Tort law and internalization: The gap between private loss and social cost

International Review of Law and Economics

Volumn 17, Issue 4, 1997, Pages 589-608

  Gilead, Israel ^a  

^a NONE

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EID: 0031537331     PISSN: 01448188     EISSN: None     Source Type: Journal    
DOI: 10.1016/S0144-8188(97)00038-0     Document Type: Article

References (148)

1. 1 The concept of externalities is "one of the most elusive in economic literature." T. Scitovsky, "The Concept of External Economics," 62 Journal of Political Economy 143 (1954), reprinted in Externalities: Theoretical Dimensions of Political Economy, eds. R. J. Staaf and F. X. Tannian, Dunellen, New York, 1973, p. 77. This concept can be defined in various ways. See W. J. Baumol and W. E. Oates, The Theory of Environmental Policy (Cambridge: Cambridge University Press, 2d ed. 1988) pp. 15-18. For the purposes of this article, externality may be defined as "a cost or benefit that the voluntary action of one or more people impose or confer on a third party without their consent." See R. Gooter and T. Ulen, Law and Economics (New York: Harper Collins, 1988), p. 45. According to Baumol and Oates, p. 17, "[an] externality is present whenever some individual's (say A's) utility or production relationships include real (that is, nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A's welfare." Externalities, according to this definition, are the outcome of interdependencies between different utility and production functions. The difference between the two definitions originates in the distinction between "technological" externalities and "pecuniary" externalities. Technological externalities affect the welfare of others directly through their production or utility functions. Pecuniary externalities affect the welfare of others indirectly, usually through price and cost changes transmitted via the market, without affecting utility or production functions (see Baumol and Oates, pp. 29-31). Baumol and Oate's definition refers only to technological externalities. It excludes pecuniary externalities on the assumption that such externalities do not produce inefficiencies. In contrast, the former definition covers pecuniary externalities as well. In this article, it is assumed that pecuniary externalities may also produce inefficiencies, although in a very limited context. See below, note 35.
2. 1 The concept of externalities is "one of the most elusive in economic literature." T. Scitovsky, "The Concept of External Economics," 62 Journal of Political Economy 143 (1954), reprinted in Externalities: Theoretical Dimensions of Political Economy, eds. R. J. Staaf and F. X. Tannian, Dunellen, New York, 1973, p. 77. This concept can be defined in various ways. See W. J. Baumol and W. E. Oates, The Theory of Environmental Policy (Cambridge: Cambridge University Press, 2d ed. 1988) pp. 15-18. For the purposes of this article, externality may be defined as "a cost or benefit that the voluntary action of one or more people impose or confer on a third party without their consent." See R. Gooter and T. Ulen, Law and Economics (New York: Harper Collins, 1988), p. 45. According to Baumol and Oates, p. 17, "[an] externality is present whenever some individual's (say A's) utility or production relationships include real (that is, nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A's welfare." Externalities, according to this definition, are the outcome of interdependencies between different utility and production functions. The difference between the two definitions originates in the distinction between "technological" externalities and "pecuniary" externalities. Technological externalities affect the welfare of others directly through their production or utility functions. Pecuniary externalities affect the welfare of others indirectly, usually through price and cost changes transmitted via the market, without affecting utility or production functions (see Baumol and Oates, pp. 29-31). Baumol and Oate's definition refers only to technological externalities. It excludes pecuniary externalities on the assumption that such externalities do not produce inefficiencies. In contrast, the former definition covers pecuniary externalities as well. In this article, it is assumed that pecuniary externalities may also produce inefficiencies, although in a very limited context. See below, note 35.
3. 1 The concept of externalities is "one of the most elusive in economic literature." T. Scitovsky, "The Concept of External Economics," 62 Journal of Political Economy 143 (1954), reprinted in Externalities: Theoretical Dimensions of Political Economy, eds. R. J. Staaf and F. X. Tannian, Dunellen, New York, 1973, p. 77. This concept can be defined in various ways. See W. J. Baumol and W. E. Oates, The Theory of Environmental Policy (Cambridge: Cambridge University Press, 2d ed. 1988) pp. 15-18. For the purposes of this article, externality may be defined as "a cost or benefit that the voluntary action of one or more people impose or confer on a third party without their consent." See R. Gooter and T. Ulen, Law and Economics (New York: Harper Collins, 1988), p. 45. According to Baumol and Oates, p. 17, "[an] externality is present whenever some individual's (say A's) utility or production relationships include real (that is, nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A's welfare." Externalities, according to this definition, are the outcome of interdependencies between different utility and production functions. The difference between the two definitions originates in the distinction between "technological" externalities and "pecuniary" externalities. Technological externalities affect the welfare of others directly through their production or utility functions. Pecuniary externalities affect the welfare of others indirectly, usually through price and cost changes transmitted via the market, without affecting utility or production functions (see Baumol and Oates, pp. 29-31). Baumol and Oate's definition refers only to technological externalities. It excludes pecuniary externalities on the assumption that such externalities do not produce inefficiencies. In contrast, the former definition covers pecuniary externalities as well. In this article, it is assumed that pecuniary externalities may also produce inefficiencies, although in a very limited context. See below, note 35.
4. 1 The concept of externalities is "one of the most elusive in economic literature." T. Scitovsky, "The Concept of External Economics," 62 Journal of Political Economy 143 (1954), reprinted in Externalities: Theoretical Dimensions of Political Economy, eds. R. J. Staaf and F. X. Tannian, Dunellen, New York, 1973, p. 77. This concept can be defined in various ways. See W. J. Baumol and W. E. Oates, The Theory of Environmental Policy (Cambridge: Cambridge University Press, 2d ed. 1988) pp. 15-18. For the purposes of this article, externality may be defined as "a cost or benefit that the voluntary action of one or more people impose or confer on a third party without their consent." See R. Gooter and T. Ulen, Law and Economics (New York: Harper Collins, 1988), p. 45. According to Baumol and Oates, p. 17, "[an] externality is present whenever some individual's (say A's) utility or production relationships include real (that is, nonmonetary) variables, whose values are chosen by others (persons, corporations, governments) without particular attention to the effects on A's welfare." Externalities, according to this definition, are the outcome of interdependencies between different utility and production functions. The difference between the two definitions originates in the distinction between "technological" externalities and "pecuniary" externalities. Technological externalities affect the welfare of others directly through their production or utility functions. Pecuniary externalities affect the welfare of others indirectly, usually through price and cost changes transmitted via the market, without affecting utility or production functions (see Baumol and Oates, pp. 29-31). Baumol and Oate's definition refers only to technological externalities. It excludes pecuniary externalities on the assumption that such externalities do not produce inefficiencies. In contrast, the former definition covers pecuniary externalities as well. In this article, it is assumed that pecuniary externalities may also produce inefficiencies, although in a very limited context. See below, note 35.
5. 2 The term "efficiency" is used to indicate an increase in aggregate welfare. As to the different types of efficiency see below, note 35. "Welfare" is used as a synonym for "utility" and "wealth," and it is measured in money terms, assuming risk neutrality.
6. 3 It should be noted that externalities do not necessarily produce inefficiencies, but may do so. It is quite possible for externalities to exist in an efficient state, and in such cases there is no need to internalize. See J. Buchanan and W. C. Stubblebine, "Externality," note 29 Economica 371 (1962) reprinted in Externalities, above note 1, 277, p. 286, and Baumol and Oates, above note 1, p. 18.
