Recovery of Pure Economic Loss in Product Liability Actions: an Economic Comparison of Three Legal Rules

• Publication year: 1987

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 11, No. 2WINTER 1988

COMMENTS

Recovery of Pure Economic Loss in Product Liability Actions: An Economic Comparison of Three Legal Rules(fn*)

Heidi A. Irvin and Mark S. Carlson

I. Introduction

The term "product liability" usually brings to mind personal injury. When products fail, however, either by reason of design or manufacturing defects, buyers may suffer loss other than personal injury. Whenever a product is used in a money-making venture, the product's failure may lead to economic loss to its owner. For example, assume a buyer purchases a personal computer for use in a business, and the computer breaks down, requiring three days for repair. The out-of-pocket cost of repairing the computer is direct economic loss. Any loss in profits resulting from the breakdown is consequential economic loss. These damages, taken together and in the absence of personal injury or property damage, constitute pure economic loss. The total social cost of accidents caused by product failure, therefore, includes both pure economic loss and personal injury or property damage. Given that pure economic losses exist, the next question is to decide who, between buyer and seller, should bear the cost of those losses.

The Washington Supreme Court has recently considered this question in the context of housing construction. The issue in Stuart v. Coldwell Banker Commercial Group(fn1) was whether the buyer or builder-seller of condominium units should bear the cost of pure economic losses attributable to latent defects in the manufacture of the condominiums. A homeowners association representing owners of the condominiums sued the builder-seller. Among other theories, the suit alleged that the builder-seller was liable for negligent construction to original and subsequent purchasers. Damages claimed represented only direct economic loss, that is, the cost of repair. In contrast to the trial court, the supreme court refused to recognize a cause of action for negligent construction under the facts presented.(fn2) The court drew a distinction between economic loss caused by defects of quality such as interior deterioration, which are appropriately governed by contract law, and personal injury or property damage caused by defects that cause accidents involving violence or collision with external objects, which are appropriately governed by tort law.(fn3) In drawing this distinction, the court analyzed the nature of the defect, the type of risk, and the manner in which the injury arose. It held that the loss in question was economic and, therefore, not appropriately remedied by an action in tort for negligent construction.(fn4) Two dissenting justices rejected the distinction drawn in the majority opinion between economic loss and personal injury or property damage, arguing that when negligence causes a latent and dangerously defective condition, the buyer should have an action for damages in tort even though the buyer suffered only economic loss.(fn5)

The Stuart decision is not inconsistent with the Tort Reform Act of 1981(fn6) but is contrary to the court's prior decision in Berg v. General Motors Corp.(fn7) Thus, the court allowed lost profits to a commercial buyer when a product he purchased to use in his business failed because of the manufacturer's negligence. The court in Stuart distinguished Berg on the ground that the plaintiff claimed lost profits in addition to cost of repair, whereas in Stuart only cost of repair was claimed, and the only injury was to the product itself. In both cases, however, the court was dealing with actions in tort in which the plaintiffs were claiming pure economic loss. These recent developments in the case law and statutes emphasize the need to compare how well each of three major legal rules-negligence, strict liability, and the Uniform Commercial Code-allocate economic loss in terms of economic efficiency.

This Comment argues that in the allocation of pure economic loss caused by product failure, the negligence rule is generally more efficient than a strict liability rule and that a contract rule is almost always more efficient than a negligence rule. Part II presents a general discussion of the attributes of an economically efficient remedy. In Part III, three legal rules used to allocate pure economic loss are scrutinized under the standards set forth in Part II.

II. Attributes of an Efficient Remedy

Before examining the attributes of an efficient(fn8) remedy, this Comment will briefly survey the economic explanations for tort and contract rules. The tort system can be explained in terms of two economic roles it plays in our society. One role is deterrence: "to control the extent to which people engage in activities which potentially impose costs on others."(fn9) A second role tort law plays is to allow victims, who are otherwise eligible, to recover damages that adequately reflect their losses.(fn10) Although the assignment of liability for damages may have no influence on how resources are allocated if transaction costs are zero,(fn11)

[t]he need for much of tort law arises from the existence of transactions costs. Often such costs are so high that no real (that is, negotiated) contract is possible at all, and yet individuals, if they could overcome these barriers, would make mutually advantageous bargains. Here the state comes to the aid of these individuals. It writes into law the terms they would have agreed to if they could have bargained.(fn12)

Consequently, the adequacy of a tort rule in dealing with an injury should be determined by comparing it to the hypothetical rule to which the parties would have agreed if they could have bargained.

In contract law, damage measures may act as a substitute for complete contingent contracts.(fn13) In theory, parties to a contract could bargain for every possible contingency. Damage measures are needed, however, because the cost of bargaining over every contingency is too high and because the occurrence of some contingencies may be difficult or impossible to verify.(fn14) When a party contemplating breach is forced to take into account the loss to the other party, "the payment of damages for breach of contract tends to promote . . . efficient breach behavior."(fn15) Although there is no perfect damage measure,(fn16) commentators suggest that when both parties are risk-neutral(fn17) the expectation or benefit of the bargain measure performs more efficiently than the reliance or out-of-pocket measure.(fn18)

The traditional limitations on recovery of consequential loss in contract also have an economic rationale. The mitigation doctrine protects against inefficient action by a nonbreaching party that would aggravate the loss by encouraging the redirection of resources formerly tied to the contract to other uses.(fn19) The rule of consequential damages, which limits recovery to loss of which the seller at the time of contracting had reason to know,(fn20) conies from Hadley v. Baxendale,(fn21) and encourages efficient transfers of information.(fn22) This contract foreseeability ruleinduces the party with knowledge of the risk either to take appropriate precautions himself or, if he believes that the other party might be the more efficient preventer or spreader (insurer) of the loss, to reveal the risk to that party and pay him to assume it. Incentives are thus created to allocate the risk in the most efficient manner.(fn23)

Commentators are not in complete agreement that the Hadley rule is better than other rules, but they do agree that the foreseeability requirement is more efficient than a rule allowing unforeseen damages.(fn24) A rule allowing recovery of unforeseen damages in contract is inefficient because it creates adverse selection(fn25) problems. Buyers with higher than average costs will not reveal those costs as potential losses when they enter a contract, so sellers will act as though their potential losses are lower than they actually are, thereby entering into some contracts when they should not.(fn26) "[0]ptimal decisions will only be made if a decisionmaker must take into account the full consequences of her decision."(fn27)

With the economic explanations for tort and contract rules in mind, we can now examine the attributes of an efficient remedy. Economists view an efficient legal rule as one that induces people to behave in such a way that no one can be made better off without making someone else worse off.(fn28) Such a rule is Pareto efficient. Pareto efficient remedies reallocate resources to reflect the resource allocations that would exist if people behaved in an efficient manner. Therefore, when evaluating any legal remedy, one should ask: "Will imposing liability create incentives for value-maximizing conduct in the future?"(fn29)

An efficient legal remedy has three components. First, it will create incentives for the relevant individuals or firms to behave efficiently. Behavioral incentives include both incentives to take the proper amount of care and incentives to engage in the proper level of activity.(fn30) Second, an efficient legal remedy will efficiently allocate risk among the firms and individuals.(fn31) Efficiently allocating risk means placing the risk on the least risk averse person(fn32) or according to the parties' relative aversion to risk. For simplicity, we will assume that all parties are risk...