App. 2007). An example of a precaution-harm combination far to the left of B* is the installation of $500 worth of plywood shielding over the windows of nearby stores in order to prevent the otherwise-near-certain destruction of $5,000 of the stores’ property. An example of a precaution-harm combination far to the right of B* is the installation of a $100,000 temporary structure around the blasting area for the purpose of preventing a small chance of flying debris breaking a $15 window on a home a mile away. Under a negligence rule the contractor would install the plywood shielding because the Hand formula dictates that it would be liable for the harm to the stores’ property if it did not do so, but it would not install the temporary structure because the Hand formula does not require precautions that cost more than the harm which they are expected to prevent. The contractor would behave identically under a strict-liability rule, but this time because it would rather install $500 in shielding than pay an expected $5,000 for property repair, and because it would rather replace a $15 window than erect a $100,000 structure. The point at which the contractor is indifferent between taking a precaution and paying for the harm it causes is B*, where the costs of each are equal.

[7] An important caveat is in order: The Hand formula was conceived in an era of strict contributory negligence, which barred recovery by victims who bore any fault for the accident in question. See Fleming James, Jr., “Contributory Negligence,” Yale Law Journal 62 (1953), 691. Victims therefore had more incentive to protect against accidents than the Hand formula alone suggests.

[8] Continuing the example from earlier, even if the store owners near the blasting site all happened to have lowerable blast shutters installed on their windows (perhaps because of an earlier riot in the area), they would not under the traditional negligence rule be required to deploy them.

[9] That is, PL does not include any expected harm to the injurer. Some courts determining PL will, however, consider “social utility” costs. For example, Pryor v. Iberia Parish School Board, 60 So.3d 594, 598 (2011).

[10] “Jurors decide almost all tort cases that go to trial in the United States.” B. Michael Dann, “Jurors and the Future of ‘Tort Reform,’ ” Chicago-Kent Law Review 78 (2003), 1127.

[11] See also Ludwig von Mises, Human Action (Ludwig von Mises Institute, Revised Edition 1963), pp. 97, 204-5, describing the inherent subjectivity of individual valuations.

[12] The premise that such a situation exists is questionable. Total pollution may be observable, but discerning total harm from the pollution, with all its secondary, tertiary, quaternary effects may be impossible.

[13] E. Allen Farnsworth, “The Past of Promise: An Historical Introduction to Contract,” Columbia Law Review 69 (1969) 576, 594-96.

[14] As discussed below, they note that liquidating damages can shift onto the promisee the marginal costs of over-reliance.

[15] There are a number of contract doctrines which serve to limit reliance. As a whole, “[c]ontract law has not developed a burden of reasonable reliance.”  Id. 123. But it is not uncommon for courts to insist that reliance be reasonable. For example, Martens v. Minnesota Min. and  Mfg. Co., 616 N.W.2d 732, 753 (Minn. 2000); Mistletoe Exp. Service of Oklahoma City, Okl. v. Locke, 762 S.W.2d 637, 638 (Tex. Ct. App. 1988). As the authors note, reliance must also be foreseeable by the promisor, the profits claimed to have been lost must not be speculative, and the promisee must mitigate post-breach damages. These doctrines fundamentally turn on whether the promisee caused the loss in question. If it did, damages are not available.

[16] Although blackletter law holds that such agreements will not be enforced if they are penalties, there are plenty of good reasons for courts nonetheless to enforce them. See, for example, Carter G. Bishop and Daniel D. Barnhizer, Contracts: Cases and Theory of Contractual Obligation (American Casebook Series, Second Edition, 2015), pp. 872-874. Judge Posner agrees. Lake River Corp. v. Carborundum Co., 769 F.2d 1284, 1288-89 (7th Cir. 1985).

[17] A Pareto improvement is one in which no party is harmed and at least one is better off. Henry N. Butler et al, Economic Analysis for Lawyers (Carolina Academic Press, Third Edition, 2014), p. 52.