Product Liability Entering the 21st Century: The U.S. Perspective

Product Liability Entering the Twenty-First Century The U.S. Perspective Michael J. Moore and W. Kip Viscusi

T

his report examines key issues concerning the law and economics of product liability. The authors begin with a brief description of the evolution of product liability doctrine in the U.S., up to the point of the liability crisis of the late 1980s. They discuss the economic implications of product risk for both consumers and producers, offer economic hypotheses on the implications of the increased scope of liability and subsequent reforms, and provide an update of trends in litigation and liability law.

Product Liability Entering the Twenty-First Century The U.S. Perspective

Michael J. Moore W. Kip Viscusi

Michael J. Moore is a visiting associate professor at the Darden School of Business Administration, University of Virginia, and a research associate at the National Bureau of Economic Research. W. Kip Viscusi is John F. Cogan Jr. Professor of Law and Economics and director of the Program on Empirical Legal Studies at Harvard Law School.

American Enterprise Institute for Public Policy Research 1150 Seventeenth Street, N.W. Washington, D.C. 20036 www.aei.org The Brookings Institution 1775 Massachusetts Avenue, N.W. Washington, D.C. 20036 www.brookings.edu

AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES

Product Liability Entering the Twenty-First Century

Product Liability Entering the Twenty-First Century The U.S. Perspective Michael J. Moore W. Kip Viscusi

AEI-Brookings Joint Center for Regulatory Studies W A S H I N G T O N,

2001

D. C .

Copyright © 2001 by AEI-Brookings Joint Center for Regulatory Studies, the American Enterprise Institute for Public Policy Research, Washington, D.C., and the Brookings Institution, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the AEI-Brookings Joint Center except brief quotations embodied in news articles, critical articles, or reviews. Product Liability Entering the Twenty-First Century: The U.S. Perspective may be ordered from: Brookings Institution Press 1775 Massachusetts Avenue, N.W. Washington, D.C. 20036 Tel.: 1-800-275-1447 or 1-202-797-6258 Fax: 202-797-6004 www.brookings.edu Library of Congress Cataloging-in-Publication Data Moore, Michael J., 1953– Product liability entering the twenty-first century : the U.S. perspective / Michael J. Moore, W. Kip Viscusi. p. cm. Includes bibliographical references. ISBN 0-8157-0229-9 (alk. paper) 1. Products liability—United States—History. 2. Products liability—Economic aspects. I. Viscusi, W. Kip. II. Title. KF1296 .M66 2001 346.7303’8—dc21 2001005538 9 8 7 6 5 4 3 2 1 The paper used in this publication meets minimum requirements of the American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials: ANSI Z39.48-1992. Typeset in Berkeley Composition by Cynthia Stock Silver Spring, Maryland Printed by Edwards Brothers Lillington, North Carolina

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Contents

FOREWORD

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BRIEF HISTORY OF PRODUCTS LIABILITY

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THE PRODUCT LIABILITY CRISIS

10

AFTERMATH: 1988–89

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ECONOMIC MODEL

14

Output, Entry, and Exit 15 Research and Development and Innovation Effects Competitiveness 18 Stock Market and Other Effects 22

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EVIDENCE ON THE CONSEQUENCES OF PRODUCT LIABILITY RISKS

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EVIDENCE ON THE EFFECTS OF PRODUCT LIABILITY REFORMS

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POLICY IMPLICATIONS OF PRODUCT LIABILITY REFORMS

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PROBLEMS AND PROSPECTS OF MASS TOXIC TORTS

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NOTES

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REFERENCES

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Foreword

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his volume is one in a series commissioned by the AEIBrookings Joint Center for Regulatory Studies to contribute to the continuing debate over regulatory reform. The series will address several fundamental issues in regulation, including the design of effective reforms, the impact of proposed reforms on the public, and the political and institutional forces that affect reform. Many forms of regulation have grown dramatically in recent decades—especially in the areas of environment, health, and safety. Moreover, expenditures in those areas are likely to continue to grow faster than the rate of government spending. Yet, the economic impact of regulation receives much less scrutiny than direct, budgeted government spending. We believe that policymakers need to rectify that imbalance. The federal government has made substantial progress in reforming economic regulation—principally by deregulating prices and reducing entry barriers in specific industries. For example, over the past two decades consumers have realized major gains from the deregulation of transportation services. Still, policymakers can achieve significant additional gains from fully deregulating other industries, such as telecommunications and electricity. While deregulating specific industries has led to substantial economywide gains, the steady rise in social regulation— vii

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which includes not only environmental, health, and safety standards but many other government-imposed rights and benefits—has had mixed results. Entrepreneurs increasingly face an assortment of employer mandates and legal liabilities that dictate decisions about products, payrolls, and personnel practices. Several scholars have questioned the wisdom of that expansion in social regulation. Some regulations, such as the phaseout of lead in gasoline, have been quite successful, while others, such as the requirement for safety caps on aspirin bottles, have led to increased risks. As those regulatory activities grow, so does the need to consider their implications more carefully. We do not take the view that all regulation is bad or that all proposed reforms are good. We should judge regulations by their individual benefits and costs, which in the past have varied widely. Similarly, we should judge reform proposals on the basis of their likely benefits and costs. The important point is that, in an era when regulation appears to impose very substantial costs in the form of higher consumer prices and lower economic output, carefully weighing the likely benefits and costs of rules and reform proposals is essential for defining an appropriate scope for regulatory activity. The debates over regulatory policy have often been highly partisan and ill-informed. We hope that this series will help illuminate many of the complex issues involved in designing and implementing regulation and regulatory reforms at all levels of government. ROBERT W. HAHN ROBERT E. LITAN AEI-Brookings Joint Center for Regulatory Studies

Product Liability Entering the Twenty-First Century

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our distinct periods dominate the recent history of product liability law in the United States. First, the two postwar decades (1950–70) were relatively uneventful, as policymakers focused on health and education and attempts to eradicate broad social problems such as racial discrimination and poverty. Three notable exceptions during this period presaged the regulatory movement of the following decade. These were the amendments to the Federal Food, Drug, and Cosmetic Act, which increased the stringency of the approval process for new drugs; the first product warnings related to the health hazards of smoking, issued by the U.S. Surgeon General’s office in 1963; and the 1965 Federal Cigarette Labeling and Advertising Act, which required hazard warning labels on cigarette packages.1 During the second period, the 1970s, social regulatory programs in general and regulations directed toward reducing risks to life and health in particular expanded dramatically. The Consumer Product Safety Commission (CPSC), the Occupational Safety and Health Administration (OSHA), and the Environmental Protection Agency (EPA) are but the most 1

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prominent regulatory programs established in the 1970s. Likewise, cigarette advertising on television was banned in 1970, continuing the health authorities’ information-based campaign against smoking. The 1970s was also characterized by macroeconomic disturbances, including oil price shocks in 1973 and 1978, a protracted recession, a period of stagflation, increasing budget deficits, and (at least in the U.S. experience) runaway inflation at the end of the decade. Concerns about this poor macroeconomic performance led to critical examination of the role of government in affecting the performance of U.S. firms. The political debates of the time centered primarily on the size and scope of government’s role in the economy and how it related to the costs of doing business. Evaluation studies of the more prominent regulatory programs began to appear, and the vast majority of these indicated that the interventions had accomplished little in terms of promoting their stated health, safety, and environmental objectives, and much in terms of increasing the burden on U.S. business.2 Moreover, medical malpractice lawsuits expanded rapidly in the late 1970s, raising concerns about costly defensive medical practices, the exit of physicians from certain high-risk specialties such as obstetrics-gynecology, and the contribution of malpractice litigation to escalating health care costs in general. During the third “era,” ushered in by the election of Ronald Reagan in 1980, increased concerns about industrial performance led to a veritable revolution in the regulatory arena. The Reagan presidency presided over broad economic recovery, accompanied by across-the-board deregulatory pressures and increased requirements for the rationalization of any new regulations. At the same time, however, safety issues were becoming more prominent in the U.S. courts. Many states, seeking to combat the perceived crisis in medical malpractice, adopted extensive reforms of malpractice law during the 1980s.