7. 3 It should be noted that externalities do not necessarily produce inefficiencies, but may do so. It is quite possible for externalities to exist in an efficient state, and in such cases there is no need to internalize. See J. Buchanan and W. C. Stubblebine, "Externality," note 29 Economica 371 (1962) reprinted in Externalities, above note 1, 277, p. 286, and Baumol and Oates, above note 1, p. 18.
8. 4 Posner sees himself as a follower of Coase. See W. M. Landes and R. A. Posner, The Economic Structure of Tort Law (Cambridge, MA: Harvard University Press, 1987), pp. 7-8. Coase, on the other hand, has recently remarked, rather ambiguously, "Posner . . . picked up what I had said about the judges and ran with it. I have never attempted to follow him. For one thing, he runs much faster than I do. He also runs in a somewhat different direction." R. H. Coase, "Law and Economics at Chicago," 36 Journal of Law and Economics 239 (1993) p. 251. The discrepancy between them contradicts the prevailing view claiming that Coase was followed by lawyers rather than by economists. See S. Schwab, "Coase defends Coase: Why Lawyers Listen and Economists Do Not," 87 Michigan Law Review 1171 (1989), p. 1191.
9. 4 Posner sees himself as a follower of Coase. See W. M. Landes and R. A. Posner, The Economic Structure of Tort Law (Cambridge, MA: Harvard University Press, 1987), pp. 7-8. Coase, on the other hand, has recently remarked, rather ambiguously, "Posner . . . picked up what I had said about the judges and ran with it. I have never attempted to follow him. For one thing, he runs much faster than I do. He also runs in a somewhat different direction." R. H. Coase, "Law and Economics at Chicago," 36 Journal of Law and Economics 239 (1993) p. 251. The discrepancy between them contradicts the prevailing view claiming that Coase was followed by lawyers rather than by economists. See S. Schwab, "Coase defends Coase: Why Lawyers Listen and Economists Do Not," 87 Michigan Law Review 1171 (1989), p. 1191.
10. 4 Posner sees himself as a follower of Coase. See W. M. Landes and R. A. Posner, The Economic Structure of Tort Law (Cambridge, MA: Harvard University Press, 1987), pp. 7-8. Coase, on the other hand, has recently remarked, rather ambiguously, "Posner . . . picked up what I had said about the judges and ran with it. I have never attempted to follow him. For one thing, he runs much faster than I do. He also runs in a somewhat different direction." R. H. Coase, "Law and Economics at Chicago," 36 Journal of Law and Economics 239 (1993) p. 251. The discrepancy between them contradicts the prevailing view claiming that Coase was followed by lawyers rather than by economists. See S. Schwab, "Coase defends Coase: Why Lawyers Listen and Economists Do Not," 87 Michigan Law Review 1171 (1989), p. 1191.
11. 5 The former, however, may influence the latter indirectly, through the operation of liability rules. See below, first part of Section III.
12. 6 In G. T. Schwartz, "Reality in the Economic Analysis of Tort Law: Does Tort Law Really Deter?" 42 UCLA Law Review 379 (1994), pp. 425-426, the author argues that, although tort law provides a significant amount of deterrence, its actual impact on the parties' behavior is less than economists tend to predict.
13. 7 According to the Coase Theorem, in the absence of transaction costs, externalities are internalized through a bargaining process between victims and injurers, and there is no need for liability rules. See R. H. Coase "The Problem of Social Cost," Journal of Law and Economics 1 (1960). Coase later clarified, however, that the assumption of zero transaction costs is unrealistic, and that he had used the Coase Theorem to illuminate the fallacies of an economic analysis that does factor in transaction costs. See R. H. Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988) pp. 174-175.
14. 7 According to the Coase Theorem, in the absence of transaction costs, externalities are internalized through a bargaining process between victims and injurers, and there is no need for liability rules. See R. H. Coase "The Problem of Social Cost," Journal of Law and Economics 1 (1960). Coase later clarified, however, that the assumption of zero transaction costs is unrealistic, and that he had used the Coase Theorem to illuminate the fallacies of an economic analysis that does factor in transaction costs. See R. H. Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988) pp. 174-175.
15. 8 The term "loss mitigation" usually refers only to the reduction of loss that has already been inflicted. Here we shall use it in a broader sense, to include prevention of loss before its infliction.
16. 9 In the railroad's sparks example, the actual private loss of revenues on the abandoned cultivation can be mitigated by revenues from alternative cultivation or alternative use of the released inputs. See Coase, Social Cost (in note 7 above), p. 33. The externalized social cost is the loss that farmers would have suffered had they changed their activity. In the pollution example, the actual private loss of the residents can be mitigated by moving to alternative locations or taking other measures against pollution. Ibid, p. 4.
17. 9 In the railroad's sparks example, the actual private loss of revenues on the abandoned cultivation can be mitigated by revenues from alternative cultivation or alternative use of the released inputs. See Coase, Social Cost (in note 7 above), p. 33. The externalized social cost is the loss that farmers would have suffered had they changed their activity. In the pollution example, the actual private loss of the residents can be mitigated by moving to alternative locations or taking other measures against pollution. Ibid, p. 4.
18. 10 One senses that Coase sees his life's work as an effort to combat the evil of Arthur Pigou. . . ." Schwab, above note 4, p. 1184.
19. 11 "A tax system which was confined to a tax on the producer for damage caused would tend to lead to unduly high costs being incurred for the prevention of damage." Coase, Social Cost, above note 7, p. 41. See also Coase, The Firm, the Market, and the Law, above note 7, p. 182.
20. 11 "A tax system which was confined to a tax on the producer for damage caused would tend to lead to unduly high costs being incurred for the prevention of damage." Coase, Social Cost, above note 7, p. 41. See also Coase, The Firm, the Market, and the Law, above note 7, p. 182.
21. 12 Coase, Social Cost, above note 7, p. 46.
22. 13 Ibid, p. 26. On the basis of this criticism Coase develops his laissez-faire message, which he contrasts with the Pigovian tradition of "Intervention by Public Authority," (Coase, The Firm, the Market and the Law, above note 7, pp. 20-27). Recently, it has been argued that Coase misunderstood Pigou or used him as a "straw man," and that "Pigou's view was thus much the same as that of Coase, although he was marginally less skeptical about the merits of state action." A. W. B. Simpson, "Coase v. Pigou Reexamined," 25 Journal of Legal Studies 53 (1996), p. 73. See Coase's reply. Ibid, p. 103, and Simpson's Addendum, Ibid, p. 99.
23. 13 Ibid, p. 26. On the basis of this criticism Coase develops his laissez-faire message, which he contrasts with the Pigovian tradition of "Intervention by Public Authority," (Coase, The Firm, the Market and the Law, above note 7, pp. 20-27). Recently, it has been argued that Coase misunderstood Pigou or used him as a "straw man," and that "Pigou's view was thus much the same as that of Coase, although he was marginally less skeptical about the merits of state action." A. W. B. Simpson, "Coase v. Pigou Reexamined," 25 Journal of Legal Studies 53 (1996), p. 73. See Coase's reply. Ibid, p. 103, and Simpson's Addendum, Ibid, p. 99.
24. 13 Ibid, p. 26. On the basis of this criticism Coase develops his laissez-faire message, which he contrasts with the Pigovian tradition of "Intervention by Public Authority," (Coase, The Firm, the Market and the Law, above note 7, pp. 20-27). Recently, it has been argued that Coase misunderstood Pigou or used him as a "straw man," and that "Pigou's view was thus much the same as that of Coase, although he was marginally less skeptical about the merits of state action." A. W. B. Simpson, "Coase v. Pigou Reexamined," 25 Journal of Legal Studies 53 (1996), p. 73. See Coase's reply. Ibid, p. 103, and Simpson's Addendum, Ibid, p. 99.
