The efficiency of liability rules is restricted not only by theoretical limitations but also by practical problems. The most obvious such problem is the transaction costs of the legal system—particularly, the costs of plaintiffs’ and defendants’ lawyers. Underlying that problem is the fundamental issue that information (in this case, information about the cause of a tort injury) is generally incomplete and costly to acquire. The lack of complete information allows room for disagreement between plaintiffs and defendants and encourages attorneys to expend effort to unearth and document additional information favorable to their case.
Incomplete information also allows errors to occur. Some torts go unchallenged, unjudged, or undercompensated; conversely, some defendants pay claims for losses for which they were not truly liable or in excess of the harm they caused. For example, one study of medical malpractice torts found that only 1.5 percent of people classified as likely victims of medical error sued and that relatively few of those who did sue appeared to have legitimate claims.9 Such errors reduce the equity of the liability system. They may also reduce its efficiency (as discussed more fully below) by prompting potential injurers to overspend or underspend on precautions or to try to avoid liability in ways that do not reduce the actual risk of injuries.
Concerns about such errors underlie much of the debate about punitive damages. One efficiency-based rationale for punitive damages is that they serve an important corrective role for torts that have a significant probability of going undetected. Potential injurers who expect to be held liable only one-third of the time will not have efficient incentives to exercise care unless they expect to pay treble damages on the occasions when they are held responsible.10
Conversely, punitive damages may reduce efficiency if they do more to create errors than to correct them. Critics argue that punitive damages are awarded arbitrarily, at the whim of juries not guided by any clear or coherent standards, and are often erroneous. As evidence, they cite cases in which the punitive damages were tens or hundreds of times larger than the compensatory damages or were awarded even though the injurer had good reason to believe that it was not negligent (in other words, that its behavior satisfied a relevant standard of due care). Whether such criticisms are valid for only a few cases or for punitive damages in general is an open question in need of further study.11
Errors—and information problems more broadly—also underpin much of the debate about the class-action procedure. By combining many claims that cover similar factual ground, that procedure reduces transaction costs that could otherwise make it impractical for plaintiffs to pursue claims that may be large as a whole but are small individually. However, critics argue that class actions are susceptible to erroneous judgments—in part because plaintiffs’ attorneys have wide latitude to bring them in certain courts that are thought to be biased against out-of-state corporate defendants—and that such errors can have nationwide implications. In some cases, plaintiffs’ attorneys may be able to leverage the possibility of such errors to achieve lucrative settlements of even frivolous claims, if defendants are sufficiently averse to risk. Also, because class members may have little incentive or opportunity to exercise effective oversight, plaintiffs’ attorneys in such cases may pursue settlements that benefit them but are not in the best interest of their clients.12
A final problem associated with limited information is the difficulty of setting the standard of due care in a negligence rule at an efficient level. Courts often defer to a community’s customary standard of care in defining negligence, and a custom that has stood the test of time in a competitive market may be a good approximation of the efficient solution.13 But customary standards may be hard to apply or nonexistent in cases of new risks or new products. Moreover, any general rule may not be detailed enough to take into account the specific opportunities and constraints facing each potential injurer and potential victim and thus may set the bar too high for some and too low for others.
9. Those findings were based on an analysis of 30,000 medical records from New York State in 1984; see A. Russell Localio and others, “Relation Between Malpractice Claims and Adverse Events Due to Negligence,” New England Journal of Medicine, vol. 325 (July 25, 1991), pp. 245-251. The analysis showed that only 14 percent of claimants appeared to have legitimate cases; however, that percentage was based on a limited sample (47 claims).
10. In principle, punitive damages could also improve efficiency by correcting for compensatory awards that do not fully reflect the amount of harm done. In practice, however, cases in which large punitive damages are awarded also tend to involve large compensatory awards.
11. The most directly relevant empirical study to date examined the occurrence of punitive damages in a year’s worth of trials from 45 of the nation’s 75 largest counties. It found a strong statistical relationship between the level of punitive damages, when awarded, and the level of compensatory damages, but it did not attempt to identify factors that would explain which cases (of a given type) yielded awards for punitive damages and which did not. Thus, the study left unresolved the question of whether the decision to award punitive damages is arbitrary. See Theodore Eisenberg and others, “The Predictability of Punitive Damages,” pp. 623-661, and A. Mitchell Polinsky, “Are Punitive Damages Really Insignificant, Predictable, and Rational? A Comment on Eisenberg et al.,” pp. 663-677, both in Journal of Legal Studies, vol. 26, no. 2 (June 1997).