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Another liability crisis, this time related to liability for unsafe products, principally asbestos, occurred in the mid-1980s. Insurance costs and product liability claims rose dramatically from 1984 through 1987. Anecdotal evidence that pharmaceutical companies and small domestic aircraft manufacturers were withdrawing or withholding products from the market to avoid potential liability suits increased concerns about the consequences of escalating liability costs for domestic industry. Critics of the product liability system said that the withdrawal of insurance carriers, escalating insurance costs, and, more generally, the potential for catastrophic liability losses were all stifling innovation and redirecting research and development efforts toward excessively safe products. Vice President Dan Quayle was particularly vocal about the effects of product liability costs on the competitiveness of U.S. firms. In the 1990s, the fourth and most recent era, two broad trends emerged in the product liability arena. First, the resolution of many asbestos-related claims relieved the burden on the courts and on insurers considerably—to the point that, in retrospect, much of the crisis of the 1980s appears to have been transitory, albeit real enough, and attributable to the onset of massive amounts of litigation related to a single product.3 At the same time, however, mass tort litigation grew more common, spurring fears of another wave of litigation and crisis for U.S. business. The most prominent of the current mass tort lawsuits are those brought by the states against tobacco manufacturers. Given the social and political climate of the times and the nature of the product, the tobacco suits have not engendered the same concerns about innovation and competitiveness as did mass lawsuits for health-related products such as fen-Phen and the Dalkon shield. The tobacco lawsuits and, more recently, the “me-too” suits brought by mayors of some U.S. cities against gun manufacturers have, however, raised legitimate concerns

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about the role of the courts and the trial lawyers in the de facto setting of regulatory policy. These events raise a number of questions, some positive in nature, others normative. Are liability “crises” an inevitable feature of the modern industrial landscape? In particular, are there structural features of technological advance, mass production and merchandising, and information technology that make highly correlated product risks more likely?4 Are there features of the insurance industry (such as its competitive structure, ratemaking practices, the regulatory environment, and the inherent informational problems that attach to all insurance programs) or of the legal system (such as contingency fees, class actions, strict liability rules, the doctrine of design defects, uncertainties surrounding the behaviors of juries, and the proper role of scientific evidence) that give liability crises their recurring, almost cyclical, character?5 What have been the effects of the liability reforms of the 1990s—have they lowered costs, enhanced competitiveness and innovation, and stabilized the insurance industry without leading to a deterioration in product quality? Does the imposition of liability on one party to a transaction or the other enhance product safety or overall efficiency, or both? What is the nature of the interaction of the liability system with other mechanisms, most notably the free market, and with regulatory programs such as workers’ compensation, OSHA, and the CPSC?6 On the normative side, is the product liability system as currently configured achieving its stated goals of making restitution to injured parties and providing the appropriate incentives to produce safe products?7 Is the level of product safety where it “should” be? Should lawyers be given de facto regulatory authority through mass torts, thus circumventing the role of Congress? In brief, empirical analyses of the consequences of increased liability indicate that liability costs exert a significant effect on

PRODUCT LIABILITY

5

the performance of firms. Incentives matter. Accidents, product recalls, and adverse information events related to product safety significantly lower firm value, providing powerful market incentives for safety. Prices, research and development, and innovation rates respond to liability changes in the expected directions. Effective product liability policy calls for a balancing of the incentives for improved product safety on the one hand and the benefits of new and existing products on the other. These different objectives are sometimes competing, so a sense of the magnitudes of the effects is often important. Reforms in liability rules can lead to improved safety, but they can also become so stringent that manufacturers withdraw products from the market. Some of these withdrawals— such as vaccines, for example—can have an adverse effect on safety. Again, empirical evidence on the magnitudes of these competing effects is crucial. The reforms instituted following the liability crisis in the 1980s appear to have improved the solvency of insurers somewhat and led to increases in productivity. The two areas of greatest concern for policy continue to be the enormous judgments in isolated cases and costs associated with mass torts. Caps on punitive damages in particular and damage awards in general are an effective means of limiting extreme losses. Such caps have demonstrable effects on liability costs, which in turn reduce insurance premiums. The desirability of a particular cap depends on its level and the ability of damages to serve compensatory and deterrence functions in the presence of the cap. Effective reforms aimed at mass tort filings are more difficult to identify. Mass tort filings clearly cause potential problems for defendant firms in that they raise the stakes of litigation enormously. Moreover, many of these mass torts involve toxic risks for products designed and manufactured long ago and whose manufacturers are unlikely to respond to the incentives such suits would generate.

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Class actions and mass torts also may serve a constructive function by pooling similar kinds of lawsuits, thus reducing litigation costs. Whether and how class actions and mass torts should be reformed remains a live issue in the tort reform debate. What is clear at this juncture is that such litigation often generates substantial costs and that the current situation is not ideal from the standpoint of generating efficient deterrence and compensation. This paper provides perspective on each of these issues. It begins with a brief description of the evolution of product liability doctrine in the United States, up to the liability crisis of the late 1980s. It then discusses the economic implications of product liability risk for both consumers and producers. Economic hypotheses regarding the implications of the increased scope of liability and of the subsequent reforms are offered. We follow by updating trends in litigation, liability law, and the insurance industry; summarizing the research evidence that has been brought to bear on the hypotheses; and highlight remaining, unanswered questions. After discussing the implications of mass torts for the liability system and for industrial performance, we close with a discussion of proposed reforms. Our survey also identifies the key issues for liability policy. For example, pharmaceutical products with broad health benefits need protection from losses stemming from isolated side effects. Liability policy also needs to perform its insurance function more rationally, providing primarily for uninsured catastrophic losses, perhaps at the risk of undercompensating smaller losses. Instituting a system of “deductibles” similar to those in most insurance policies would be helpful in this regard. A national product liability policy would reduce the latitude of the states to effect wealth transfers from out-ofstate producers though litigation but would violate principles of federalism.

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Brief History of Product Liability Products liability in the United States falls under the law of torts, which governs private transactions in which there is no written contract. Under the law of torts, one person has a claim against another if, through an action, exchange, or other interaction, the injured party has been harmed, which harm has been caused by the injuring party through some act or omission and which act or omission constitutes a breach of duty.8 The modern law of torts has its later roots in the mid-nineteenth century, when the frequency of accidents covered by tort law increased significantly, largely as a result of the development of the railroad.9 Since that time, changes have occurred in the legal standard of liability, the coverage of the law, and the allowable defenses. Tort law in the United States has three purposes. First, it provides for compensation of injured parties, or compensatory damages. Determination of the amount of loss is often extremely problematic in tort cases, as is the coverage of compensable losses. Awards for pain and suffering have become prominent in the media and can often dwarf the more traditional awards for medical costs and lost earnings. Most recently, successful lawsuits have been brought for fear of harm, rather than for actual harm, in cases of environmental exposures to potential carcinogens. Similarly, mental anguish, loss of consortium, and other emotional harms have gained increasing prominence. In a recent case in Philadelphia, a fortune-teller was awarded $1 million after a CAT scan allegedly destroyed her ability to foresee the future.10 The second function of tort law is to provide manufacturers incentives for taking precautions. Thus, a manufacturer can make a judgment about the potential for lawsuits and their costs and weigh this against the costs of increased product safety.

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As the expected costs of an accident rise, the incentives for manufacturers to make safe products will increase as well. Determination of the proper level of safety precautions is difficult, however, and much of the law (and regulations) in the safety arena has focused on “zero-risk” solutions. That these solutions will result in inefficient efforts to produce safe products should be obvious.11 The third function of tort law is to punish offenders. Punitive damages are awarded over and above compensation and can often be substantial. General Motors was recently fined $4 billion in punitive damages in a lawsuit brought by four California families who were harmed in automobile accidents. One of the more interesting recent developments is the movement by states to claim the punitive damages awarded in tort cases, rather than have them accrue to the injured party. The implications of this change for litigation rates and related economic outcomes are at this point unclear. Three general liability standards have governed various aspects of tort law in the United States. A contributory negligence standard was in effect for most of the nineteenth and twentieth centuries. Under this standard, a manufacturer or any other injuring party could claim that despite his or her negligent behavior, the injured party’s behavior contributed to the accident and thus absolved the injuring party of any liability. Gradually the contributory negligence standard was replaced by strict liability, which held manufacturers liable for product-related accidents regardless of fault or the extent of precautions the manufacturer took. Under either of these two standards, the costs of an accident fall entirely on one party or the other. Under a third standard, known as comparative negligence, which some states have recently adopted, fault and costs are shared according to the degree to which each party contributed to the accident.

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At the turn of the twentieth century, when tort law was still governed by the standard of contributory negligence, the coverage of tort law was reduced substantially by the advent of workers’ compensation, which covered industrial accidents.12 Workers’ compensation programs, which were instituted to provide prompt payment of benefits to the families of workers injured or killed on the job, contained two crucial features that differentiated them from the general law of torts in place at the time. The liability standard under workers’ compensation was, and remains, one of strict liability, whereby the employer is presumed liable for accidents that occur on the job regardless of fault. Also, the benefits paid are capped at amounts determined by state workers’ compensation boards, so that the huge damage settlements and verdicts more common in other areas of tort are not allowed under workers’ compensation.13 Liability for product-related accidents in most of the United States is now strict as well. Product defects can be of three types: a defect in manufacture, a defect in design, or a defect in warning. A chain saw that was missing the antikickback device or tire treads that separated because of poor workmanship would constitute a manufacturing defect. A design defect would arise if elements of a product’s basic design caused the accident. Recent examples include the Firestone Wilderness AT tire (where the design defect is only alleged at this point), the Ford Pinto, the Dalkon Shield intrauterine device, and cigarettes. Failures to warn can arise, for example, when pharmaceutical products have unintended side effects, as in the thalidomide tragedy in Europe. In one notorious case, a woman was awarded $200,000 in compensatory damages and $2.7 million in punitive damages for burns caused when a cup of McDonald’s coffee overturned in her lap as she drove away from the restaurant. Coffee cups in the United States now carry warning labels indicating that the contents are very hot.