25. 13 Ibid, p. 26. On the basis of this criticism Coase develops his laissez-faire message, which he contrasts with the Pigovian tradition of "Intervention by Public Authority," (Coase, The Firm, the Market and the Law, above note 7, pp. 20-27). Recently, it has been argued that Coase misunderstood Pigou or used him as a "straw man," and that "Pigou's view was thus much the same as that of Coase, although he was marginally less skeptical about the merits of state action." A. W. B. Simpson, "Coase v. Pigou Reexamined," 25 Journal of Legal Studies 53 (1996), p. 73. See Coase's reply. Ibid, p. 103, and Simpson's Addendum, Ibid, p. 99.
26. 13 Ibid, p. 26. On the basis of this criticism Coase develops his laissez-faire message, which he contrasts with the Pigovian tradition of "Intervention by Public Authority," (Coase, The Firm, the Market and the Law, above note 7, pp. 20-27). Recently, it has been argued that Coase misunderstood Pigou or used him as a "straw man," and that "Pigou's view was thus much the same as that of Coase, although he was marginally less skeptical about the merits of state action." A. W. B. Simpson, "Coase v. Pigou Reexamined," 25 Journal of Legal Studies 53 (1996), p. 73. See Coase's reply. Ibid, p. 103, and Simpson's Addendum, Ibid, p. 99.
27. 14 R. Cooter, "The Cost of Coase," 11 Journal of Legal Studies 1 (1982), p. 8. Cooter analyzed the two examples used by Coase and reached the conclusion that the mitigated loss which equals externalized social cost is the fall in the rental value of the affected land. Ibid, p. 7. See also Schwab, above note 4, pp. 1186-1187.
28. 14 R. Cooter, "The Cost of Coase," 11 Journal of Legal Studies 1 (1982), p. 8. Cooter analyzed the two examples used by Coase and reached the conclusion that the mitigated loss which equals externalized social cost is the fall in the rental value of the affected land. Ibid, p. 7. See also Schwab, above note 4, pp. 1186-1187.
29. 15 Coase, The Firm, the Market, and the Law, above note 7, p. 177.
30. 16 As sanctioned by Coase, above note 12. Simpson argues that Pigou held this view as well (see above note 13, pp. 70-71).
31. 17 The branch of law that deals with such rights is the law of restitution or unjust enrichment. See W. Bishop and J. Sutton, "Efficiency and Justice in Tort Damages: The Shortcomings of the Pecuniary Loss Rule," 15 Journal of Legal Studies 347 (1986), pp. 348 and 350.
32. 18 Assuming, of course, that the interrupted activity generates rent, and that the interruption is not marginal. In the margin, price equals production costs and there is no rent.
33. 19 This result is contingent upon the net increase in the rent of other activities exceeding the net loss of consumer surplus in the process.
34. 20 See W. Bishop, "Economic Loss in Tort," 2 Oxford Journal of Legal Studies 1 (1981); Bishop and Sutton, Pecuniary Loss Rule, above note 17; V. P. Goldberg, "Recovery for Economic Loss Following the Exxon Valdez Oil Spill," 23 Journal of Legal Studies 1 (1994); Landes and Posner, Economic Structure, above note 4, pp. 251-255; S. Shavell, Economic Analysis of Accident Law (Cambridge, MA: Harvard University Press, 1987) pp. 135-140.
35. 20 See W. Bishop, "Economic Loss in Tort," 2 Oxford Journal of Legal Studies 1 (1981); Bishop and Sutton, Pecuniary Loss Rule, above note 17; V. P. Goldberg, "Recovery for Economic Loss Following the Exxon Valdez Oil Spill," 23 Journal of Legal Studies 1 (1994); Landes and Posner, Economic Structure, above note 4, pp. 251-255; S. Shavell, Economic Analysis of Accident Law (Cambridge, MA: Harvard University Press, 1987) pp. 135-140.
36. 20 See W. Bishop, "Economic Loss in Tort," 2 Oxford Journal of Legal Studies 1 (1981); Bishop and Sutton, Pecuniary Loss Rule, above note 17; V. P. Goldberg, "Recovery for Economic Loss Following the Exxon Valdez Oil Spill," 23 Journal of Legal Studies 1 (1994); Landes and Posner, Economic Structure, above note 4, pp. 251-255; S. Shavell, Economic Analysis of Accident Law (Cambridge, MA: Harvard University Press, 1987) pp. 135-140.
37. 20 See W. Bishop, "Economic Loss in Tort," 2 Oxford Journal of Legal Studies 1 (1981); Bishop and Sutton, Pecuniary Loss Rule, above note 17; V. P. Goldberg, "Recovery for Economic Loss Following the Exxon Valdez Oil Spill," 23 Journal of Legal Studies 1 (1994); Landes and Posner, Economic Structure, above note 4, pp. 251-255; S. Shavell, Economic Analysis of Accident Law (Cambridge, MA: Harvard University Press, 1987) pp. 135-140.
38. 20 See W. Bishop, "Economic Loss in Tort," 2 Oxford Journal of Legal Studies 1 (1981); Bishop and Sutton, Pecuniary Loss Rule, above note 17; V. P. Goldberg, "Recovery for Economic Loss Following the Exxon Valdez Oil Spill," 23 Journal of Legal Studies 1 (1994); Landes and Posner, Economic Structure, above note 4, pp. 251-255; S. Shavell, Economic Analysis of Accident Law (Cambridge, MA: Harvard University Press, 1987) pp. 135-140.
39. 21 For a comprehensive discussion of the exclusionary rule see B. Feldthusen, Economic Negligence, 3rd edition, (Carswell, Toronto, 1994). The rule is discussed below, in the third part of Section IV.
40. 22 See Bishop, Economic Loss, above note 20, pp. 4-7.
41. 23 Goldberg, Oil Spill, above note 20, pp. 24-34.
42. 24 Rizzo argued that the presence of excess capacity is itself an unexplained, inefficient, anomaly. See M. J. Rizzo, "The Economic Loss Problem: A Comment on Bishop," 2 Oxford Journal of Legal Studies 197 (1982); M. J. Rizzo, "A Theory of Economic Loss in the Law of Torts," 11 Journal of Legal Studies 281 (1982). In my view, a state of excess capacity can be efficient and requires no explanation. Hotels rarely have 100-% vacancy, and retail stores may often be empty or half empty. Excess capacity is an anomaly only when it is inefficient, namely, when those inputs that are sometimes used and sometimes not have a better alternative use. In the absence of such alternative use nothing is wrong with excess capacity. In this regard see also Bishop, "Economic Loss: A Reply to Professor Rizzo," 2 Oxford Journal of Legal Studies 207 (1982). See also D. Rabin, "Tort Recovery for Negligently Inflicted Economic Loss: A Reassessment," 37 Stanford Law Review 1513 (1985), p. 1536, note 72.
43. 24 Rizzo argued that the presence of excess capacity is itself an unexplained, inefficient, anomaly. See M. J. Rizzo, "The Economic Loss Problem: A Comment on Bishop," 2 Oxford Journal of Legal Studies 197 (1982); M. J. Rizzo, "A Theory of Economic Loss in the Law of Torts," 11 Journal of Legal Studies 281 (1982). In my view, a state of excess capacity can be efficient and requires no explanation. Hotels rarely have 100-% vacancy, and retail stores may often be empty or half empty. Excess capacity is an anomaly only when it is inefficient, namely, when those inputs that are sometimes used and sometimes not have a better alternative use. In the absence of such alternative use nothing is wrong with excess capacity. In this regard see also Bishop, "Economic Loss: A Reply to Professor Rizzo," 2 Oxford Journal of Legal Studies 207 (1982). See also D. Rabin, "Tort Recovery for Negligently Inflicted Economic Loss: A Reassessment," 37 Stanford Law Review 1513 (1985), p. 1536, note 72.
