The law and economics of products liability.

Author:Hylton, Keith N.
Position:I. Introduction through III. Products Liability Law: Economic Analysis C. Some Real-World Complications 1. Consumption Effects c. Adverse Selection, Moral Hazard, and Correlated Claims ii. Moral Hazard, p. 2457-2485
 
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  1. INTRODUCTION

    No area of the law is perfect, and this truism certainly applies to products liability. But products liability law has come in for some unusually harsh criticism in the law and economics literature of late, (1) and much of the treatment of this area by economically-oriented legal scholars has been negative for at least a generation. (2)

    This Article offers a balanced economic assessment of products liability law. Any reliable assessment of the overall welfare impact of the system will have to depend on empirical work. Economic theory can do no more than offer predictions about the incentives created by the law, hypotheses about the law's welfare effects, and identify the empirical questions that should be addressed.

    This Article is largely a positive analysis of products liability law, (3) in the sense that it aims to predict the incentive effects and the welfare consequences of the law, with close regard to its specific legal tests. The other major part of this Article is a normative assessment of the pieces of the law that arguably should be reformed. My overarching goal is to set up a framework that can be used both to understand and to criticize the law.

    In contrast to the law and economics literature suggesting that products liability law is one big mistake, and perhaps should be abolished, (4) I argue that the law probably improves social welfare, though it is in need of reform in several areas. For judges and lawyers who have to work within the existing framework, my hope is that a tailored set of reforms would be more useful than the broad-brush critiques that have dominated the law and economics literature on products liability. On the other hand, a strictly positive economic theory would also be less useful to courts because it would suggest that everything could be just fine. To the extent that there are puzzles about the effects and the likely function of the law, a positive theory can provide answers; (5) but the law is so well entrenched, and so often critiqued, that a normative component is clearly desirable in this case.

    Products liability law operates largely on products that have observable utility and hidden risks, relative to the safer alternatives available on the market. The observable-utility feature offers an advantage that attracts consumers. The hidden-risk feature leads to injuries. This combination of features is unlikely to be regulated well by the market. The market is likely to fail, for these products, in providing incentives for optimal consumption or for producers to make welfare-enhancing design changes. In contrast, for products with open and obvious risks, the market is likely to regulate optimally, in the sense that where alternative designs exist that offer equivalent utility and less risk, the market will effectively exclude the riskier products.

    The law has the potential to correct the market's failures. Moreover, the scope of the market that is regulated by products liability law is so vast that the work of courts cannot be supplanted by government regulatory agencies, even if it were possible to avoid problems such as agency capture and languid public-sector incentives. Even in the absence of capture or dull incentives, courts applying liability rules to producers have an advantage over government regulators because they respond to real injuries rather than breaches of regulatory orders, which may or may not generate serious injuries.

    However, there are some glaring inefficiencies in the products liability system. The cost of litigation is passed on, at least in part, to the consumer, in the form of an implicit liability premium substantially greater than the amount required to fund a compensation scheme for injured consumers. Effectively, consumers must pay a tax on products that supports a comparatively inefficient and administratively cumbersome litigation industry. (6) In addition, products liability law fails to send the right signals for precaution and for product search on the part of product buyers, a group that includes businesses as well as ordinary consumers.

    The law can be reformed so that it comes closer to its potential by addressing problems observed in several pockets of products liability doctrine. The reforms I propose require no legislative intervention; they are capable of being implemented by courts. I consider this an ideal feature of any list of reforms because legislative intervention runs the risk of political stalemate and interest-group meddling. The subjects I suggest for reform are: (1) the feasible safe alternative requirement, (2) legal doctrine governing ambiguous risk-utility tradeoffs (or what I refer to below as "risk-risk" tradeoffs), (3) insurance market inefficiencies (adverse selection and moral hazard), (4) preemption, (5) bright line rules versus vague standards, and (6) controlling incentives for fraud in mass torts. This is by no means an exhaustive list of all of the potential areas of reform in products liability law. But it does address some of the key sources of uncertainty and excessive cost in the system.

    My analysis of incentives and welfare effects proceeds in several stages. First, I employ the supply and demand curve framework, familiar from elementary economics courses, to examine the effects of strict producer liability in markets with informed consumers and in markets with uninformed consumers. (7) I analyze consumption effects and design incentive effects in an ideal setting in which there are no litigation costs or insurance market inefficiencies. In this ideal setting, strict producer liability leads to socially preferable consumption and design decisions (i.e., enhancing society's welfare), in comparison to a rule of no liability, when consumers are not informed about product risks. (8) I then move away from the ideal setting by incorporating litigation costs, uncertainty over the application of the liability rule, and insurance-market inefficiencies, all of which point to the conclusion that the welfare effects of strict producer liability are ambiguous. In Part III of the argument, I apply the analysis to the actual legal tests generated in the products liability case law, the risk-utility and consumer expectations tests. I examine how the actual tests perform under ideal market conditions and under real-world conditions.

    "In the ideal setting, the consumer expectations test is socially preferable to the risk-utility test. This is because the risk-utility test generates socially excessive consumption when incremental risk is less than incremental utility (i.e., positive net utility designs), and the two tests perform equivalently with respect to design incentives." (9) In the real-world analysis, which allows for litigation costs and insurance-market inefficiencies, it is no longer clear that the consumer expectations test is preferable to the risk-utility test. With complex products, unobservable risk is always present, which implies that the consumer expectations test forces the manufacturer to provide a costly and inefficient form of insurance to the consumer. In contrast, the risk-utility test has the feature that it spreads the payoffs between positive net and negative net utility designs. In a world of expensive litigation and uncertainty, this feature probably makes the risk-utility test preferable to the consumer expectations test, in terms of its effects on consumption and design incentives.

    I focus on product design litigation because that is the most controversial area of products liability. (10) The other two major areas of products liability litigation, manufacturing defect and failure to warn lawsuits, have generated relatively clear law and raise fewer difficulties in analyzing incentive effects. I argue, in Part IV, that the simple strict liability rule that applies in manufacturing defect cases--i.e., defects that result from glitches in the manufacturing process--is defensible in light of the information and expectations consumers are likely to have. In a market in which the vast majority of products are not dangerous due to manufacturing glitches, a paradox of safety will hold: consumers will not search for defects due to glitches for the same reason that they do not search for zebras in Central Park; they are unlikely to find any. In light of this safety paradox, strict liability enables the market to distinguish (and ultimately usher out of circulation) products generated from low-quality manufacturing processes. Failure to warn litigation is less controversial and defensible for a different reason: it is simply a species of negligence litigation, which courts have managed for hundreds of years. (11)

    Part II provides a brief history of the law and the evolution of policy in the courts. Part III sets out the economics of products liability law; first analyzing the effects of a simple strict liability rule, and then looking at the effects of the actual legal tests. I examine the law's effects on consumption and design choice incentives. Part IV discusses manufacturing defect and failure to warn litigation. Part V summarizes the implications of the positive analysis and examines reform proposals.

    11. BACKGROUND ON LAW AND POLICY

    SO much has been written on the development of products liability doctrine that there is little need for an extended discussion here. (12) Instead of tracing the development of the law, I will focus on the policies reflected in it and its implications for the incentives of sellers and manufacturers.

    There is general agreement that the first important innovation in products liability law was the abandonment of the privity doctrine of Winterbottom v. Wright. (13) Under the privity rule, a consumer injured by a negligently constructed product could maintain a negligence action only against the immediate seller, i.e., the party with whom he was in privity of contract. (14) The privity requirement was effectively abandoned in Cardozo's...

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