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Liability law in the United States has increased in scope largely due to three developments. First was the abolition of the doctrine of privity, which had allowed injured parties to sue only those parties directly involved in the transaction. Once privity was abolished, an individual who bought a chain saw that kicked back and cut off his leg could sue the manufacturer of the saw, rather than the retailer, and a shipyard worker who developed mesothelioma could sue the manufacturer of asbestos, rather than the owner of the shipyard. A second crucial development in the expansion of tort liability was the introduction of the design defect doctrine. Third was the imposition of the duty to warn. The Product Liability Crisis The second half of the 1980s witnessed a tremendous escalation of activity in product liability. The number of cases commenced at the federal level rose from 2,393 in 1975 to 13,408 by 1989, for an average annual growth rate of 33 percent. This growth reflected more than an increase in the overall litigiousness of society. As a percent of all federal civil cases, product liability increased from 2.0 percent to 5.7 percent over the same period. At the same time, insurance premiums were escalating rapidly. Table 1 presents information on liability premiums in nominal terms and as a percentage of all insurance. Although periods of substantial increases had been observed in the general liability insurance market in the past (1967–71, for example), nothing even close to the real increases of 74.6 percent in 1985 and 65.8 percent in 1986 had ever been seen before. Several explanations have been offered regarding these events. One prominent hypothesis is that the escalation reflected the underwriting cycle for the insurance industry rather than any changes in the underlying risks or litigation behaviors. Under this hypothesis, insurers are led, in times of high inter-

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Table 1. Trends in Liability Premiums, 1953–98 Percent unless otherwise indicated

Year

Premiums (thousands of dollars)

Nominal growth

Real growth

Percent of total insurance

1953 1954 1955 1956 1957 1958 1959 1960 1961 1962

395,685 443,085 470,887 518,909 563,030 600,944 668,152 746,194 792,768 820,625

... 12.0 6.3 10.2 8.5 6.7 11.2 11.7 6.2 3.5

... 12.7 5.9 7.2 5.6 4.9 9.5 10.3 5.5 2.2

... NA NA NA NA NA NA NA NA NA

1963 1964 1965 1966 1967 1968 1969 1970 1971 1972

845,410 860,837 880,977 934,078 1,027,964 1,133,043 1,327,593 1,658,245 1,845,236 1,980,290

3.0 1.8 2.3 6.0 10.1 10.2 17.2 24.9 11.3 7.3

1.4 0.8 0.4 2.5 7.1 5.5 11.0 19.3 8.0 3.9

NA NA NA NA NA NA 6.01 6.66 6.85 6.66

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

2,093,521 2,275,395 3,085,226 4,251,298 5,845,075 6,490,064 6,612,474 6,414,678 6,046,292 5,668,459

5.7 8.7 35.6 37.8 37.5 11.0 1.9 –3.0 –5.7 –6.2

–3.0 –3.6 28.7 32.9 30.8 2.0 –11.4 –15.5 –14.6 –10.0

6.52 6.70 6.22 7.04 8.07 7.95 7.34 6.71 6.09 5.45

1983 1984 1985

5,679,295 6,479,268 11,544,152

0.2 14.1 78.2

–3.6 10.2 74.6

5.21 5.48 8.01 (table continues)

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Table 1. (continued)

Year

Premiums (thousands of dollars)

Nominal growth

Real growth

Percent of total insurance

1986 1987 1988 1989 1990 1991 1992

19,364,658 20,873,777 19,077,182 18,434,466 18,123,123 16,851,155 17,055,977

67.7 7.8 –8.6 –3.4 –1.7 –7.0 1.2

65.8 –13.2 –13.0 –8.0 –7.8 –10.1 –1.7

10.97 10.80 9.44 8.85 8.32 7.56 7.48

1993 1994 1995 1996 1997 1998

17,751,659 18,802,092 18,581,740 19,575,820 20,088,167 19,017,955

4.1 5.9 –1.2 5.3 2.6 –5.3

1.4 3.2 –3.7 2.0 1.6 –6.0

7.35 7.50 7.16 7.29 7.27 6.76

Source: A. M. Best Company (various years); Viscusi (1991). NA = Not available

est rates, to compete for new policyholders by lowering premiums below loss levels, financing any excess losses out of earnings on their investments. With the abnormally high real interest rates of the early 1980s, insurers allegedly succumbed to competitive pressure to cut premiums. This pressure was reversed in the latter part of the decade. With real interest rates declining, funds available to cover losses were lowered, calling for a corresponding increase in premiums. This pressure was compounded by the exit of European firms at that time from the U.S. reinsurance market. A second widely advanced hypothesis is that the insurance companies somehow managed to collude to increase premiums and thus induce reforms to reduce the liability burden. With many thousands of insurance companies competing in the domestic U.S. insurance market, this scenario seems highly unlikely.

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A third hypothesis is that liability burdens on firms actually rose, either because the riskiness of products increased or because changes in liability standards shifted more of the burden onto firms. This hypothesis does not seem compelling either. Accident rates for all types of injuries, including those attributable to products, have declined steadily over the past fifty years. A fourth hypothesis is that insurance companies act in a risk-averse manner, raising premiums above their actuarially fair level in order to provide a buffer in case of some unknown contingency, such as the wave of asbestos litigation. Aftermath: 1988–98 As table 1 shows, premium growth began to level off beginning in 1988. In nominal terms premiums in 1998 were almost identical to their 1988 level, so in real terms, they actually fell. At the same time, liability premiums as a percentage of all insurance returned to their levels before the crisis of the mid-1980s. Whether this leveling signals a decline in the cost of insurance, or a movement out of insurance markets altogether, perhaps toward self-insurance, cannot be determined from the premiums data. Given the overall increase in the level of economic activity during this period, it seems doubtful that the number of companies operating would have fallen. Thus, it appears that the real price of insurance has declined. Table 2 presents data on the profitability of product liability insurance carriers from 1989 through 1998. Although premiums may have stabilized over this period, the profitability of insurance companies clearly remained tenuous. Between 1992 and 1995, for instance, the overall operating ratios (losses plus associated expenses less earning on investments divided by revenues) exceeded 1.00, with a peak of 1.16 in 1995. Because revenues and administrative costs remained constant over this

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Table 2. Underwriting Performance, Other Liability, 1989–98 Percent unless otherwise indicated

Year

Number of premiums written

Losses and loss ratio

Underwriting expenses

Gain on Overall invest- operating ments ratio

1989 1990 1991 1992 1993

18,434,466 18,123,123 16,851,155 17,055,977 17,751,659

84.1 82.7 82.1 105.4 105.0

25.5 26.3 27.9 27.5 27.4

22.1 22.7 24.5 30.0 29.2

88.0 86.7 85.9 103.3 103.6

1994 1995 1996 1997 1998

18,802,092 18,581,740 19,575,820 20,088,167 19,017,955

98.5 115.0 96.4 83.2 81.9

26.6 28.1 26.7 27.2 29.3

22.8 27.6 28.1 30.5 29.6

102.7 116.0 95.4 80.1 84.9

Source: A. M. Best & Company (1999).

period, the poor performance resulted largely from excess losses, as indicated by the loss ratios in the third column. In the late 1990s, performance was good, with losses well below premiums and with operating ratios well below 1.00. Economic Model In this section we develop a simple economic model that highlights a number of predictions regarding the effects of changes in product liability risk and in legal rules regarding responsibility for the accidents that result when these risks materialize. If manufacturing firms and insurers are risk neutral, they will act to maximize expected returns, including the costs of accidents. If consumers are risk averse, they will act to maximize expected utility but not necessarily expected returns. Given these maintained assumptions, we can generate simple hypotheses about the effects of changes on the expected costs of accidents.

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Output, Entry, and Exit. For the case of manufacturing firms, a static economic model provides a flexible approach to analyzing many of the economic effects of interest. In the simplest case, suppose that N identical firms sell q units of output at price p and that production costs, c, accident risks, φ, and the loss per accident, L, are constant.14 The firms’ profits, π, then equal revenues minus expected costs, or π = pq – cq –φLq.15 In this case, the firm will make zero profits. If market demand, Q, is linear in price and output, p = a – bQ, each firm will produce output equal to q = 1/N [(a – c –φL)/b]. The price of output will be determined by production and liability costs, or p = c + φL. According to this expression for the firm’s supply of output, as the amount of the loss per accident rises, or as the product risk rises (or both), firm and industry output contracts, and prices rise. Consumers are worse off, with a transfer of wealth to injured parties. The extent to which liability costs can be passed on to consumers and the ultimate welfare losses depend in the usual manner on the elasticities of demand and supply. In this simplified example, with constant costs and zero profits, the incidence falls entirely on the consumer. More generally, questions of incidence have been relatively unexplored in the literature. If demand for a product is elastic (as when there are many close substitutes), increases in company-specific product risks or incurred liability losses will fall entirely on the firm. If demand is less elastic, the profit effects will be less prominent. Thus, a manufacturer of bottled water would be quite sensitive to risk changes associated with the discovery of minor impurities, whereas the maker of a patented pharmaceutical product might be less sensitive to the discovery of minor side effects. Similarly, the discovery of a risk that plagued the products of all manufacturers in an industry would have less of a differential effect on individual firms but would affect consumers more

