The most easily measured “costs” of the liability system are its direct costs—that is, those incurred by plaintiffs, defendants, and their insurance companies in litigating and settling specific claims, as well as the court costs that are ultimately paid by taxpayers. For the purposes of policy analysis, however, that measure of costs is too large in one respect and too small in another.
It is too large in that some direct “costs” merely shift money from injurers to victims and thus are not true costs to society as a whole. In economic terms, payments that do not involve any use of resources to produce goods or services are called “transfer payments.” Those that do involve using resources for production are known as “real resource costs” (also “social costs” or simply “costs”). Specifically, the portion of a settlement or judgment that goes to the plaintiffs is a transfer payment. The portion that goes to the plaintiffs’ attorneys, in contrast, is a real cost because it reflects the value of the resources (attorneys’ time, office space, equipment, and so on) devoted to that case and thus not available for other uses.1
Conversely, measures of direct costs are too small for policy purposes in that they naturally exclude indirect costs— those associated not with specific claims but with actions that businesses and consumers take or forgo because of the incentives of the liability system as a whole. Indirect costs include various kinds of real resource costs, such as:
The costs of precautions taken by potential injurers,
The opportunity costs (forgone value) of goods and services that potential injurers withdraw from the market or do not create because of liability concerns,
The opportunity costs of goods and services that consumers do not buy because of liability-induced price increases, and
The disruption costs of layoffs and bankruptcies caused by liability problems.2
Indirect costs are not necessarily bad: from the perspective of efficiency, the question is whether they yield benefits larger than the costs.
1. The statement that all legal costs are real resource costs assumes that lawyers’ services are priced correctly in the market. To the extent that legal fees are kept artificially high by some market imperfection or governmental interference, they include both resource costs and transfer payments.
2. Indirect costs may also include transfer payments, but this discussion focuses only on real resource costs.