Coase and a Learned Hand
The principle of least cost avoidance
You are reading Economic Forces, a free weekly newsletter on economics, especially price theory, without the politics. Economic Forces arrives weekly in the inboxes of over 13,000 subscribers. You can support our newsletter by sharing this free post or becoming a paid subscriber:
An important characteristic of price theory, especially the UCLA brand of price theory, is the role of property rights. A lot of the discussion that we have done here at Economic Forces focuses on solving property rights problems either ex ante or in the abstract. A related problem is to figure out what to do after an action has taken place, which is typically a problem for the court system. Today, I want to talk about torts and liability.
When we are talking about torts, what we are talking about is some sort of wrongful act or some infringement of rights. This is different than some sort of contractual dispute. The difficulty with torts is that sometimes it is difficult to determine who is at fault. This could be the case because it is unknown who committed the action (for example, a hit and run accident) or it could be because the parties to the events disagree about who is at fault. Even when there is a clear victim, one might argue that the victim could have reasonably avoided the harm. These issues are especially evident in things that we typically refer to as “accidents.”
Since torts are about costs, an economist would typically argue that tort law should be written and enforced such that these costs are minimized. But what do we mean by costs? Of course, there is the cost associated with whatever harm has been done, but the law itself will create additional costs. For example, once the law is in place, people will have an idea of the penalties that they face for doing harm (even by accident). Those people will then take action to try to avoid accidents. To the extent that they wouldn’t otherwise take these actions, these are also costs – and costs that are borne independent of whether an accident takes place. Herein lies an important implication of the trade-offs faced by lawmakers and judges. If one makes the penalty sufficiently large, it might make people so careful that few accidents ever take place. However, if the cost of this preventative action is greater than the harm itself, then this reduction in harm isn’t a net benefit to society.
This discussion should make clear a common confusion about tort law. Many people often associate tort law with a method of determining compensation for the victim and ambulance-chasing attorneys. Nonetheless, it is probably more accurate to say that tort law should be about deterrence. In doing so, the law should be written and enforced such that the total cost (the cost of the accidents plus the cost of avoiding accidents) should be minimized.
That all sounds great, but how would one do this in practice?
An interesting application of this line of thinking is what is known as the Learned Hand Rule, named after the New York judge Learned Hand (phenomenal name!). He explicitly articulated this rule in the 1947 case of the United States v. Carroll Towing Company (I say “explicitly” because some like to point out that he applied this rule in a much earlier opinion). The basic issue in that case is that a tugboat had inadvertently unmoored barges from a pier. As a result, a barge carrying flour that was owned by the United States government ended up sinking. The government then sued the towing company for negligence.
In writing the opinion of the case, Judge Learned Hand explained the criteria for determining negligence as follows:
It appears … that there is no general rule to determine when the absence of a bargee or other attendant will make the owner of the barge liable for injuries to other vessels if she breaks away from her moorings. However, in any cases where he would be so liable for injuries to others obviously he must reduce his damages proportionately, if the injury is to his own barge. It becomes apparent why there can be no such general rule, when we consider the grounds for such a liability. Since there are occasions when every vessel will break from her moorings, and since, if she does, she becomes a menace to those about her; the owner's duty, as in other similar situations, to provide against resulting injuries is a function of three variables:
(1) The probability that she will break away;
(2) the gravity of the resulting injury, if she does;
(3) the burden of adequate precautions.
Possibly it serves to bring this notion into relief to state it in algebraic terms: if the probability be called P; the injury, L; and the burden, B; liability depends upon whether B is less than L multiplied by P: i.e., whether B < PL.
The court found that it was the accuser who was negligent. The barge had been left moored to the pier, but unattended. Leaving the barge unattended made it both more likely that something bad would happen and increased the cost of potential damages, the corresponding expected loss was much larger than the cost of actions that would have prevented those consequences. As a result, the accuser was negligent.
Note that this rule applies to both parties and therefore reveals a corollary of the Learned Hand Rule: the principle of least cost avoidance. In the event that one party, but not the other, could have avoided the accident at lower cost than the expected loss, that is the negligent party. In the event that both parties could have avoided the accident at lower cost than the expected loss, the party that could have avoided the loss at the least cost is held negligent.
In formulating this rule, Judge Learned Hand was effectively applying Coaseian reasoning. For example, assume away transaction costs for a moment. Prior to any accident taking place, the parties involved might recognize the potential for an accident. Given the magnitude of the cost of the accident and the likelihood of that accident, if the party who would suffer from that accident could prevent the accident at the least cost, then that party should bear the cost. In the event that the other party could prevent the accident at the lowest cost, then the potentially harmed party should be willing to pay them to take the action necessary to prevent the accident.
In reality, however, transaction costs aren’t zero and the parties might have asymmetric information about the potential harm. Nonetheless, if the principle of least cost avoidance is written into the law or if the law is enforced according to the principle, it helps to align incentives of the parties involved ex ante and therefore can act as an effective form of deterrence while minimizing the total costs of accidents.