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broadly, as well as firms, taken as a whole, if they are inelastic suppliers. When expected accident costs get large enough, firms shut down. In the model given above, this occurs when φL > (a – c). A more interesting case incorporates the firm’s ability to invest in product safety. Denote these safety investments by s. Increases in s decrease the product risk, φ′(s) < 0, and increase the marginal cost of production, c′(s) > 0. If consumers can observe product quality, safety improvements will increase their willingness to pay for the product p′(s) > 0. The profit function is now π = p(s)q – c(s)q – φ(s)Lq. Safety investments will be made up the point at which the marginal benefit, which includes increased demand and reduced liability costs, equals the marginal cost of investing in safety, or p′(s) + φ′(s)L = c′(s). If the loss per accident, L, increases, investment in safety will increase as well. This relationship will not continue indefinitely, however, because at a given point, the firm does better to shut down. At any level of safety investment, this point is reached when revenues cannot cover average costs, or p < c + φL. A revenue shortfall obviously becomes more likely as losses, L, and product risks, φ, increase. It is also the case that, in this framework, if consumers cannot observe product quality, so that p′(s) = 0, the firm will underinvest in safety, because the returns to the investment will be lower. Research and Development and Innovation Effects. Firms can make two types of product development expenditures that are relevant to the discussion of product liability. As above, they can invest resources in safety improvements. Alternatively, they can devote research and development efforts to the introduction of new products or processes. The question here is the extent to which an increase in the product liability burden will shift the research and development emphasis away from inno-

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vations and toward safety-oriented refinements.16 For example, would a pharmaceutical firm devote more resources to the development of childproof bottle caps and less to the development of new analgesic compounds if losses due to accidental poisonings were to increase? To analyze these issues conceptually, suppose we add product novelty, z, into the price and cost functions, so that profits are now π = p(s, z) – c(s, z) – φ(s)L.17 If the firm now makes expenditures on product novelty and safety to maximize unit profits, it will do so by equating the marginal benefits per unit cost of safety to the marginal benefits per unit cost of novelty, or (ps – φs L)/cs = pz /cz. For the case in which unit revenues are linear in s and z, and in which product risk equals 1 – s the revenues and liability costs are given by p + αz + βs – (1 – s)L, where the parameters α and β describe the intensity of preferences for novelty and safety. Unit revenues R0, net of liability costs, L0, are given by the expression R0 = p + αz + βs – (1 – s)L0. We can rearrange terms to describe the unit net revenue function in terms of product novelty, z = [1/α (R0 + L – p) – 1/α (β + L)s], which has a slope given by dz/ds = [1/α (β + L)]. The firm will choose novelty and safety, given these preferences, to maximize the value of the net revenue function. An equilibrium in which the firm devotes resources to both safety and novelty is sketched in figure 1. Also shown in figure 1 is the corner solution, in which liability costs have risen to L1, the point at which the firm devotes nothing to product novelty, due to the high level of liability. Note that this situation also can arise when consumer preferences for safety become more important. It is widely believed that preferences for safety are increasing in wealth levels, so that an increased emphasis on safety can arise independently of any increase in concerns over liability losses, per se. It is also true, however, that the impact of increases in potential losses will be greater, the greater is the demand for safety.

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Figure 1. Safety versus Noveltya z

R1 R0

s

Source: Authors’ calculations. a. z = novelty, s = safety, and R = unit revenue function. See text for explanation.

Competitiveness. Much of the impetus for liability reform in the early part of the 1990s derived from the belief that liability costs were hampering the competitiveness of U.S. firms relative to their competitors from other countries. Rhetoric on both sides of the debate was particularly heavy in this regard. Much of the impetus behind Vice President Quayle’s Council on Competitiveness revolved around this issue. As Litan notes, much of this debate has focused on the wrong issue.18 Concerns over the effects of product liability on “competitiveness” were really concerns over a worsening domestic trade balance. In reality, anything that increases domestic pro-

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duction costs in a particular industry will not affect the trade balance, as changes in price will induce changes in the nominal exchange rate that exactly compensate, unless a change is somehow induced in the difference between savings and investment. Increased liability costs that affect either savings or investment could have an effect on the trade balance. This effect, however, would not arise because of any change in the competitive position of U.S. firms. The argument of those who maintain that liability costs provide an advantage to overseas producers is based on the (alleged) disadvantage that domestic firms face because they (allegedly) have to spread higher liability costs over future product offerings, whereas foreign competitors are not burdened by these losses and thus can sell at a lower price. How plausible is this claim? First, it is not clear how the domestic firms manage to sell their future output at a higher price. In a competitive world market, U.S. producers would take the world price as given, and the losses would be paid entirely by their shareholders. If the concerns are over liability for future sales, they have little foundation. Certainly, a foreign firm could withdraw from the U.S. market, rather than face a large penalty for unsafe products that materialized in the future. But there is an implicit penalty for withdrawal too, namely, the forgone profits from operating in the U.S. market. If an overseas manufacturer wished to remain in the market and sell an unsafe product, it could do so, but it would face the same risks as domestic producers. If it avoided the risk by producing a safer product and thus did not have to incorporate liability costs into its pricing, why would it be inefficient to do so? Costs for safety improvements would rise to the point warranted by the relative costs and benefits of compliance, and the standard of living of U.S. consumers would rise. Ex ante costs would affect all firms participating in the market and as such would confer no disadvantage on domestic firms.

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The unique aspect of the competitiveness argument appears to turn more on the effects of liability for accidents caused by products already sold. U.S. manufacturers argued that their liability costs were excessive because of the large number of their existing products already in the hands of consumers. An oftencited example was the domestic small aircraft industry, where the liability losses associated with the large number of airplanes already in existence imposed a substantial burden on the relatively smaller number of aircraft to be sold in the future. Because new entrants did not have this burden, the argument went, they enjoyed a competitive advantage. Ex post liability losses do not depend on current output and thus do not affect the marginal costs of production. They are, rather, a tax on an existing stock of durable goods in circulation. Such a tax would lead to exit by incumbent firms to the extent that it affected long-run average costs. The consequences of this exit for existing and potential competition, stockholders, consumers, and workers, are far from clear a priori. There are two important cases to consider. If the exiting domestic firms subject to this ex post liability tax make up a large part of the market, the reduced supply would affect price in the absence of entry by new competitors. Such a situation could make it attractive for a new small aircraft manufacturer to enter the U.S. market and compete with existing manufacturers. It is not clear, however, that this competition would necessarily have to come from overseas. It is also unclear whether the remaining firms would benefit. Although exit of existing producers would create some deficiencies in supply, the price increase would cause quantity demanded to fall as well. Whether those producers who took up the slack (domestic or otherwise) by entering the market or expanding production would be better or worse off as a result depends on the relative supply and demand elasticities.

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A related question concerns the composition of the domestic market before the losses are discovered. U.S. manufacturers appear to assume that they dominate the domestic market and that the majority of the products already in circulation were thus produced domestically. This assumption is of course not necessarily true. Suppose that a British pharmaceutical company was found liable for adverse side effects of a drug that it supplied monopolistically in the United States and that it left the U.S. market as a result. Would this bring harm to U.S. drug companies? In the second case, where the domestic industry is small, the liability tax would again force some incumbent firms to shut down. Others not burdened by the tax would then replace these firms. As in the previous case, these could be domestic firms as well as overseas competitors. More important, if the industry is so small that the liability tax does not affect the world price, the costs to the U.S. economy as a whole would be small as well. In summary, the effects of product liability on the competitiveness of U.S. firms appear to have been exaggerated. For ex ante risks, the advantages conferred on outside firms relative to those U.S. producers hampered by potential liability costs seem minimal. As long as they continue to operate in the U.S. market, foreign firms are subject to U.S. laws and will have the same costs as their U.S. competitors. If they attempt to evade the tax by leaving the U.S. market, they will forgo the profits that drew them there in the first place. If they mitigate the risk by producing a safer product, the benefits that accrue to them are little different than those that would accrue to a domestic firm that produced a higher-quality product. On an ex post basis, a liability tax on durable output already sold would confer an advantage on firms with fewer products already in the marketplace. Whether these are domestic or

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overseas producers is an empirical question. Likewise, the effects of such a tax on those not subject to the tax can only be determined empirically: if the tax leads to a world price increase, profits will rise or fall depending on elasticities of supply and demand. The arguments for product liability as “competitiveness policy” appear to be aimed more toward protecting the owners and workers of inefficient domestic firms, namely, those firms that cannot produce a safe product at a price low enough to meet the competition. As is so often the case in this area, domestic consumers would be subsidizing the beneficiaries of this protection. Stock Market and Other Effects. Liability losses, when they materialize, are reflected in the market capitalization of a firm. For example, when Ford Motor Company announced in August 2000 that it was recalling Firestone’s Wilderness AT tires on Ford cars, the auto company’s stock was trading at $47 a share. Within days, it had fallen to $25. The total loss of market capitalization to Ford alone, based on shares outstanding at the time, thus exceeded $20 billion. Moreover, a firm’s response to a liability crisis can either exacerbate the direct losses due to liability claims or temper them by developing its reputation in the eyes of consumers. A firm’s reputation is a fundamental component of its intangible capital. Reputations for safety are important determinants of demand, particularly as wealth levels rise. They can have important spillover effects for new brands and products and provide the opportunity for product differentiation advantages. Each of these beneficial effects of reputation is at risk when products fail. The risk of loss is compounded by the severe nonlinearity in the willingness to pay for small decreases in risk, relative to the willingness to accept small increases in risk. Consumers

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appear to be quite sensitive to the latter.19 Thus, reputation capital could be very difficult to develop, because consumers do not value safety improvements highly but appear to be extremely sensitive to increases in the perceived risk of a product. The more elastic the demand for the product, the greater the risk of losing reputation capital. Liability risk can manifest itself along other dimensions that seek to limit exposure, such as firm size and, perhaps, capital structure. To the extent that shareholders’ “deep pockets” give rise to increased litigation, firms have an incentive to limit losses by limiting the size of the firm.20 Evidence on the effect of liability risk on capital structure has not yet been presented. If firms can limit their liability by issuing debt instead of equity, it seems likely that the presence of significant liability risk would create a bias toward debt. Evidence on the Consequences of Product Liability Risks Empirical evidence on the consequences of product liability risks takes a variety of forms. Little direct evidence is available because the ex ante risks of product defects are very difficult to measure in real world contexts. A wealth of indirect evidence exists, however, on the effects of liability-related events on a range of outcomes. In particular, researchers have examined the effects of product recalls and accidents on stock prices, the effects of changes in product risk on consumer valuations, and the effects of changes in insurance pricing on research and development activity and on innovation rates. Evidence is also mounting on the effects of recent product liability reforms on economic outcomes, such as insurance premiums and losses, and on productivity growth; this evidence is discussed in the next section. It is important to keep separate the positive and normative implications of the studies of product liability risks and reforms.

