The Costs and Benefits of Tort Liability

Analyzing the policy questions that surround tort liability is difficult because of incomplete data not only on tort cases themselves but also on the indirect costs and benefits of the tort system. Indeed, from the standpoint of economic efficiency, the actions that the system encourages potential injurers and victims to take (or refrain from taking) to avoid injuries can be more important than some of the direct “costs” associated with individual cases.

In efficiency terms, the primary benefits of the tort system are measured not by payments to victims—which represent transfers of wealth but not gains or losses to society as a whole—but by reductions in injury costs. Those benefits arise indirectly, through precautions taken by potential injurers (for example, efforts to design safer products or reduce production defects).⁶ Thus, they are not observable in data on trials or settlements.

Several important types of costs are also indirect, including the costs of specific actions that firms take to reduce the injury risks associated with their products (such as including air bags in automobiles), the opportunity costs of goods and services not offered because of liability concerns or not purchased because of liability-related price increases, and the disruption costs of layoffs and bankruptcies.

Indirect benefits and costs are very difficult to measure. In general, data do not exist to show how liability affects the degree of care that potential injurers take—let alone how injury costs change as a result of that care. Moreover, theoretical analysis alone cannot answer the key questions, because the extent to which the potential efficiency benefits of tort liability are realized depends on the relationship between the true costs of injuries and the expected costs to injurers. If potential injurers expect to pay one dollar more for each additional dollar of injuries they cause, they will have the optimal incentive to take all (and only) cost-effective precautionary actions. But they might anticipate paying more than one dollar per dollar of additional injury (for example, because of excessive punitive damages) or less than that (for example, if some of their torts go undetected or if their liability costs are insured and their premiums do not rise commensurately). For potential injurers whose actions are thought at the time to be harmless—such as the firms that manufactured or used asbestos before its health risks were identified—there is no expectation of increased liability costs and hence no specific incentive for precaution.⁷

Controversy over both the efficiency and equity effects of liability has particularly focused on nonpecuniary damages (punitive damages and compensatory damages for pain and suffering). Critics argue that large nonpecuniary damages are awarded arbitrarily and unpredictably, with little connection to the actual harm or to the character of the injurer’s conduct. In that view, such damages are not only inequitable but also inefficient: arbitrary and unpredictable awards do not provide incentives for precaution but do raise costs, thereby distorting price signals. Critics further argue that nonpecuniary damages, whether arbitrary or not, have a separate adverse effect on the distribution of risk—in particular, that liability for pain and suffering implicitly provides consumers with a form of inefficient overinsurance.⁸

In contrast, supporters of the liability system argue that large punitive damages can serve equity by expressing society’s disapproval of behavior that reflects wanton disregard or contempt for potential victims. Such damages can also promote efficiency, they say, by providing proper incentives for the prevention of injuries that have a significant probability of going undetected. (For example, if bolt manufacturers expect the role of defective bolts to go unrecognized in four out of five accidents that their products cause, they will have inefficiently low incentives to prevent defects unless they expect to pay five times the actual damage on those occasions when they are penalized.) Supporters further argue that pain and suffering represent real losses that should be reflected in the prices of products (to send consumers efficient signals) and that limiting awards for such losses might undercompensate some injury victims.

Without direct data or clear theoretical predictions about the incentive effects of tort liability, analysts have tried to tease out the truth statistically. However, their most detailed efforts to date, which have focused mainly on punitive damages, have not yielded conclusive results. The best available study of the effects of punitive damages in the United States found no evidence that the 46 states that allow such damages have fewer environmental or safety torts than the four states that do not allow them. However, that lack of evidence may simply reflect the limitations of the data.⁹

Given the scarcity of data on the benefits and many of the costs of the current tort system, economists cannot judge the system’s efficiency. But they can answer a narrower question about its cost-effectiveness as a means of compensating injury victims. The best available data on the direct costs of tort cases suggest that victims who file claims receive an average of 46 cents from each direct dollar spent on the system (with the other 54 cents going to attorneys’ fees and insurance expenses).¹⁰ The best available data show that such transaction costs are proportionately much smaller in public insurance programs—20 percent nationwide in state workers’ compensation programs (though that figure excludes spending on claimants’ attorneys, which is reportedly rising) and 15 percent in the federal Vaccine Injury Compensation Program. A no-fault public insurance program for other torts would probably not lower transaction costs to those levels, in part because of the costs of establishing which injurers were responsible for particular injuries. Nonetheless, it is safe to say that the existing tort system is a relatively costly way to compensate victims and, thus, that any justifications for it must rest on its effects on deterrence, equity, or both.

Next > Policy Options for Changing the Tort System

6. Some indirect benefits may also arise from better distribution of risk. In principle, risk-averse consumers who expect to be compensated for injuries more fully through the liability system than they would be through their own insurance may be more willing to buy certain goods or services (space heaters, perhaps).

7. However, the mere possibility that seemingly harmless activity may later produce tort claims increases uncertainty and gives potential injurers general incentives to buy insurance, investigate possible risks, and take generic prevention or avoidance measures (such as not researching or developing new products), which may be efficient or inefficient.

8. The argument is that consumers benefit by insuring themselves against pecuniary losses, such as lost income or increased medical costs, but not against pain and suffering (as illustrated by the fact that people generally do not purchase life insurance policies for their young children). Thus, when producers expect to pay non-pecuniary damages and build the costs of those damages into the prices they charge for goods and services, consumers implicitly pay a kind of insurance premium for coverage they would not otherwise choose to buy. The effect of that implicit premium and coverage is to shift wealth inefficiently—raising it in the event of an injury, but not by enough to justify the reduction in wealth in the case of no injury.

Last reviewed October 2024