44. 24 Rizzo argued that the presence of excess capacity is itself an unexplained, inefficient, anomaly. See M. J. Rizzo, "The Economic Loss Problem: A Comment on Bishop," 2 Oxford Journal of Legal Studies 197 (1982); M. J. Rizzo, "A Theory of Economic Loss in the Law of Torts," 11 Journal of Legal Studies 281 (1982). In my view, a state of excess capacity can be efficient and requires no explanation. Hotels rarely have 100-% vacancy, and retail stores may often be empty or half empty. Excess capacity is an anomaly only when it is inefficient, namely, when those inputs that are sometimes used and sometimes not have a better alternative use. In the absence of such alternative use nothing is wrong with excess capacity. In this regard see also Bishop, "Economic Loss: A Reply to Professor Rizzo," 2 Oxford Journal of Legal Studies 207 (1982). See also D. Rabin, "Tort Recovery for Negligently Inflicted Economic Loss: A Reassessment," 37 Stanford Law Review 1513 (1985), p. 1536, note 72.
45. 24 Rizzo argued that the presence of excess capacity is itself an unexplained, inefficient, anomaly. See M. J. Rizzo, "The Economic Loss Problem: A Comment on Bishop," 2 Oxford Journal of Legal Studies 197 (1982); M. J. Rizzo, "A Theory of Economic Loss in the Law of Torts," 11 Journal of Legal Studies 281 (1982). In my view, a state of excess capacity can be efficient and requires no explanation. Hotels rarely have 100-% vacancy, and retail stores may often be empty or half empty. Excess capacity is an anomaly only when it is inefficient, namely, when those inputs that are sometimes used and sometimes not have a better alternative use. In the absence of such alternative use nothing is wrong with excess capacity. In this regard see also Bishop, "Economic Loss: A Reply to Professor Rizzo," 2 Oxford Journal of Legal Studies 207 (1982). See also D. Rabin, "Tort Recovery for Negligently Inflicted Economic Loss: A Reassessment," 37 Stanford Law Review 1513 (1985), p. 1536, note 72.
46. 25 The process for generating alternative rent is a complex one, and so is its measurement. Sometimes additional inputs are transferred directly from the interrupted production to the production of substitutes. It may well be, however, that the additional inputs for the production of substitutes come from other lines of production, while inputs of the interrupted production are redeployed elsewhere.
47. 26 Furthermore, even when inputs of the interrupted production cannot be redeployed, the redeployment of other inputs may generate additional rent. Assume, for example, that inputs are transferred from other uses to repair a resource damaged by the loss-inflicting activity. If the rent on these inputs is increased as a result of their transfer, such increase is an offsetting gain. Goldberg's statement, that repairer's gains do not offset physical damage but merely restate them, should therefore be qualified in cases of increased rent. See Goldberg, Oil Spill, above note 20, pp. 34-35.
48. 27 Shavell, Accident Law, above note 20, p. 138.
49. 28 One example is interference with the contractual or precontractual relations of another producer in a way that transfers the gain from these relations from the interrupted producer to another producer.
50. 29 See Rabin, above note 24. Yet, even when the whole gain is transferred from one producer to another, negative implications and side effects may cause additional losses that are not offset. Interference with contractual or precontractual relations, for example, undermines commercial certainty - a real social cost.
51. 30 It should be noted that gains that offset the private loss of interrupted producers do not include the additional rent resulting from a rise in the price of product or service already produced. This additional rent comes at the expense of consumers who have to pay more for the product or service.
52. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
53. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
54. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
55. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
56. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
57. 31 Bishop, Economic Loss, above note 20, pp. 5 and 12. See also Goldberg, Oil Spill, above note 20, p. 33. Of course, there are other factors that create or increase social cost in cases of interrupted production. Producers anticipating a rise in demand when other producers are interrupted tend to structure their production in a way that increases capacity inefficiently (Bishop, Ibid, p. 15). Social cost is also incurred when producers take measures to avoid a private loss that does not represent any social cost (Bishop, Ibid, p. 9). See below, note 45. See also Shavell, Accident Law, above note 20, pp. 136-139. Another source of social cost is risk aversion. See Bishop, Ibid. p. 7. Yet, these added social costs do not weaken the conclusion that social cost, through their mitigation by gains of third parties, may be smaller than the private loss of interrupted producers.
58. 32 In the railroad's sparks example, an activity-related benefit is the welfare of those who use the trains, whereas in the pollution example, it is the welfare of those who consume the products of the polluting factory. 33 Marginal products and services whose price equals consumption value do not generate a consumer surplus.
59. 34 Producers and service providers tend to disregard this consumer surplus whenever it does not affect their rent. For a similar reason I have argued, in the context of product liability, that the Coase Theorem is inapplicable to competitive markets, because victims in a competitive market cannot offer their consumer surplus to producers as a Coasean bribe. The non-transferability of producer surplus is a built-in transaction costs barrier in competitive markets. See I. Gilead, "Coase Theorem, Competitive Market and Products Liability Law," 20 Israel Law Review 39 (1985).
60. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost.note See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
61. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
62. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
63. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
64. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
65. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
66. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
67. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
68. 35 Bishop discusses externalized benefits in the limited context of negligent misrepresentation. W. Bishop, "Negligent Misrepresentation: Economist's View," 96 Law Quarterly Review 360 (1980), pp. 365-366. He acknowledges that the production of information generates benefits to third parties, and that these benefits should be offset against the inflicted losses to avoid overdeterrence. Yet, Bishop explicitly argues that these benefits do not exist in "[m]uch of tort law," namely, in typical cases of negligence and nuisance (p. 365). I fail to see why not. As indicated, almost every product that is manufactured or any service that is provided generate consumer surplus. The tendency to understate the offsetting effect of activity-related benefits may be explained, however, by the elusiveness of consumer surplus. Consumer surplus is usually spread over a large group of mostly unidentified beneficiaries, and is often immeasurable because it represents subjective preferences. Another explanation, as many probably will argue, is that activity-related benefits are irrelevant and should be ignored because they represent pecuniary externalities and not technological externalities. As already indicated (above note I), it is customary to assume that pecuniary externalities, as opposed to technological ones, do not produce inefficiencies. It is true that activity-related benefits are a kind of pecuniary externality. Yet, pecuniary externalities may produce inefficiencies. Assume, for example, that at its marginal level a loss-inflicting activity enjoys no profit, that it inflicts a loss of 1, and that it produces net activity-related benefits of 2. The total effect of the activity in its margin is positive. Internalization of the inflicted loss to the injurer, however, will render this marginal level of activity unprofitable from his point of view and the activity will contract. This reduction in the level of the loss-inflicting activity is inefficient. Loss internalization here leads to overdeterrence because the injurer externalizes the activity-related benefit, and because the internalization system fails to offset this benefit against the private loss. Why, then, is it generally assumed that pecuniary externalities do not produce inefficiencies? The answer can be found in the different types of efficiency. Pecuniary externalities, unlike technological externalities, do not directly affect production and utility functions, and therefore do not produce productive or distributive inefficiencies (in productive efficiency the economy is on its production-possibility frontier; in distributive efficiency consumers cannot increase their aggregate welfare by swapping products and services). Yet the third type of efficiency, allocative efficiency, may be negatively affected by pecuniary externalities. As recognized in Baumol and Oates (above note 1, pp. 29-31) pecuniary externalities take the form of a movement along the utility-possibility frontier. Such movement may bring the economy to a point where it produces an inefficient combination of products and services. It is inefficient in the sense that a different combination at another point on the frontier could make all parties better off. Pecuniary externalities, in other words, may lead to an inefficient change of activity levels, and this is exactly what emerges from the above example. The analysis of the "double taxation" issue supports this contention. See below, note 48 and the accompanying text. The opposite argument, that advantages transmitted via the market are normally offset by corresponding disadvantages to others, is questionable and artificially narrows the definition of social cost. See K. W. Kapp, "On the Nature and Significance of Social Cost," 12 Kyklos 334 (1969), reprinted in Externalities, above note 1, 3 p. 8. For various aspects of the distorting effect of pecuniary externalities see: Scitovski, above note 1; F. J. Anderson, "Pecuniary Externalities and Referent Groups in the Operation of the Price System," 40 Southern Economic Journal 442 (1974); L. H. Loong and R. Zeckhauser, "Pecuniary Externalities do Matter When Contingent Claims Markets are Incomplete," 97 Quarterly Journal of Economics 17 (1982); Y. K. Ng, "Rents and Pecuniary Externalities in Cost-benefit Analysis: Comment," 73 American Economic Review 1168 (1983); H. S. Esfahani and D. Mookherjee, "Productivity, Contracting Modes, and Developments," 46 Journal of Development Economics 203 (1995); and L. Makovski and J. M. Ostroy, "Appropriation and Efficiency: A Revision of the First Theorem of Welfare Economics," 85 American Economic Review 808 (1995).