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In the absence of an observed effect of product liability risk on economic outcomes, one might conclude that market forces are not operating as predicted and that some intervention in the product safety arena is warranted. If meaningful risk effects are observed, all that can be said is that market forces are having some effect, not that they are operating efficiently. Claims of the latter sort are typically very difficult to make without information on things that are fundamentally unobservable.21 The existence of market effects is thus a necessary, but not a sufficient, condition to conclude that product safety markets regulate themselves. The magnitudes of some of the observed effects suggest that market effects are often quite important, however, and it seems plausible to infer from these results that markets are providing substantial incentives. In many cases where the magnitudes of the market incentives can be compared with those provided by government interventions, the relative efficacy of market forces is considerable.22 From a policy perspective, this finding suggests that attempts to regulate safety through market-oriented mechanisms, such as the experience rating of workers’ compensation programs, will be more effective than command-and-control interventions, such as many of the early OSHA design standards. Much of the evidence on the effects of product liability risks appears as anecdotes or case studies. Although generalizing from these studies is difficult, they do point to some of the forces at work in the product liability arena. The anecdotal evidence also provided much of the impetus for the liability reform movement. The anecdotes summarize cases in which liability risks led manufacturers to withdraw from the market altogether. Kitch summarizes the case history surrounding product liability litigation and the market for vaccines.23 In the case of the potential swine flu outbreak in the United States in 1976, for example, producers refused to manufacture the vaccine until

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the government agreed to assume the costs of any unforeseen side effects. When these side effects did, in fact, materialize, in the form of a small number of cases of Guillain-Barré syndrome, the government settled approximately 750 claims for almost $75 million. A second notable case involved the use of alternative polio vaccines. In the case of Johnson v. American Cyanamid (1984), a jury awarded $10 million, $8 million of which was punitive damages, to the parents of a plaintiff who contracted polio after being administered the Sabin (live virus) polio vaccine. Observers were particularly concerned in this case about the sizable punitive damages, despite the manufacturer’s clear warnings of the minute risk of side effects and despite the fact that the product had been manufactured according to accepted industry safety standards. The third, and perhaps most notorious, case in the vaccine market involved the pertussis (whooping cough) component of the DTP vaccine administered generally to U.S. schoolchildren. As a consequence of a small number of lawsuits related to side effects, filed in the 1980s, all but one manufacturer of the DPT vaccine withdrew from the U.S. market.24 Case studies such as these, while instructive, do not identify systematic relationships among the causal forces of product liability risks and the economic outcomes that they are hypothesized to generate. More systematic research is summarized in table 3. The studies presented there examine a range of economic outcomes alluded to in the development of the economic model above. For example, the series of models estimated by Viscusi and Moore examine the relationship between liability risks and measures of innovative activity.25 The basic message of these studies is that relatively low levels of liability risks are associated with higher levels of R&D activity. This pattern is reversed at very high levels of liability risk. The interpretation of this pattern is that risks create incentives for

Market value of firm

Firm size

Market value of firm

Patents, new product introductions

Liability premiums/ sales

R&D/sales

Product and process R&D intensity

Rate of new product introductions

Prescription drug prices, U.S. vs. Canada

Ringleb and Wiggins (1990)

Viscusi and Hersch (1990)

Viscusi and Moore (1991a)

Viscusi and Moore (1991b)

Viscusi and Moore (1991b)

Viscusi and Moore (1993)

Viscusi and Moore (1993)

Manning (1997)

Outcome

Jarrell and Peltzman (1985)

Authors

Prior litigation rates/ sales

Liability premiums and losses/sales

Liability premiums and losses/sales

Liability premium/ sales

Past R&D activity

Product liability premiums/sales

Characteristics of product liability lawsuit filings

Cancer exposure for chemical workers

Product recalls— autos and drugs

Risk measure

Results

Prior litigation (liability risk) explains all of observed price differences at tail of distribution. Substantial effect on overall distribution.

Product liability costs lead to reduced rates of new product introductions

Product liability costs increase R&D intensity but lead to reductions at very high levels

Product liability costs increase R&D intensity but lead to reductions at very high levels

Product liability costs higher where new product R&D is greater

Product liability costs higher where new product R&D is greater

Announcements of negative and positive events affect stock price in expected direction. Other economic effects significant and in expected direction

Smaller firms in specialty chemical industries following increased liability risks

Significant decrease in market capitalization following product recalls

Table 3. Effect of Product Risks: Summary of Research Results

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safety at low-risk levels but lead to stagnation of the innovation process beyond some threshold. This result is important for those setting liability levels. In particular, if a product presents some risk as a side effect but reduces other health risks more generally, a product withdrawal due to excessive liability for the side effects could lead to an increase in overall health risks. The leading example of this is the withdrawal of vaccines like the live-virus polio vaccine because of isolated instances of adverse side effects. From another perspective, it is possible in principle to set liability costs at a level that maximizes the improvements in safety by balancing the product quality and withdrawal effects. Several stock market studies provide compelling evidence that product recalls and litigation adversely affect the wealth of manufacturers.26 This is true for a range of products. Auto recall studies are most prevalent, since auto recalls themselves are most prevalent. Evidence on other industries, such as pharmaceuticals, Agent Orange, and medical devices is broadly consistent with the results of the auto recall studies. It is clear from these results that the potential stock market losses from defects in product design and manufacture provide enormous incentives for safety. The stock market response reflects two broad forces, depending on the nature of the study. When recalls are made in the absence of any litigation, stock price effects reflect changes in the demand for quality. These represent the purest form of the market incentives. When the stock price effects are related to announcements of liability filings or judgments, the stock price movements reflect the market’s estimate of the cost of the future litigation. As noted earlier, it is not clear whether the incentives provided meet some social optimality standard. Their importance, however, cannot be ignored. The market response to product defects is considerable and goes a long way toward promoting safer products.

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In a very interesting recent study, Manning compares prescription drug prices in the United States and Canada to determine the effects of product liability risks on observed price differentials.27 These price differentials received intense scrutiny during the 2000 American presidential campaign and are being used by some to push for price controls on pharmaceuticals. It is argued that many U.S. consumers, particularly the elderly, are paying a premium on their drug prices, which are not regulated, in order to fund research and development activities of pharmaceutical manufacturers. This premium allegedly subsidizes foreign consumers of American drugs, who pay a lower price. Although the safety and efficacy requirements of the U.S. Food and Drug Administration have resulted in a very lengthy approval process that adds considerably to the price of drugs, it is not clear how much of this price premium is due to safety-related research. According to Manning’s results, virtually all of the differences in prices between the United States and Canada at the high end of the risk spectrum for specific drugs can be attributed to litigation risk. More generally, Manning finds that about one-half of the average difference between the price paid in the United States and that paid by foreign consumers reflects litigation risks. Product liability costs are thus shown to have a broad range of economic effects. They create incentives for safety through the R&D process. They lead to withdrawals of very risky products. They are reflected in higher prices, at least for inelastically demanded products such as prescription medicines. Finally, they can have significant effects on the value of the firm, reflecting potential costs for mass torts in some cases and losses in reputation in others. Once again, the welfare implications of these results are far from clear. Risk levels might still be too high, despite the evidence on product withdrawals and the cries of alarm over competitiveness on the part of domestic manufacturers. Informational asymmetries could mean that prices

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might not fully reflect the risks inherent in products. Also, the anecdotal evidence might be just that. In the absence of more comprehensive evidence, such as that provided in the cited studies, the anecdotes are not particularly useful for policy purposes. Evidence on the Effects of Product Liability Reforms Concerns over the escalating costs of liability insurance, together with anecdotal evidence on product withdrawals and catastrophic losses, led to a number of reforms at the state level in the 1980s and 1990s. Whether these reforms were actually called for, given the economic consequences of the growth in costs, is in question. It may have been that the extant level of risk had not previously been priced out in the product and insurance markets, or that the consequences of technological advance had led to new, riskier products whose risks were not reflected in existing insurance premiums and litigation rates. The dramatic increases in risks and premiums suggest that there was much more to the story than this, but there is no way to determine how much of the change reflected fundamental changes in the nature of products rather than changes in societal attitudes toward litigation, increased demands for safety, or flaws in the legal institutions. Also, it is far from clear whether the increased costs reflected broad changes in the litigiousness of society, rather than the effects of the single mass of tort filings related to asbestos. The asbestos cases have since worked their way through the courts, and there has since been a corresponding reduction in the growth of losses, premiums, and claims. As a consequence of these upward trends in premiums, losses, and claims, several states instituted reforms in their product liability statutes. Little, if any, corresponding reform has occurred at the federal level. Most attempts at reform have been

Industrial fatalities

Medical malpractice

Liability losses, premiums, and loss ratios

Prices for DTP vaccine

State-year produc- Various state-specific tivity growth reforms

Liability losses, premiums, and loss ratios

Moore and Viscusi (1989)

Snyder and Hughes (1990) Hughes and Snyder (1995)

Viscusi and others (1993)

Manning (1994)

Campbell, Kessler, and Shepherd (1999)

Born and Viscusi (1999)

Various state-specific reforms

Strict liability for adverse side-effects

Various state-specific reforms

Reforms associated with decreases in losses, premiums, and loss ratios. Effect on levels higher for high loss carriers.

