A System Gone Bad

Sunday, January 30, 2000

Liability law, or tort law, allocates the costs of accidents among individuals. Accidental injuries are frequent in modern society. One car rear-ends another, damaging property and causing personal injuries; a soda pop bottle explodes, injuring a consumer; a physician misdiagnoses a patient’s illness, resulting in medical complications when the illness is ultimately treated.

In theory, tort law has two principal goals. The first is to provide compensation to parties injured in accidents in an effort to provide a form of social insurance. If individuals were risk-averse, they would seek to insure themselves against accidental injuries caused by others. If market failures prevent individuals from purchasing such insurance in private markets, however, or if we as a society believe that it is inequitable or unfair to let individuals bear the cost of insuring against the carelessness of others, then government intervention in the form of liability laws may be warranted.

The second goal is to provide potential injurers with incentives to avoid accidents for which the social costs of prevention are less than the costs created by the accident, thus deterring careless behavior by charging injurers for the accidents they cause. If taking precautions against harming others is costly, and if potential injurers are not required to pay for the harm they cause, they will in general take fewer precautions than are socially desirable. By requiring individuals to pay compensation for the harm they cause if an accident occurs, tort law can encourage potential injurers to act with greater degrees of precaution.

The enormous expansion in the reach of the tort system over the past forty years has been well documented. Despite its expansion, however, the system for allocating accident costs in the United States performs poorly in terms of both the compensation and the deterrence goals. The system has high transaction costs and fails to compensate injured parties appropriately. In addition, the system leads to inefficient precautionary care measures. In the health care sector, for instance, liability pressure has led to defensive medicine—precautionary treatments with minimal medical benefit administered out of fear of legal liability.

Why does the liability system perform as poorly as it does? How might it evolve in the future, and to what extent will such an evolution improve its functioning? Finally, how might alternatives to tort—such as no-fault insurance—provide individuals with insurance against accidental injury while preserving incentives for innovation and appropriate accident avoidance behavior? The next two sections provide some answers.

BACKGROUND AND EXTENT OF THE PROBLEM

In general, tort claims are adjudicated in state courts according to state laws and state court precedents. Historically, tort law has required four elements for a successful claim: injury, cause, duty, and negligence. First, the claimant must show that he or she actually suffered an injury and a tangible loss. Second, the claimant must attribute his injury to the actions of the defendant. Third, the claimant must show that the defendant owed the claimant a duty to take care. Fourth, the claimant must prove that the defendant was negligent. Stated simply, this entails showing that the defendant took less care in connection with the cause of the injury than would have been taken by a "reasonable person" in the defendant’s position. Taken together, this four-part test of the validity of a tort claim is known as the negligence rule.

In a simple economic model of the tort system, the negligence rule provides incentives for defendants to engage in optimal precautionary behavior. The negligence rule does not, in theory, provide complete insurance; only plaintiffs injured by a defendant’s negligent actions receive compensation. At least in part for this reason, tort law has over the past forty years gradually expanded its emphasis on compensation. Compensation has grown as the courts have accepted an increasingly broad definition of negligence and rejected contractual limitations on liability. In many cases (most notably, those involving defective products), strict liability—which holds defendants liable regardless of whether they were negligent—has replaced negligence as the operative tort standard.

A tort system with more expansive compensation than that specified by the negligence rule, even a system with strict liability for all claims, could also provide defendants with optimal incentives. Under strict liability, defendants would fully internalize the costs of all accidents. In cases in which accident avoidance imposed fewer social costs than did allowing accidents to happen, defendants would find it in their interests to take care; in cases in which accident avoidance was cost-ineffective, defendants would decline to take care but would compensate plaintiffs for their injuries.


The overwhelming majority of patients who win medical malpractice suits cannot prove that their doctors were negligent. Juries tend to make their decisions based on the extent of the injury, not the extent of the fault.


But this model does not capture important features of the real world such as transaction costs, mistakes, and insurance. Each of these factors can impair the performance of the liability system in terms of both the compensation and the accident avoidance goals.

The transaction costs of the current liability system are perhaps its best-known drawback. Administration of tort compensation involves costs for courts, attorneys for the injured (plaintiff), attorneys for the injurer (defendant), and other institutions such as liability insurers. These transaction costs can result in both the undercompensation of injured parties (because injured parties bear some of the transaction cost burden) and more precaution than is socially optimal (because injurers pay both for the injuries they cause and for some of the transaction costs).

In addition, because accurate information on the causes and effects of accidents is difficult to obtain, the system inevitably allocates liability erroneously in some cases. Those mistakes reduce the social value of the insurance the system provides to victims by adding uncertainty to the compensation process. Mistakes also create risks for potential injurers—including the risk that they will be held responsible for accidents they did not cause and the risk that damages will not equal the true costs of the injurer’s negligent behavior.