69. 36 People must, to a certain extent, walk, commute, consume basic products, get medical treatment, and so on. The ability to mitigate these losses by moving to alternative activities is limited despite the prospect of road accidents, product-related accidents, or professional malpractice.
70. 37 See Bishop, Economic Loss, above note 20, pp. 4-7; Bishop, Reply, above note 24, p. 208.
71. 37 See Bishop, Economic Loss, above note 20, pp. 4-7; Bishop, Reply, above note 24, p. 208.
72. 38 Yet, the private loss may exceed the social cost of the destruction when the destroyed products or inputs are not marginal, namely, when their market price exceeds production costs.
73. 39 The market price of the repair may be offset by an increase in the rent of the repair services that would have otherwise been engaged in a less profitable activity. See above note 26.
74. 40 Bishop, Economic Loss, above note 20, p. 6.
75. 41 See Bishop and Sutton, Pecuniary Loss Rule, above note 35, p. 363.
76. 42 ". . . [T]he victim of a detrimental externality should face a zero charge: The victim should neither be taxed nor compensated for the damages absorbed." (Baumol and Oates, above note 1, p. 23) "To provide proper incentives to victims for defensive activities, neither compensation nor a tax is appropriate." (Ibid, p. 25). For the argument that if injurers behave efficiently so will the victims, see Landes and Posner, Economic Structure, above note 4, pp. 75-76.
77. 42 ". . . [T]he victim of a detrimental externality should face a zero charge: The victim should neither be taxed nor compensated for the damages absorbed." (Baumol and Oates, above note 1, p. 23) "To provide proper incentives to victims for defensive activities, neither compensation nor a tax is appropriate." (Ibid, p. 25). For the argument that if injurers behave efficiently so will the victims, see Landes and Posner, Economic Structure, above note 4, pp. 75-76.
78. 42 ". . . [T]he victim of a detrimental externality should face a zero charge: The victim should neither be taxed nor compensated for the damages absorbed." (Baumol and Oates, above note 1, p. 23) "To provide proper incentives to victims for defensive activities, neither compensation nor a tax is appropriate." (Ibid, p. 25). For the argument that if injurers behave efficiently so will the victims, see Landes and Posner, Economic Structure, above note 4, pp. 75-76.
79. 43 Coase, Social Cost, above note 7, pp. 2, 13, and 41-42.
80. 44 See Coase, The Firm, the Market, and the Law, above note 7. pp. 181-182.
81. 45 Although victims may be considered the cause of their own loss by reason of engaging in activity that is susceptible to loss, they do not externalize this loss. They internalize it because they actually suffer it. There are, however, at least two possible types of situations in which victims and injurers can be considered joint generators of externalities. First, victims, like injurers, externalize loss they are unaware of. Second, to avoid a private loss, victims may use resources at a cost higher than the social cost of their loss.
82. 46 Unless proper rules of mitigation deny an award of damages that would lead to such inefficiencies. It should be noted that these "second-stage" externalities are of a special kind. Their immediate cause is not the activity of the victims but rather the collective organs that impose taxes or liability on injurers.
83. 47 Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182.
84. 48 Coase, Social Cost, above note 7, p. 42. It is illuminating to examine the "double taxation" complex from the perspective of pecuniary externalities discussed above, in note 35. Baumol has argued that Coase's mistake in his "double taxation" proposal originates in his failure to see that these "second-stage" externalities are pecuniary externalities and therefore should not be internalized (Baumol and Oates, above note 1, pp. 31-32). Yet, Baumol will probably agree with Coase's clarification that victims should only be taxed in the case of injurers' overdeterrence, and only in this case. In other words, he will agree that the "second-stage" pecuniary externalities should be internalized when injurers are overdeterred. This conclusion supports the contention that pecuniary externalities may lead to allocative inefficiency.
85. 49 See Baumol and Oates, above note 42, and W. Baumol, "On Taxation and the Control of Externalities," 62 American Economic Review 307 (1972), p. 309. Coase agrees with Baumol's analysis and with the conclusion that internalization of externalized social cost to injurers is sufficient for optimal resource allocation (Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182. In his article, "Unity in Tort, Contract, and Property: The Model of Precaution," 73 California Law Review 1 (1985), p. 4, Cooter states that ". . . [c]ompensation in its simplest form is inconsistent with double responsibility at the margin." Shavell argues along the same line that "optimal levels of activity will be reached only when victims bear their losses without being compensated, while injurers pay taxes equal to expected harm." (Shavell, Accident Law, above note 20, pp. 29-30). As to Posner, see below, the first part of Section IV. Calabresi supported the same conclusion in a private conversation. It should be noted, however, that compensation does not necessarily produce inefficiencies. It may do so. See above note 3.
86. 49 See Baumol and Oates, above note 42, and W. Baumol, "On Taxation and the Control of Externalities," 62 American Economic Review 307 (1972), p. 309. Coase agrees with Baumol's analysis and with the conclusion that internalization of externalized social cost to injurers is sufficient for optimal resource allocation (Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182. In his article, "Unity in Tort, Contract, and Property: The Model of Precaution," 73 California Law Review 1 (1985), p. 4, Cooter states that ". . . [c]ompensation in its simplest form is inconsistent with double responsibility at the margin." Shavell argues along the same line that "optimal levels of activity will be reached only when victims bear their losses without being compensated, while injurers pay taxes equal to expected harm." (Shavell, Accident Law, above note 20, pp. 29-30). As to Posner, see below, the first part of Section IV. Calabresi supported the same conclusion in a private conversation. It should be noted, however, that compensation does not necessarily produce inefficiencies. It may do so. See above note 3.