Cost-reducing reforms associated with significant increases in productivity.

Movement to strict liability leads to 20-fold increase in price of DTP vaccine.

Reforms associated with decreases in premiums, losses, and loss ratios for general liability. Weaker effects for medical malpractice.

English rule leads to decreased litigation frequencies, conditioned on claims that are not dropped. Unconditional litigation rates rise. Expenditures are higher under English Rule.

Increases in maximum benefit levels for fatalities associated with decline in fatality rates. Effect stronger for large firms.

Change to strict liability for workplace injuries associated with significant decline in occupational fatality rates.

Liability costs associated with decreases in severe accident rate claims, increases in claims for less severe accidents.

Results

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Introduction of English Rule for allocating legal costs

Workers’ compensation benefit ceilings

Strict liability provisions in workers’ compensation

Industrial fatalities

Fishback (1987)

Workers’ compensation benefit levels

Reform measure

Industrial fatalities

Outcome

Chelius (1982)

Authors

Table 4. Effect of Product Liability Reforms: Summary of Research Results

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defeated either in Congress or by presidential veto, a situation that appears to reflect the influence of political interest groups. States are loath to give up control to the federal government by moving to a national liability system, because such a move would take away their power to redistribute wealth into their states from out-of-state manufacturers.28 Likewise, plaintiffs’ attorneys are major contributors to political parties at the federal level and can and do use their influence to block efforts at reform. State reforms were aimed primarily at solving the problems of the insurance industry. They included features such as caps on damage awards and contingency fees, limits on the amount of punitive damages, changes in the doctrine of joint and several liability, and reforms of collateral source rules. Other changes, such as the movement in some states to a strict liability standard, were potentially cost-increasing, however. More broadly, the movement in the latter part of the twentieth century toward strict liability and the evolution of the design defect and hazard warning doctrines were all legal reforms thought to increase the costs of liability, and therefore its consequences. A wealth of information on the economic functioning of liability rules is available from state workers’ compensation programs. The essential nature of most industrial accident programs emerged in the early part of the twentieth century, when state programs adopted two key features: the adoption of a strict liability standard, which held employers responsible for accidents that occurred on the job regardless of fault; and caps on damages. It was argued at the time that these rules would encourage prompt payment of claims, reduce litigation, and limit the risk of catastrophic losses to employers. Experience with the system has borne out this argument to some extent; however, litigation over the classification of disease severity is extensive and costly, and “new wave” claims for job stress, among

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other work-related diseases and conditions, are threatening to bankrupt the system. It is safe to say that the movement to strict liability has led to a reduction in severe accidents.29 When employers are held strictly liable for accidents, the rates of job fatalities and injury severity both fall significantly. This effect is strengthened by increases in liability costs embodied in benefit level increases. Much of the alarm expressed during the product liability crisis of 1985–87 centered on the effects of increased costs on productivity. If these concerns were warranted, then reforms that reduced liability costs should have a significant effect on productivity growth. This hypothesis is examined by Campbell, Kessler, and Shepherd, who look at state reforms that capped damages and contingency fees, abolished punitive damages, changed collateral source rules, set mandatory periodic payments, changed joint and several liability laws, moved to comparative negligence standards, and required mandatory payment of prejudgment interest.30 Using a panel data set of industries measured at the state and year level, and data on product liability reforms during the 1972–90 period, they find that states that changed laws to decrease levels of liability experienced greater increases in aggregate productivity than those that did not. The effects of reforms that reduced costs in the long run appear to be stronger still. Those reforms that increased costs had a mixed effect on productivity growth.31 Much of the concern over the growth of liability costs centered around a solvency crisis in the insurance industry. Profit rates were significantly negative during the late 1980s, with many carriers increasing liability premiums dramatically or dropping particularly risky product lines altogether. Born and Viscusi and Viscusi and others study the effects of reforms on the pricing of general liability and malpractice insurance.32 In the Born and Viscusi study, the ratemaking file of National Association of Insurance Commissioners, a large dataset of com-

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panies covering the years 1984–91, is used to analyze effects of liability and malpractice reforms on insurance costs. Reforms studied include monetary caps on punitive and nonpunitive damages, limitations on circumstances in which damages may be awarded, punitive damages barred in medical malpractice actions, and monetary caps on medical malpractice damages. The Born and Viscusi analysis uses two reform indicator variables, one representing damage caps and the other various other reforms aimed at limiting liability. Outcomes studied include litigation patterns, loss ratios, premiums, and losses for each type of insurance. The principal findings show that reforms reduced the insurance burden significantly and that the effect was not felt equally across the distribution of losses. In particular, in the regression models estimated, the changes in the levels of liability losses appeared to be much larger for firms with large losses. Relative effects, or elasticities, were not as strongly suggestive of this result. In addition to these findings, Born and Viscusi also show that reforms had a larger effect on product liability losses than on premiums, thus leading to an increase in the profitability of insurers. In a study of the effects of strict liability on pricing, Manning examines the effects on prices of changes in the liability regime governing pharmaceutical products in the United States.33 The design of the study is straightforward: prices for the aforementioned DTP vaccine are compared to those of the vaccine without the pertussis component (DT). With this latter price series as the control group, increases in the relative price of the DTP vaccine can be attributed to the litigation surrounding the side effects of the pertussis vaccine. Indeed, in the regression results, virtually all of the movement in DTP prices not explained by DT price changes is attributable to cumulative litigation experience. The increase in the DTP price was substantial. Manning’s results indicate an increase over the sample period of more than 2000 percent, most of which was

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attributable to litigation costs. Likewise, the price of the oral (live virus) polio vaccine is shown to be about 300 percent higher than it would have been in the absence of the movement to strict liability. Finally, in a series of papers that studied the issue of allocating litigation costs, Snyder and Hughes examine Florida’s experiment with the English Rule, under which the losing party must compensate the winner for costs related to liability claims. Although the theoretical direction of the effect of this change is ambiguous, the Snyder and Hughes papers go a long way toward separating out the competing effects empirically. Snyder and Hughes also control for the selection of cases at each stage of the litigation process, thus allowing estimation of the structural (behavioral) effects of the rule. Key findings of this research show that movement to the English Rule led to decreased litigation rates, conditional on selection into the pool of litigated claims. Unconditional estimates, however, indicate that litigation rates are higher than is indicated by the unconditional estimates. Also, consistent with theoretical predictions, legal expenditures increase significantly on the part of both parties under the English Rule compared with the American Rule. Policy Implications of Product Liability Reforms Sweeping statements about reforms are difficult to make, as the nature of the most effective reforms depends critically on unique aspects of industry structure. For example, reforms of malpractice law can have more or less desirable effects, depending on the nature of reimbursement practices by medical insurers. These same reforms also would have a quite different effect in an industry where the consumers are more directly tied to the cost of their utilization of the product.