The pervasiveness of insurance drives a similar wedge between the seemingly sensible incentives provided by the system and optimal decision making, also known as the "moral hazard" effect. Markets for health care provide a case in point: most patients’ care is financed through first-party health insurance, and most physicians’ financial liability for acts of negligence is financed through third-party malpractice liability insurance. On one hand, increasing financial penalties for physicians above the expected costs of medical injuries may be welfare-improving, if moral hazard from malpractice insurance leads physicians to take too few precautions. On the other hand, moral hazard from health insurance may be more important. Despite their insurance against the financial risks of malpractice, physicians may employ costly precautionary treatments in order to avoid nonfinancial malpractice penalties, such as fear of reputational harm, decreased self-esteem from adverse publicity, and the time and unpleasantness of defending a claim. If this is true, physicians may have the incentive in general to consume (and produce) precautionary medical care that has marginal social costs greater than the marginal social benefits because neither they nor their patients bear the costs of care in any particular case. In this situation, even compensation equal to the expected costs of medical injury may result in social losses due to defensive medicine.

AVENUES FOR REFORM

Empirical evidence confirms the validity of these theoretical concerns about the liability system’s performance (see my essay The Economic Effects of the Liability System for an extensive review). What policy reforms can make things better?

Some states have adopted statutory reforms that mandate specific liability decreases. Although such reforms have been shown to improve the performance of the system in terms of the accident avoidance goal, they do little in terms of the compensation goal. Caps on damages, for example, limit awards to those individuals with the most serious injuries. For this reason, researchers and policymakers have suggested a wide range of largely untried reforms—some advocating radical changes to the allocation of responsibility for injuries—that seek to address both compensation and deterrence goals. These reforms can be divided into three classes.

1. Guidelines. This most gradual class of reforms retains the current system of trial by judge and jury but adds additional guidelines or other structures to the legal process. In particular, guidelines are a commonly suggested mechanism for improving the process of resolving medical malpractice claims, although the general principle could be extended to other types of tort claims. Medical practice guidelines specify appropriate treatments for patients in particular clinical circumstances. Guidelines would affect mainly the determination of negligence. Traditionally, physician negligence depends on a jury’s finding of noncompliance with community standards of care, as interpreted by one or more expert witnesses. This relatively unstructured inquiry has the potential to lead to inconsistent or unpredictable application of the negligence rule. Statutory reform to state liability law could allow defendants to use compliance with practice guidelines to establish either an absolute or a rebuttable presumption of due care; conversely, guidelines-based reforms could allow plaintiffs to use noncompliance with guidelines to establish either an absolute or a rebuttable presumption of negligence.

By systematizing the standard of care, guidelines could enable the liability system to process cases more quickly, more economically, and with fewer errors. In doing so, they may both improve compensation and reduce inefficient precautionary care. However, design and implementation of a well-functioning system of guidelines is difficult. In health care, for example, ex ante specification of the relationships between illness and appropriate medical treatment decision making would be at best extremely complex and would have to change rapidly with medical technology. Even the best-designed system of guidelines would likely require expert testimony on a case-by-case basis to aid in interpretation and application.

2. Alternative Dispute Resolution. Under this approach, states would replace the right to sue for certain types of injuries in court with mandatory and binding alternative dispute resolution (ADR), such as arbitration or mediation. ADR proposals generally transfer power to resolve claims into an administrative system with a specialized expert fact-finder/decision-maker who operates under fewer constraints than civil court judges. In this way, the goals of ADR are similar to those of guidelines: to provide a more rapid and accurate means of delivering compensation and apportioning responsibility for injury. ADR may offer substantial promise. But, to the extent that an ADR system seeks to preserve all the evidentiary and due process rights that the parties would have in a tort case, it would be less likely to offer substantial advantages.

3. No Fault. No-fault systems are the most radical suggestion for reforming the liability system. No fault would also limit or remove individuals’ right to sue for certain injuries and instead compensate them according to a schedule of damages and/or an administrative hearing, generally at a more modest level than occurs in tort, regardless of the fault of the alleged injurer. Most no-fault proposals are coupled with an administrative framework that seeks to monitor the behavior of potential injurers in order to preserve incentives for appropriate accident avoidance.


Caps on liability rewards might sound good in theory, but in practice they often merely punish people who have received very serious injuries.


A well-functioning no-fault system offers the obvious advantage of improving compensation and reducing transaction costs while still achieving deterrence. The most serious drawback to no-fault compensation systems is the expense of compensating everyone who is injured, instead of only those injured negligently. One response to this is to compensate only less-severely injured parties through the no-fault system and allow more-severely injured parties to sue in tort. Many states have implemented limited no-fault approaches to compensate people injured in automobile accidents. However, although limiting the reach of a no-fault system may reduce its costs of operation, it would also reduce its benefits.

There is no simple way to achieve the twin goals of the liability system. Among other factors, transaction costs, informational imperfections, and other market failures cause the U.S. liability system to perform poorly. These same factors, however, limit the ability of more radical, untried reforms to improve compensation for and deterrence of accidental injury. Further study of existing reforms, and experimental implementation of untried reforms, will improve our understanding of the best approaches to fix a broken system.