87. 49 See Baumol and Oates, above note 42, and W. Baumol, "On Taxation and the Control of Externalities," 62 American Economic Review 307 (1972), p. 309. Coase agrees with Baumol's analysis and with the conclusion that internalization of externalized social cost to injurers is sufficient for optimal resource allocation (Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182. In his article, "Unity in Tort, Contract, and Property: The Model of Precaution," 73 California Law Review 1 (1985), p. 4, Cooter states that ". . . [c]ompensation in its simplest form is inconsistent with double responsibility at the margin." Shavell argues along the same line that "optimal levels of activity will be reached only when victims bear their losses without being compensated, while injurers pay taxes equal to expected harm." (Shavell, Accident Law, above note 20, pp. 29-30). As to Posner, see below, the first part of Section IV. Calabresi supported the same conclusion in a private conversation. It should be noted, however, that compensation does not necessarily produce inefficiencies. It may do so. See above note 3.
88. 49 See Baumol and Oates, above note 42, and W. Baumol, "On Taxation and the Control of Externalities," 62 American Economic Review 307 (1972), p. 309. Coase agrees with Baumol's analysis and with the conclusion that internalization of externalized social cost to injurers is sufficient for optimal resource allocation (Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182. In his article, "Unity in Tort, Contract, and Property: The Model of Precaution," 73 California Law Review 1 (1985), p. 4, Cooter states that ". . . [c]ompensation in its simplest form is inconsistent with double responsibility at the margin." Shavell argues along the same line that "optimal levels of activity will be reached only when victims bear their losses without being compensated, while injurers pay taxes equal to expected harm." (Shavell, Accident Law, above note 20, pp. 29-30). As to Posner, see below, the first part of Section IV. Calabresi supported the same conclusion in a private conversation. It should be noted, however, that compensation does not necessarily produce inefficiencies. It may do so. See above note 3.
89. 49 See Baumol and Oates, above note 42, and W. Baumol, "On Taxation and the Control of Externalities," 62 American Economic Review 307 (1972), p. 309. Coase agrees with Baumol's analysis and with the conclusion that internalization of externalized social cost to injurers is sufficient for optimal resource allocation (Coase, The Firm, the Market, and the Law, above note 7, pp. 181-182. In his article, "Unity in Tort, Contract, and Property: The Model of Precaution," 73 California Law Review 1 (1985), p. 4, Cooter states that ". . . [c]ompensation in its simplest form is inconsistent with double responsibility at the margin." Shavell argues along the same line that "optimal levels of activity will be reached only when victims bear their losses without being compensated, while injurers pay taxes equal to expected harm." (Shavell, Accident Law, above note 20, pp. 29-30). As to Posner, see below, the first part of Section IV. Calabresi supported the same conclusion in a private conversation. It should be noted, however, that compensation does not necessarily produce inefficiencies. It may do so. See above note 3.
90. 50 To avoid these distorting effects, payments to victims should take the form of a lump sum that is conceived by victims as unrelated to their activity. It is hard to see, however, how damages for loss can be disassociated from the activity in which this loss is incurred.
91. 51 This is the case except when the rule of contributory negligence denies compensation.
92. 52 In their recent article "Property Rules versus Liability Rules: An Economic Analysis," 109 Harvard Law Review 715 (1996), p. 723, L. Kaplow and S. Shavell implicitly assume that "harmful externalities" and the harm for which the injurer is liable are basically the same.
93. 53 Landes and Posner, Economic Structure, above note 4, pp. 85-88 and 96-107; R. A. Posner, Economic Analysis of Law (Boston: Little Brown, 1992) pp. 163-167.
94. 53 Landes and Posner, Economic Structure, above note 4, pp. 85-88 and 96-107; R. A. Posner, Economic Analysis of Law (Boston: Little Brown, 1992) pp. 163-167.
95. 54 Posner actually extends the Hand Formula to cases of nuisance that are governed by the rule of reasonable use, arguing that this rule is basically equivalent to the negligence rule. See Landes and Posner, Economic Structure, (cited previously in note 4), pp. 39 and 48-51.
96. 55 Ibid, p. 59.
97. 56 Posner, Economic Analysis, above note 53, p. 176. See also S. G. Gilles, "Rule-Based Negligence and the Regulation of Activity Levels," 22 Journal of Legal Studies 319 (1992), p. 320.
98. 56 Posner, Economic Analysis, above note 53, p. 176. See also S. G. Gilles, "Rule-Based Negligence and the Regulation of Activity Levels," 22 Journal of Legal Studies 319 (1992), p. 320.
99. 57 Whenever prevention by reduction of activity level is less costly than increased care, B overstates private cost. Costs of prevention may be understated if the burden of increased care leads to a reduction in activity level as well, and such reduction imposes an extra cost on the injurer.
100. 58 The preliminary requirement that internalization will take place only if B is lower than L (PL > B) may occasionally prevent internalization of loss that exceeds social cost. This, however, will happen only when B exceeds the social cost of prevention in the same way that L exceeds the social cost of the private loss. Moreover, when B does act to bar internalization of private loss that exceeds externalized social cost it also bars internalization of the social cost itself, and therefore may lead to the "overkill" of injurers' underdeterrence. B will also lead to injurers' underdeterrence when it screens efficient internalization by overstating the social cost of prevention.
101. 59 See Posner, Economic Analysis, above note 53, pp. 175-180; Landes and Posner, Economic Structure, above note 4, pp. 64-71.
102. 59 See Posner, Economic Analysis, above note 53, pp. 175-180; Landes and Posner, Economic Structure, above note 4, pp. 64-71.
103. 60 This is actually what Gilles has suggested with regard to B. Gilles, above note 56. It should be noted, however, that when activity levels and the welfare of third parties are integrated directly into L and B, the adjusted formula may deny internalization when the Hand Formula allows it. Liability under the adjusted formula, in other words, is not strict liability.
104. 61 The defense of contributory negligence, let us recall, also ignores activity levels.
105. 62 Strict liability, on the other hand, may improve internalization when the Hand Formula leads to underdeterrence because B, by ignoring activity levels, overstates the social cost of prevention.
106. 63 See Economic Analysis, above note 53, p. 185, and Landes and Posner, Economic Structure, above note 4, p. 68.
107. 63 See Economic Analysis, above note 53, p. 185, and Landes and Posner, Economic Structure, above note 4, p. 68.
108. 64 Landes and Posner, Economic Structure, above note 4, p. 71. See also Gilles, above note 56, p. 320, summarizing Posner's approach to activity levels.
109. 64 Landes and Posner, Economic Structure, above note 4, p. 71. See also Gilles, above note 56, p. 320, summarizing Posner's approach to activity levels.
110. 65 Coase observed that proposals to design optimal systems of internalization "are the stuff that dreams are made of." (Coase, The Firm, the Market, and the Law, above note 7, p. 185). He also remarked that it would "require a detailed knowledge of individual preferences, and I am unable to imagine how the data needed for such a taxation system could be assembled. (Coase, Social Cost, above note 4, p. 41). Baumol too shares this view, acknowledging that "we do not know how to calculate the required taxes and subsidies and we do not know how to approximate them by trial and error." (Baumol, Control of Externalities, above note 50, p. 318).
111. 65 Coase observed that proposals to design optimal systems of internalization "are the stuff that dreams are made of." (Coase, The Firm, the Market, and the Law, above note 7, p. 185). He also remarked that it would "require a detailed knowledge of individual preferences, and I am unable to imagine how the data needed for such a taxation system could be assembled. (Coase, Social Cost, above note 4, p. 41). Baumol too shares this view, acknowledging that "we do not know how to calculate the required taxes and subsidies and we do not know how to approximate them by trial and error." (Baumol, Control of Externalities, above note 50, p. 318).
112. 65 Coase observed that proposals to design optimal systems of internalization "are the stuff that dreams are made of." (Coase, The Firm, the Market, and the Law, above note 7, p. 185). He also remarked that it would "require a detailed knowledge of individual preferences, and I am unable to imagine how the data needed for such a taxation system could be assembled. (Coase, Social Cost, above note 4, p. 41). Baumol too shares this view, acknowledging that "we do not know how to calculate the required taxes and subsidies and we do not know how to approximate them by trial and error." (Baumol, Control of Externalities, above note 50, p. 318).