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In other cases the effects of proposed reforms are unclear, or the reforms themselves are unwarranted on other grounds. For example, caps on contingency fees have an ambiguous effect on litigation costs. Perhaps more important, such caps interfere with what is essentially a private contract between a lawyer and client. In the absence of compelling evidence that such contracts impose external costs on others, reform of contingency fees is not warranted. At the same time, contingency fees negotiated by states are public policy decisions that should be open to public scrutiny and competitive bidding to prevent abuses. Reforms of negligence standards are also difficult to evaluate in total. We know, for example, that modification of contributory negligence can make it easier for injured parties to recover and increase incentives to file claims, all else held equal. We do not, however, know what such reforms would do to defensive practices, what these practices would cost, and what the overall effect would be on social welfare. The two most problematic areas in the liability arena are the extreme losses in isolated cases, such as the recent $4 billion judgment against General Motors, and the costs of mass toxic torts. Limits on large losses can be achieved through reform of the punitive damage function. There are three reasonable policies in this regard. First, caps on punitive damages can be set by statute, as some states have done; such caps will effectively limit large losses. Likewise, caps on damage awards in general will lead to decreased awards and possibly to decreases in filings. Large losses also can be reduced by requiring judges, rather than juries, to set the level of punitive damages. Finally, allowing for regulatory compliance as a defense against punitive damages will protect firms who meet all existing legal and regulatory requirements for safeguards and follow “best practice” in their product development and manufacture. For example,

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a drug that passes the rigorous FDA approval process and for which unanticipated side effects later materialize should not expose the manufacturer to catastrophic losses. The nature of reforms regarding mass toxic torts is more tenuous. The root of the problem is the design defect doctrine combined with the nature of long-term latent risks and massproduced products. Regulatory compliance defenses would certainly be effective in reducing these losses. Likewise, caps on awards would limit the cost of these awards. A final area of reform is the rationalization of differences across states in liability risks. One recurring feature of the U.S. product liability arena is the consistent inability of the federal government to introduce a comprehensive national liability policy. The benefits of such a policy could be extensive. Differences in state rules lead to substantial administrative and compliance costs, to uncertainty over risks, and possibly to migration of affected parties to jurisdictions that are more favorable to their particular position. Although some states have recently adopted reforms, with corresponding effects on productivity, malpractice risks, and other outcomes, other states have lagged behind and indeed have used liability law to transfer wealth from out-of-state producers to within-state recipients. Alabama is notable in this regard. A national product liability policy would reduce the latitude of the states to effect these wealth transfers from out-of-state producers through litigation, but it would violate principles of federalism. Moreover, a national liability policy may not exclusively serve the public interest. The usual inference one makes when examining the behavior of regulators is that some interest group is influencing the observed behavior. A national policy would reduce the power of interest groups at the state level but increase it nationally. Plaintiffs’ attorneys are certainly important in this regard, and their lobbying efforts have been cited by many as one of the chief roadblocks to a more rational liability

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policy. Nor has experience with other national risk policies, such as Superfund, been reassuring for those arguing for a national liability policy. A national policy could take the form of a safety policy that more effectively integrates the various institutions that seek to promote safety. Regulators are almost certainly more able to judge scientific evidence consistently than are judges and juries. Using the approach embodied in workers’ compensation laws, regulatory policy could establish a more effective means for compensating victims while protecting the solvency of employers. Of course, workers’ compensation programs are not without problems associated with excess litigation, as noted earlier. These problems seem to be easily remedied, however, through the use of standard insurance tools such as copayments and deductibles. Finally, the introduction of a regulatory compliance defense would effectively eliminate many of the problems associated with latent, long-term risks. Under such a defense, when such risks manifested themselves, producers would not be held liable if they could prove that they followed the regulatory safety standards in effect at the time the product was designed. Problems and Prospects of Mass Toxic Torts Perhaps the most vexing product liability problem now facing public officials is that posed by mass toxic torts. Such cases have the potential to bankrupt manufacturers of the products involved. Examples are Johns-Manville, the maker of asbestos, and A.H. Robins, the manufacturer of the Dalkon Shield. Recent estimates of the extent of litigation in these and other cases are remarkable in their magnitudes. In the Agent Orange litigation, U.S. veterans filed more than 125,000 cases. More than 210,000 cases were filed in the Dalkon Shield episode, and 340,000 cases—the largest number by far—were filed seeking damages for illness and death caused by exposure to asbestos.

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Three factors contribute to the problem of mass toxic torts. First is the problem of mass exposure. Given the long latency period of many of the risks, there is no immediate feedback process by which firms can evaluate the performance of their products in the hands of the ultimate consumers. If the risks associated with a product, such as asbestos, or even tobacco, materialize only many years after exposure, the potential for affecting large groups of consumers becomes enormous. Second, given the nature of the design defect doctrine, a product with a defective design that can reach many millions of consumers can lead to substantial risk exposure for firms. Finally, scientific uncertainty over causation can lead both to overcompensation and to increased litigation, if cases are attributed entirely to a particular cause, such as asbestos, and not to contributing factors, such as cigarette smoking. Clearly, mass toxic torts as currently manifested in the litigation process are not meeting the stated objectives of the tort system. Determination of the appropriate compensation level is difficult, particularly when the cause of illness is uncertain. Deterrence effects are potentially offset by product withdrawals. Judges have a difficult time evaluating technical scientific evidence, and the determination of causation and other technical matters can contribute significantly to litigation costs.34 At the time of this writing, mass torts are prominent features of the legal landscape. The tobacco lawsuits are unprecedented in their magnitude, and the repercussions of these suits will be felt for some time. Likewise, the Ford-Firestone crisis raises important questions about the role of product risks in business-to-business arrangements and about the proper means to respond to product crises. The evolution of product liability law as it relates to cases such as these appears then to be the most important issue currently on the product liability agenda.

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Although there is much to criticize in this area, there is also cause for optimism. Firms do respond to product risks, a fact that suggests that the market mechanism can be used to achieve desirable product safety outcomes. Moreover, liability reforms do affect behavior. The problem thus appears to be establishing the appropriate reforms and striking the appropriate balance between market and nonmarket forces and between incentives for manufacturing safer products and incentives for withdrawing potential risky ones. Punitive damages appear to go too far in this regard. Compensatory damages alone not only can provide sufficient incentives for safety, but also can perform an insurance function that enhances overall welfare. It appears that selective application of liability incentives to those areas where real problems exist, as in the case of asbestos and other mass torts, would be most beneficial in terms of overall efficiency. Similarly, a policy aimed at reducing the frequency of less severe claims, much like the deductibles in standard insurance contracts, would go a long way toward guaranteeing the solvency of insurance carriers and manufacturers, while at the same time leaving more funds available for more severe losses. In most other cases, market forces provide adequate incentives through reputation effects and price differentials for product quality. The solvency of insurance carriers is certainly an important part of the problem, and many reforms have been directed toward a solution in this regard. The solvency of firms that produce useful products is at least as important, however, and reforms need to be developed to facilitate their continued survival. Ultimately, consumers need to be represented as well, with a liability policy that balances the benefits and costs of technological advances, as well as benefits and liability costs related to the more mundane, but not perfectly safe, products used in everyday life.

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Notes Michael J. Moore wishes to thank the German Marshall Fund, which provided support through the AEI-Brookings Joint Center on Regulatory Studies; the John M. Olin Foundation, which provided support through the John M. Olin Visiting Professorship at the Stigler Center for the Economy and the State, Graduate School of Business, University of Chicago; and the Darden School Foundation at the Darden Graduate School of Business, University of Virginia, for their support. W. Kip Viscusi’s research is supported by the Sheldon Seevak Research Fund and the Harvard Olin Center for Law, Economics, and Business. The views expressed herein are those of the authors and not necessarily those of any of the organizations identified above or institutions with which the authors are affiliated. 1. On the Food, Drug and Cosmetics Act amendments, see Peltzman (1975). 2. On the early performance of OSHA, see Viscusi (1983). On the CPSC, see Viscusi (1984a). On the FDA, see Peltzman (1973). Early studies of particular safety standards include Linneman’s (1980) study of the mattress flammability standard, Viscusi’s studies of the childproof safety cap regulation (1984b) and the OSHA cotton dust standard (1985), and Peltzman’s (1975) study of mandatory safety belt regulations. 3. See, for example, Hensler and others (1985); Kakalik and others (1984). 4. Schuck (1987). 5. Huber (1988). 6. For evidence on all of these issues, see Huber and Litan (1991); Schuck (1991). 7. A third goal of the tort liability system in general is to punish offenders. We do not discuss this goal in any detail. 8. For a more detailed treatment in a law and economics framework, see Cooter and Ulen (1997). 9. This section draws on Landes and Posner (1987, ch.1). 10. The award was reversed on appeal to a higher court. 11. See Nichols and Zeckhauser (1986). 12. For a brief survey, see Moore (1998). For an extensive treatment, see Fishback and Kantor (1999). 13. Evidence on the effects of the liability and compensation structure of workers’ compensation is discussed below. 14. A more general formulation would weight the losses by a weight factor reflecting the negligence standard and allow for punitive damage effects that affect the loss, based on the firm’s efforts to exercise care. We ignore these effects in the development of the model results but include them in the discussion. 15. In this formulation, liability losses are modeled as if the firm were strictly liable, so that it would pay the loss in its entirety. We could allow for

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other liability standards by substituting a monotonic transformation of the loss amount without qualitatively affecting the results (Viscusi and Moore 1993). 16. Safer products can, of course, be considered new products as well, so there is some ambiguity in this distinction. We distinguish between safety improvements of existing products and fundamentally new products. 17. This model is a version of the framework presented in Viscusi and Moore (1993). To concentrate on the innovation effects, we have dropped the output term and focus on unit profits. 18. Litan (1991). 19. See the survey results in Viscusi and Magat (1987). 20. Ringleb and Wiggins (1990) document a negative relationship between firm size and the risk of large-scale, long-term hazards. 21. See, however, Viscusi and Moore (1987) on the adequacy of workers’ compensation benefit levels. 22. Moore and Viscusi (1987). 23. Kitch (1985). 24. For further case studies from the pharmaceutical industry, see Lasagna (1991). 25. Viscusi and Moore (1991a, 1991b, 1993). See also Eads and Reuter (1983). 26. See, for example, Jarrell and Peltzman (1985); Viscusi and Hersch (1990). 27. Manning (1997). 28. Neely (1988). 29. This reduction was noted by Fishback (1987) in a study of the history of workers’ compensation and by Chelius (1982) and Moore and Viscusi (1989) with respect to the effects of changes in benefit levels. 30. Campbell, Kessler, and Shepherd (1998). 31. Due to data limitations and the statistical design, the authors are able to study only the average effects of cost-increasing and cost-decreasing reforms. This is a common feature of all of the studies reviewed here. 32. Born and Viscusi (1998); Viscusi and others (1993). 33. Manning (1994). 34. Foster and Huber (1998).

