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Overview
The recent lawsuits involving cigarettes, guns, and other products have created a new phenomenon. Such litigation results in negotiated regulatory policies to settle the suit or serves as a financial lever to promote support for governmental policies. The allocation of responsibilities for policy becomes blurred, as litigation becomes the mechanism forcing regulatory changes. The policies that result from litigation almost invariably involve less public input and accountability than government regulation.
In many policy contexts there is an interaction between regulation and litigation. Many of the economic rationales for government regulation pertain to various forms of market failure, such as inadequate consumer information or failure to account for externalities to parties outside of a market transaction. These same forms of market failure often lead to litigation as well, as injured parties seek to obtain damages for the harms that have been inflicted on them because of a lack of appropriate recognition of their economic interests by the party inflicting the harm. The policy task is to coordinate the influences of these two different sets of social institutions, recognizing their different strengths and different functions. In each case, however, the ideal level of harm is not zero. A risk-free society is neither feasible nor desirable because of the inordinate costs of eliminating risk.
The potential importance of the interaction between regulation and litigation is not a new issue. This overlap of institutional responsibilities and functions was a central theme of an American Law Institute study on tort liability published a decade ago. Traditionally the focus has been on broad conceptual issues, such as the potential for institutional overlap on the creation of economic incentives. The policy concerns arising from these analyses often have focused on fairly narrow policy remedies, such as the provision of a regulatory compliance defense for firms that are in compliance with explicit government standards but are nevertheless subject to litigation.
The different functioning of institutions that litigate and those that regulate is apparent from a look at their roles in promoting health and safety. Consider first the creation of economic incentives. Regulation is generally superior in addressing technical scientific issues because of the importance of expertise in analyzing these regulatory issues. Moreover, government regulation on behalf of society at large is especially appropriate when decisions about policy pertain to an entire product line rather than to purchase of a specific product by an individual. Design defects and hazard warnings, for example, should be assessed on a productwide basis. What any individual knows about the risks is not the key concern. Whether the firm provides adequate information within the market context for a representative purchaser to make a knowledgeable risk-taking decision is.
Difficulties arise when these matters are delegated to juries on a case-by-case basis. Recent literature has documented the failings of juries in thinking systematically about risk, as jurors exhibit a wide variety of systematic biases in assessing accident situations, such as hindsight bias in the evaluation of past actions involving risk. Government regulations will usually provide a more sound approach to promoting health than litigation does, which by its nature focuses on individual circumstances rather than the functioning of an entire product market. The stringency of government regulations may be excessive from a benefit-cost standpoint, owing to the restrictive nature of regulatory agencies' legislative mandates. When this occurs, regulatory standards for health and safety typically should not require any augmentation through judicial proceedings.
If, however, regulations do not exist for a product, litigation can often help address gaps in the regulatory structure and stimulate regulatory activity. One of the most prominent examples is asbestos risks. Historically, asbestos risks had not been strongly regulated, but the emergence of a wave of asbestos litigation induced the Occupational Safety and Health Administration and the Environmental Protection Agency to set stringent regulation. In this instance, the combination of litigation and subsequent regulation led to inordinately large safety incentives. Litigation may complement regulation when it provides for a transfer of income to injured parties to address the damages incurred.
A general problem with distinct roles for litigation and regulation is that there is no formal or informal mechanism for coordinating the roles of these two institutions. That one institution is imposing economic penalties for a particular type of risk does not prevent the other from also imposing sanctions. The little coordination that does exist consists of the existence of regulatory compliance defenses, which typically are restricted fairly narrowly to punitive damages and are only pertinent in a few states. That there is a continuing inherent problem in coordinating the roles of regulation and litigation is well documented in the literature.
What is new is that the character of these coordination problems has changed dramatically since the mid-1990s. The advent of litigation about products such as tobacco, guns, and lead paint went well beyond the historical interactions of regulation and litigation that have been of concern in the literature. No longer was the issue one of litigation creating incentives that overlapped with those resulting from regulation. Rather, litigation was being used as the financial lever to force companies to accept negotiated regulatory policies as part of the litigation. Thus litigation led to regulation, but not regulation that went through the usual rule-making process as a result of a careful analysis by government regulatory agencies subject to their legislative mandates. Rather, the parties in the lawsuit negotiated regulatory changes as part of the package to end the litigation.
These negotiated solutions have also gone beyond simply specifying regulatory changes. In at least one instance the settlement has led to the imposition of what is effectively an excise tax on products. Rather than imposing a conventional damages award on the defendant, the tobacco settlement imposes charges on customers on a per unit basis in the future. Thus the settlement establishes a tax on the product payable to the plaintiff and paid for almost entirely by the consumer rather than a damages payment paid for by the defendant. Litigation against health maintenance organizations (HMOs) proposes a similar tax-like structure. Thus litigation has developed in a manner that not only usurps the traditional governmental authority for government regulation but also shifts the locus of establishing tax policy from the legislature to the parties in the litigation. Citizen interests are not explicitly represented, and, unlike the case of the regulatory changes, there is no mechanism to ensure that these outcomes are in society's best interests. Moreover, there is typically no procedure for even creating the appearance of the degree of legitimacy usually accorded to governmental policies.
If there is an error in these litigation settlements that impose regulatory and tax changes, the potential adverse consequences could be enormous. The stakes of the tobacco litigation exceeded more than $200 billion in expected penalties during the next twenty-five years. The regulatory changes also could have significant anticompetitive effects. Although other litigation involves stakes that are typically not as great as those in tobacco, in the effects on particular industries, the influences could be even greater.
Optimal Deterrence
The chapters in this book shed light on the likely consequences of regulation through litigation for insurance markets and society at large. The authors focus on various case studies.
In considering the merits of litigation it is useful to assess how it performs from the standpoint of efficient deterrence and efficient insurance. One of the chief functions of a liability system and government regulations is to establish optimal levels of deterrence. The case studies in this volume focus almost exclusively on health and safety risks for which the main economic issue is whether the incentives created lead to the appropriate levels of health and safety. The optimum level of risk is not zero but is rather an efficient level of risk that reflects the appropriate balancing between the benefits and costs of risk reduction.
Risk reduction measures should be undertaken only to the extent that their benefits exceed the costs. For example, adding a particular safety device to a machine is desirable only if the benefits of the safety device exceed the costs of modifying the product. Importantly, benefits are judged not only according to financial consequences but also more broadly on society's willingness to pay for the reductions in risks to health, as the appropriate benefit value recognizes the value of the risk reduction that goes beyond the financial effects. Safety is optimized when the marginal benefits equal marginal costs. Often there is a continuum of risk choices, such as the allowable level of exposure to toxic chemicals. As long as the incremental benefits of increased safety exceed the incremental costs, more tightening of the regulation or the imposition of liability on the firm is desirable. Regulation or litigation is excessively stringent, however, when firms are pushed to enact measures whose incremental costs outweigh incremental benefits.
The implications of policies for choices of the level of health and safety are rarely neutral. Ideally, litigation should also help create incentives for efficient levels of safety, but this objective may be compromised when the main focus of the litigation is to provide compensation.
The discussion by Kenneth S. Abraham in chapter 7 distinguishes two different types of litigation, each of which has different implications for economic incentives. Litigation that he calls "forward looking" focuses on setting up requirements on firm behavior or a funding mechanism that will directly influence incentives for the future. The settlement of the tobacco litigation was forward looking in that it led to regulatory changes and a damages formula that was largely tantamount to an excise tax on cigarettes. Similarly, the litigation involving guns, which is reviewed in chapter 3 by Phillip Cook and Jens Ludwig, is forward looking to the extent that it seeks to impose safety requirements on the design of handguns as well as restrictions on the distribution of handguns. Although the litigation against health maintenance organizations, discussed in chapter 6, is less well developed than that for cigarettes and guns, the overall model that is being adopted closely follows the one for tobacco and is forward looking in character.
Litigation that Abraham calls "backward looking" is more similar in character to conventional tort litigation. The lawsuits by women suffering problems they attribute to breast implants and the lead paint litigation against landlords fall into the backward-looking category. These suits seek to obtain compensation for parties that have been injured. Such compensation will establish payment structures that could potentially alter future incentives because firms will expect to be subject to similar sanctions from future litigation. However, if all such decisions have already been made or if the product is no longer sold, there will be no incentive effect unless these suits impinge on current behavior in some manner. Thus there will be no incentive effect for lead paint manufacturers because lead paint is no longer produced in the United States. However, the lead paint suits against landlords potentially could have an incentive effect to the extent that they affect building maintenance, efforts to remove lead paint, and warnings to tenants about lead paint risks. There may also be more general deterrent efforts for landlords beyond lead paint.
Optimal Insurance
A second potential function of social institutions dealing with risk is providing optimal insurance to those who have suffered injuries or illnesses. Regulatory policies by the federal government usually do not provide any insurance compensation for victims but instead are focused almost exclusively on establishing regulatory standards for health and safety. Insurance functions are typically handled through targeted government programs that focus on the disabled, the poor, or the elderly.
In contrast, litigation often has as its principal purpose an effort to transfer income to those who have suffered injuries. From the standpoint of optimal insurance this transfer should be sufficient to completely cover the economic loss when people have suffered a financial loss. The desirability of providing this insurance stems from individual risk aversion, which makes insurance of such losses desirable. When governmental entities have suffered economic losses, such as the medical costs attributable to tobacco that were incurred by the states, this type of insurance rationale would not be pertinent. Governmental entities should be risk neutral except for extremely large losses because they can spread these losses across a large citizenry base. Thus any optimal insurance rationale for transfers to the government must assume that the losses ultimately borne by individual taxpayers will be sufficiently great that risk aversion will come into play.
For individuals sustaining injuries and suffering illnesses, there will be financial losses and effects on individual health. The object of insurance for financial losses is to restore individuals to their pre-accident level of utility, but that objective is not pertinent to health effects. Typically, it will not be desirable for an individual to purchase so much insurance as to be as well off as he or she would have been had the illness or injury not occurred because these events reduce people's ability to derive welfare benefits from additional funds. Even enormous transfers of money may not be adequate enough to restore the pre-accident welfare level to one who has become severely disabled. There is also the practical problem of ascertaining a person's psychic losses from such major injuries. Thus in the case of the breast implant litigation, there will be an insurance objective, but the proper role of the courts will typically fall short of restoring the plaintiff 's pre-illness level of utility even when liability for the firm is established.
The Case Studies
This volume presents case studies of different types of litigation as well as broader analyses of the role of mass torts and class actions and their implications for economic performance.
Continues...
Excerpted from Regulation by Litigation Copyright © 2002 by AEI-Brookings Joint Center for Regulatory Studies Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