113. 66 See the text accompanying note 13 above.
114. 67 Such an assumption is implicit in Posner's argument that positive externalities can be integrated into his negligence model without undermining it (Landes and Posner, Economic Structure, above note 4, p. 69).
115. 68 As emphasized by Coase, above note 65.
116. 69 Nor has Posner provided a satisfactory solution to another aspect of the Gap: the distorting effect of compensatory damages. Posner acknowledges that the award of damages to victims leads to their underdeterrence, and that tort law is unable to achieve optimal deterrence because it compensates victims. See Landes and Posner, Economic Structure, above note 4, pp. 69-70, following Shavell who argued that neither negligence nor strict liability can achieve optimal internalization (Shavell, above note 20, pp. 29-30). Posner nevertheless supports the award of compensatory damages that are "at least as great as L in the Hand Formula" . . . "to give the victim an incentive to sue, which is essential to the maintenance of the tort system as an effective, credible deterrent to negligence." (Posner, Economic Analysis, above note 53, p. 191). This explanation is questionable. In many cases, much smaller awards will provide sufficient incentives to sue, and the smaller the award, the smaller the ensuing inefficiencies. Furthermore, when the loss is continuous, as in nuisance, victims are motivated to sue so as to prevent or reduce future loss, regardless of compensation or damages awards.
117. 69 Nor has Posner provided a satisfactory solution to another aspect of the Gap: the distorting effect of compensatory damages. Posner acknowledges that the award of damages to victims leads to their underdeterrence, and that tort law is unable to achieve optimal deterrence because it compensates victims. See Landes and Posner, Economic Structure, above note 4, pp. 69-70, following Shavell who argued that neither negligence nor strict liability can achieve optimal internalization (Shavell, above note 20, pp. 29-30). Posner nevertheless supports the award of compensatory damages that are "at least as great as L in the Hand Formula" . . . "to give the victim an incentive to sue, which is essential to the maintenance of the tort system as an effective, credible deterrent to negligence." (Posner, Economic Analysis, above note 53, p. 191). This explanation is questionable. In many cases, much smaller awards will provide sufficient incentives to sue, and the smaller the award, the smaller the ensuing inefficiencies. Furthermore, when the loss is continuous, as in nuisance, victims are motivated to sue so as to prevent or reduce future loss, regardless of compensation or damages awards.
118. 69 Nor has Posner provided a satisfactory solution to another aspect of the Gap: the distorting effect of compensatory damages. Posner acknowledges that the award of damages to victims leads to their underdeterrence, and that tort law is unable to achieve optimal deterrence because it compensates victims. See Landes and Posner, Economic Structure, above note 4, pp. 69-70, following Shavell who argued that neither negligence nor strict liability can achieve optimal internalization (Shavell, above note 20, pp. 29-30). Posner nevertheless supports the award of compensatory damages that are "at least as great as L in the Hand Formula" . . . "to give the victim an incentive to sue, which is essential to the maintenance of the tort system as an effective, credible deterrent to negligence." (Posner, Economic Analysis, above note 53, p. 191). This explanation is questionable. In many cases, much smaller awards will provide sufficient incentives to sue, and the smaller the award, the smaller the ensuing inefficiencies. Furthermore, when the loss is continuous, as in nuisance, victims are motivated to sue so as to prevent or reduce future loss, regardless of compensation or damages awards.
119. 70 See above in the first part of Section II.
120. 71 On the debate as to whether comparative negligence is more efficient than contributory negligence or vice versa see T. Y. Chung, "Efficiency of Comparative Negligence: A Game Theoretic Analysis," 22 Journal of Legal Studies 395 (1993); D. Orr, "The Superiority of Comparative Negligence: Another Vote," 20 Journal of Legal Studies 119 (1991). It is often argued that there is no difference between the outcomes under comparative negligence and contributory negligence because, under both rules, once injurers are induced to take due care, so will victims, knowing that otherwise they alone will incur the whole loss. See Posner, Economic Analysis, above note 4, pp. 169-172; Shavell, Accident Law, above note 20, pp. 15-16. Yet, this line of reasoning is based on the assumption that the internalized private loss equals the social cost, so that injurers are not overdeterred. My point is that when private loss exceeds social cost, it seems that only comparative negligence can avoid overdeterrence of injurers. Assume, for example, that private loss is 100, that the social cost is 80 because the victim can reduce his expected private loss to 70 by investing 10, and that the injurer's only alternative is to prevent the loss of 100 by investing 90. By reducing damages to 80, comparative negligence can create the proper incentives for both parties: The victim will invest 10 to avoid the loss of 30, knowing that the injurer will not invest 90 to avoid damages of 80. In contrast, under contributory negligence, the victim will assume that the injurer will invest 90 to avoid loss and damages of 100 and, therefore, will have no incentives to mitigate a private loss that the injurer will prevent. To avoid this inefficiency, contributory negligence should be interpreted as denying liability even when the victim can prevent only a small fraction of his loss, but such an interpretation injects comparative aspects into the "all or nothing" defense.
121. 71 On the debate as to whether comparative negligence is more efficient than contributory negligence or vice versa see T. Y. Chung, "Efficiency of Comparative Negligence: A Game Theoretic Analysis," 22 Journal of Legal Studies 395 (1993); D. Orr, "The Superiority of Comparative Negligence: Another Vote," 20 Journal of Legal Studies 119 (1991). It is often argued that there is no difference between the outcomes under comparative negligence and contributory negligence because, under both rules, once injurers are induced to take due care, so will victims, knowing that otherwise they alone will incur the whole loss. See Posner, Economic Analysis, above note 4, pp. 169-172; Shavell, Accident Law, above note 20, pp. 15-16. Yet, this line of reasoning is based on the assumption that the internalized private loss equals the social cost, so that injurers are not overdeterred. My point is that when private loss exceeds social cost, it seems that only comparative negligence can avoid overdeterrence of injurers. Assume, for example, that private loss is 100, that the social cost is 80 because the victim can reduce his expected private loss to 70 by investing 10, and that the injurer's only alternative is to prevent the loss of 100 by investing 90. By reducing damages to 80, comparative negligence can create the proper incentives for both parties: The victim will invest 10 to avoid the loss of 30, knowing that the injurer will not invest 90 to avoid damages of 80. In contrast, under contributory negligence, the victim will assume that the injurer will invest 90 to avoid loss and damages of 100 and, therefore, will have no incentives to mitigate a private loss that the injurer will prevent. To avoid this inefficiency, contributory negligence should be interpreted as denying liability even when the victim can prevent only a small fraction of his loss, but such an interpretation injects comparative aspects into the "all or nothing" defense.
122. 71 On the debate as to whether comparative negligence is more efficient than contributory negligence or vice versa see T. Y. Chung, "Efficiency of Comparative Negligence: A Game Theoretic Analysis," 22 Journal of Legal Studies 395 (1993); D. Orr, "The Superiority of Comparative Negligence: Another Vote," 20 Journal of Legal Studies 119 (1991). It is often argued that there is no difference between the outcomes under comparative negligence and contributory negligence because, under both rules, once injurers are induced to take due care, so will victims, knowing that otherwise they alone will incur the whole loss. See Posner, Economic Analysis, above note 4, pp. 169-172; Shavell, Accident Law, above note 20, pp. 15-16. Yet, this line of reasoning is based on the assumption that the internalized private loss equals the social cost, so that injurers are not overdeterred. My point is that when private loss exceeds social cost, it seems that only comparative negligence can avoid overdeterrence of injurers. Assume, for example, that private loss is 100, that the social cost is 80 because the victim can reduce his expected private loss to 70 by investing 10, and that the injurer's only alternative is to prevent the loss of 100 by investing 90. By reducing damages to 80, comparative negligence can create the proper incentives for both parties: The victim will invest 10 to avoid the loss of 30, knowing that the injurer will not invest 90 to avoid damages of 80. In contrast, under contributory negligence, the victim will assume that the injurer will invest 90 to avoid loss and damages of 100 and, therefore, will have no incentives to mitigate a private loss that the injurer will prevent. To avoid this inefficiency, contributory negligence should be interpreted as denying liability even when the victim can prevent only a small fraction of his loss, but such an interpretation injects comparative aspects into the "all or nothing" defense.
123. 71 On the debate as to whether comparative negligence is more efficient than contributory negligence or vice versa see T. Y. Chung, "Efficiency of Comparative Negligence: A Game Theoretic Analysis," 22 Journal of Legal Studies 395 (1993); D. Orr, "The Superiority of Comparative Negligence: Another Vote," 20 Journal of Legal Studies 119 (1991). It is often argued that there is no difference between the outcomes under comparative negligence and contributory negligence because, under both rules, once injurers are induced to take due care, so will victims, knowing that otherwise they alone will incur the whole loss. See Posner, Economic Analysis, above note 4, pp. 169-172; Shavell, Accident Law, above note 20, pp. 15-16. Yet, this line of reasoning is based on the assumption that the internalized private loss equals the social cost, so that injurers are not overdeterred. My point is that when private loss exceeds social cost, it seems that only comparative negligence can avoid overdeterrence of injurers. Assume, for example, that private loss is 100, that the social cost is 80 because the victim can reduce his expected private loss to 70 by investing 10, and that the injurer's only alternative is to prevent the loss of 100 by investing 90. By reducing damages to 80, comparative negligence can create the proper incentives for both parties: The victim will invest 10 to avoid the loss of 30, knowing that the injurer will not invest 90 to avoid damages of 80. In contrast, under contributory negligence, the victim will assume that the injurer will invest 90 to avoid loss and damages of 100 and, therefore, will have no incentives to mitigate a private loss that the injurer will prevent. To avoid this inefficiency, contributory negligence should be interpreted as denying liability even when the victim can prevent only a small fraction of his loss, but such an interpretation injects comparative aspects into the "all or nothing" defense.
124. 72 Landes and Posner, Economic Structure, above note 4, p. 69.
125. 73 Ibid, pp. 251-255; Bishop, Economic Loss, above note 20; and Goldberg, Oil Spill, above note 20.
126. 73 Ibid, pp. 251-255; Bishop, Economic Loss, above note 20; and Goldberg, Oil Spill, above note 20.
127. 73 Ibid, pp. 251-255; Bishop, Economic Loss, above note 20; and Goldberg, Oil Spill, above note 20.
128. 74 Feldthusen, Economic Negligence, above note 21, p. 1.
129. 75 Ibid, pp. 207-208.
130. 76 As implied by Posner in Tort Law, Cases and Economic Analysis, (Boston: Little Brown, 1982), pp. 467-468.
131. 77 Above note 37 and accompanying text.
132. 78 See Bishop and Sutton, Pecuniary Loss Rule, above note 17, pp. 360 and 355-361, and 367; Rabin, above note 24; Goldberg, Oil Spill, above note 20, pp. 24-34. Yet, trying to justify the exclusionary rule, Goldberg suggests that "it is likely that as the size of the class of indirect claimants increases, so too will the gap between the measured damages and the actual social harm" (p. 34). It is unclear, however, why and how the size of an affected group is related to the gap between private loss and social cost.
133. 78 See Bishop and Sutton, Pecuniary Loss Rule, above note 17, pp. 360 and 355-361, and 367; Rabin, above note 24; Goldberg, Oil Spill, above note 20, pp. 24-34. Yet, trying to justify the exclusionary rule, Goldberg suggests that "it is likely that as the size of the class of indirect claimants increases, so too will the gap between the measured damages and the actual social harm" (p. 34). It is unclear, however, why and how the size of an affected group is related to the gap between private loss and social cost.
134. 79 According to Feldthusen, Economic Negligence, above note 21, these exceptions allow recovery in cases of "joint venture," namely, "where the use value of the damaged property is shared between the property owner and the relational loss plaintiff" (p. 244); in cases of "transferred loss," namely, where "the property owner is able to allocate to the plaintiff by contract the risk of property damage and consequential loss" (p. 253); and in the few cases where the economic loss is consequent on damage to a public resource (p. 259).
135. 80 Feldthusen, Economic Negligence, above note 21, pp. 2-3 and 132-133. Feldthusen's fourth category, product defect economic loss, will not be discussed here because such loss is internalized under the laws of contract and sale. See Ibid, pp. 171-205.
136. 80 Feldthusen, Economic Negligence, above note 21, pp. 2-3 and 132-133. Feldthusen's fourth category, product defect economic loss, will not be discussed here because such loss is internalized under the laws of contract and sale. See Ibid, pp. 171-205.
137. 81 See Bishop, Economic Loss, above note 20, p. 28. Bishop estimated that, normally, misrepresentation causes some social cost, which is lower than private loss.
138. 82 Feldthusen, Economic Negligence, above note 21, pp. 37-52 and 131-132. The leading case is Caparo Industries plc v. Dickman [1990] 1 All E. R. 568.
139. 83 Bishop argued that common law rules concerning misrepresentation may be justified by the criterion of economic efficiency. Bishop, Misrepresentation, above note 35. Although this argument seems to contradict the above conclusion, this is not so. Bishop's analysis was based on the assumption that losses in negligent misrepresentation "represent real costs to society" (p. 379). As indicated in note 82 above, Bishop later acknowledged that these losses do not normally overlap the social cost.
140. 84 Transportation and the manufacture of products, for example, are activities that inflict significant damage and losses other than purely economic ones. Obviously, they also generate significant activity-related benefits. The exclusionary rule, however, is unable to offset these benefits against significant losses that are not purely economic.
141. 85 For other explanations see above note 35.
142. 86 See above note 65 and the accompanying text.
143. 87 See above note 13 and accompanying text.
144. 88 Landes and Posner, Economic Structure, above note 4, p. 53.
145. 89 See Posner, Economic Analysis, above note 53, p. 197.
146. 90 When, for example, each victim in a large group of victims suffers an insignificant private loss, the total loss may be substantial, but internalization will not take place because victims lack incentives to sue or are even unaware of their loss. This is why the loss of consumer surplus, which is a social cost, is usually not internalized by tort law. For consumer surplus as an ingredient of social cost see Bishop and Sutton, Pecuniary Loss Rule, above note 17, pp. 353-354.
147. 91 Strict liability, for example, is justified with regard to activities that inflict physical damage while generating limited welfare for third parties. In the absence of significant loss-related gains and activity-related benefits, and provided that the victims' ability to mitigate their loss is limited, private loss basically corresponds with externalized social cost, and strict liability is required for effective internalization. In contrast, liability should be restrained, for example, in the context of tort-related injuries resulting from prescription drugs, where activity-related benefits are large, or with regard to cases where pecuniary losses of interrupted activities are offset by loss-related gains of other activities.
148. 92 G. T. Schwartz distinguishes between "positive" economic writings in support of the tort law internalization system, and "negative" analysts claiming that tort law has gone much too far. Schwartz, above note 6, pp. 380-381.