References A. M. Best & Company. Various years. Best’s Aggregates and Averages: Property and Casualty. Oldwick, N.J. Born, Patricia, and W. Kip Viscusi. 1999. “The Distribution of the Insurance Market Effects of Tort Liability Reforms.” Brookings Papers on Economic Activity, Microeconomics: 1998.

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Campbell, Thomas J., Daniel P. Kessler, and George B. Shepherd. 1999. “The Link between Product Liability Reforms and Productivity: Some Empirical Evidence.” Brookings Papers on Economic Activity, Microeconomics: 1998. Chelius, James R. 1982. “The Influence of Workers’ Compensation on Safety Incentives.” Industrial and Labor Relations Review 35: 235–42. Cooter, Robert, and Thomas Ulen. 1997. Law and Economics, 3d edition. Addison-Wesley. Eads, George, and Peter Reuter. 1983. Designing Safer Products: Corporate Responses to Product Liability Law and Regulation. Santa Monica, Calif.: RAND Institute for Civil Justice. Fishback, Price V. 1987. “Liability Rules and Accident Prevention in the Workplace: Empirical Evidence from the Early Twentieth Century.” Journal of Legal Studies 16: 305–28. Fishback, Price V., and Shawn E. Kantor. 1999. Prelude to the Welfare State. Chicago: National Bureau of Economic Research. Foster, Kenneth R., and Peter W. Huber. 1998. Judging Science: Scientific Knowledge and the Federal Courts. MIT Press. Hensler, Deborah R., and others. 1985. Asbestos in the Courts: The Challenge of Mass Toxic Torts. Santa Monica, Calif.: RAND Institute for Civil Justice. Huber, Peter W. 1988. Liability: The Legal Revolution and Its Consequences. Basic Books. Huber, Peter W., and Robert E. Litan, eds. 1991. The Liability Maze: The Impact of Liability Law on Safety and Innovation. Brookings. Hughes, James W., and Edward M. Snyder. 1995. “Litigation and Settlement under the English and American Rules: Theory and Evidence.” Journal of Law and Economics 38 (1): 225–50. Jarrell, Greg, and Sam Peltzman. 1985. “The Effects of Product Recalls on the Wealth of Sellers.” Journal of Political Economy 93 (3): 512–36. Kakalik, James S., and others. 1984. Costs of Asbestos Litigation. Santa Monica, Calif.: RAND Institute for Civil Justice. Kitch, Edmund W. 1985. “Vaccines and Product Liability: A Case of Contagious Litigation.” Regulation 9 (3): 11–18. Landes, William M., and Richard A. Posner. 1987. The Economic Structure of Tort Law. Harvard University Press. Lasagna, Louis. 1991. “The Chilling Effect of Product Liability on New Drug Development.” In Huber and Litan (1991). Linneman, Peter. 1980. “The Effects of Consumer Safety Standards: The 1973 Mattress Flammability Standard.” Journal of Law and Economics 23 (2): 461–79. Litan, Robert E. 1991. “The Liability Explosion and American Trade Performance: Myths and Realities.” In Schuck (1991).

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Manning, Richard L. 1994. “Changing Rules of Tort Law and the Market for Childhood Vaccines.” Journal of Law and Economics 37 (1): 247–75. ———. 1997. “Products Liability and Prescription Drug Prices in Canada and the United States.” Journal of Law and Economics 40 (1): 203–43. Moore, Michael J. 1998. “Insurance for Workplace Injuries.” In New Palgrave Dictionary of Economics and the Law, edited by Peter Newman. New York: Stockton Press. Moore, Michael J., and W. Kip Viscusi. 1989. “Promoting Safety through Workers’ Compensation: The Efficacy and Net Wage Costs of Injury Insurance.” RAND Journal of Economics 20 (4): 499–515. Neely, Ralph. 1988. The Product Liability Mess: How Business Can Be Rescued from the Politics of State Courts. Free Press. Nichols, Albert, and Richard Zeckhauser. 1986. “The Perils of Prudence: How Conservative Risk Assessments Distort Regulation.” Regulation 10 (2): 13–24. Peltzman, Sam. 1973. “An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments.” Journal of Political Economy 81 (5): 1049–91. ———. 1975. “The Effects of Automobile Safety Regulation.” Journal of Political Economy 83 (4): 677–725. Ringleb, Al H., and Steven N. Wiggins. 1990. “Liability and Large-Scale, LongTerm Hazards.” Journal of Political Economy 98: 574–95. Schuck, Peter H. 1987. Agent Orange on Trial: Mass Toxic Disasters in the Courts. Belknap/Harvard. ———. 1991. Tort Law and the Public Interest. Norton for the American Assembly. Snyder, Edward M., and James W. Hughes. 1990. “The English Rule for Allocating Legal Costs: Evidence Confronts Theory.” Journal of Law, Economics, and Organization 6 (Fall): 345–80. Viscusi, W. Kip. 1983. Risk by Choice: Regulating Health and Safety in the Workplace. Harvard University Press. ———. 1984a. “The Lulling Effect: The Impact of Child-Resistant Packaging on Aspirin and Analgesic Ingestions.” American Economic Review 74: 324–27. ———. 1984b. Regulating Consumer Product Safety. American Enterprise Institute. ———. 1985. “Cotton Dust Regulation: An OSHA Success Story?” Journal of Policy Analysis and Management 4 (3): 325–43. ———. 1991. Reforming Products Liability. Harvard University Press. Viscusi, W. Kip, and Joni Hersch. 1990. “The Market Response to Product Safety Litigation.” Journal of Regulatory Economics 2: 215–30.

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Viscusi, W. Kip, and Wesley A. Magat. 1987. Learning about Risk: Consumer and Worker Responses to Hazard Information. Harvard University Press. Viscusi, W. Kip, and Michael J. Moore. 1987. “Workers’ Compensation: Wage Effects, Benefit Inadequacies, and the Value of Health Losses.” Review of Economics and Statistics 69: 249–61. ———. 1991a. “An Industrial Profile of the Links between Product Liability and Innovation.” In Huber and Litan (1991). ———. 1991b. “Rationalizing the Relationship between Product Liability and Innovation.” In Schuck (1991). ———. 1993. “Product Liability, Research and Development, and Innovation.” Journal of Political Economy 101 (1): 161–84. Viscusi, W. Kip, and others. 1993. “The Effect of the 1980s Tort Reform Legislation on General Liability and Medical Malpractice Insurance.” Journal of Risk and Uncertainty 6:165–86.

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Director Robert W. Hahn Codirector Robert E. Litan Fellows Robert W. Crandall Christopher C. DeMuth Randall W. Lutter Clifford M. Winston

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In response to growing concerns about the impact of regulation on consumers, business, and government, the American Enterprise Institute and the Brookings Institution established the AEI-Brookings Joint Center for Regulatory Studies. The primary purpose of the center is to hold lawmakers and regulators more accountable by providing thoughtful, objective analysis of existing regulatory programs and new regulatory proposals. The Joint Center builds on AEI’s and Brookings’s impressive body of work over the past three decades that evaluated the economic impact of regulation and offered constructive suggestions for implementing reforms to enhance productivity and consumer welfare. The views in Joint Center publications are those of the authors and do not necessarily reflect the views of the staff, council of academic advisers, or fellows.

COUNCIL OF ACADEMIC ADVISERS Kenneth J. Arrow Stanford University

Maureen L. Cropper University of Maryland and World Bank

Philip K. Howard Covington & Burling

Paul L. Joskow Massachusetts Institute of Technology

Rodney W. Nichols New York Academy of Sciences

Roger G. Noll Stanford University

Gilbert S. Omenn University of Michigan

Peter Passell Milken Institute

Richard Schmalensee Massachusetts Institute of Technology

Robert N. Stavins Harvard University

Cass R. Sunstein University of Chicago

W. Kip Viscusi Harvard University

Product Liability Entering the Twenty-First Century The U.S. Perspective Michael J. Moore and W. Kip Viscusi

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his report examines key issues concerning the law and economics of product liability. The authors begin with a brief description of the evolution of product liability doctrine in the U.S., up to the point of the liability crisis of the late 1980s. They discuss the economic implications of product risk for both consumers and producers, offer economic hypotheses on the implications of the increased scope of liability and subsequent reforms, and provide an update of trends in litigation and liability law.

Product Liability Entering the Twenty-First Century The U.S. Perspective

Michael J. Moore W. Kip Viscusi

Michael J. Moore is a visiting associate professor at the Darden School of Business Administration, University of Virginia, and a research associate at the National Bureau of Economic Research. W. Kip Viscusi is John F. Cogan Jr. Professor of Law and Economics and director of the Program on Empirical Legal Studies at Harvard Law School.

American Enterprise Institute for Public Policy Research 1150 Seventeenth Street, N.W. Washington, D.C. 20036 www.aei.org The Brookings Institution 1775 Massachusetts Avenue, N.W. Washington, D.C. 20036 www.brookings.edu

AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES