Andri G. Wibisana
2. THE POLLUTER-PAYS PRINCIPLE
2.2. Application of the Principle
2.2.1. Instruments to implement the principle 1. Liability rules: negligence versus strict liability
tion, the injurer has to bear the cost of precaution and the cost of expected damage. It can also be said that the injurer will satisfy the optimal level of precaution, since the cost of non-negligence is much higher for him compared to that of negligence. On the other hand, it is also worth mentioning that he will not take precaution above the optimal level, since to avoid liability it is enough for the injurer to attain the optimal level. When the injurer takes precaution above the optimal level, he will no longer bear the cost of expected damage (because he is no longer liable to pay for the damage). At this level, the cost that the injurer has to bear is the cost of precaution. More importantly, since a negli- gence rule will give an incentive to the injurer to take the optimal level of precaution, it can be said that up to this point the negligence rule is efficient.
Under a strict liability rule, the injurer will be held liable to compensate the damage whenever an accident occurs. Under strict liability, social costs, repre- sented by total accident costs, will become private costs, because the injurer will be liable for the social costs he causes. Here, to reduce the possibility of being held liable, the injurer will take as many precautions as possible, since the higher the precaution level he takes, the more the probability of accident will be reduced. However, a rational injurer will take an optimal level of precaution, since, at this level, total accident costs (social costs) are reaching the minimum point, namely the point where the cost of precaution per unit equals the reduction of probability from taking an additional unit of precaution times the damage cost. This is exactly the same precaution level that the injurer will take under a negligence rule. Therefore, it can be said that strict liability is also efficient with respect to the incentive of taking optimum precautions.
Although negligence and strict liability will both have the same result with regard to the incentive of taking precautions, they will have different results in terms of expected liability costs for the injurer at the point of the optimal precaution level. Under the negligence rule, the injurer will not be held liable whenever he takes the optimal level of precaution. Hence, at this point he has to bear the cost equal only to the cost of precaution at the optimal level of precaution. Under strict liability, the injurer is still liable for the damage, although he has taken the optimal level of precaution. Therefore, at this point, the injurer will have to bear the cost equal to the cost of precaution at the opti- mal level of precaution plus the cost of damage. At the optimal level of precau- tion, the injurer bears more costs under strict liability than under a negligence rule. Hence, given the condition of optimal precaution level, under strict liabil- ity the victim is still compensated, whereas under a negligence rule he is not.
The result will also be different if the level of activity is introduced.15In
15 The following explanation is adapted from Kaplow and Shavell (1999, pp.
4–5).
this case, the social benefit is the benefit of the activity minus the total social costs (total accident costs) of engaging in the activity. Under a negligence rule, at the optimal level of precaution the injurer will only bear the cost of precau- tion up to the cost of the optimal level of precaution. As long as the precaution level is kept at the optimal level, increasing the injurer’s activity level will cost him only part of the total social costs, since the cost of damage is excluded from his liability. Hence, it can be interpreted that since the injurer will escape the liability as long as he takes the optimal level of precaution, the injurer will not take the optimal level of activity. As a result, the amount of activity may be excessively inefficient.
The result will be different under strict liability. Since the injurer will be liable whenever the accident occurs, at the optimal level of precaution, he will bear costs equal to the total social costs. Considering the activity level, the benefit for the injurer will be as much as the social benefit (SB). It can be said that under strict liability, the injurer will pay adequate attention not only to the optimal level of precaution, but also to the optimal level of activity.
Theoretically, the risk of an accident taking place depends not only on the level of precaution, but also on the number of activities one has been involved in.16Hence, since strict liability will induce the injurer to take into account both optimal precaution and activity level, we could argue that strict liability is superior to the negligence rule.
2.2.1.2. Liability and regulation
Shavell has discussed several factors that determine the desirability of liabil- ity and of regulation. The first determinant is the possibility of different knowledge about risky activities possessed by private parties and by a regula- tory agency. Differences in knowledge might embrace information about the value of parties’ activities, the costs of reducing risks, or the probability or magnitude of risks. Shavell concludes that if private parties possess informa- tion that is superior to that of the regulatory authority, it would be more desir- able if the private parties decide how to control risks without intervention of the authority. Hence, if private parties have better information about control- ling risks than the authority does, then it is better to apply liability than regu- lation. Conversely, if the authority possesses better information, the social advantage would seem to lie in the direction of favouring the use of regulation.
Shavell also states that, in terms of information, liability is generally prefer-
16 Faure and Skogh have given an example about the risk of having a traffic accident, which depends not only on the care that the driver takes but also on the number of kilometres driven in a certain period of time. Here the authors also conclude that in terms of providing incentives to engage in the optimal activity level, only strict liability will be efficient. See Faure and Skogh (2003, pp. 252–3).
able because private parties are those who are engaged in and derive benefits from their activities. Therefore, they know quite a lot about the nature of the risks of their activities, about the changes of the risks, and the costs of reduc- ing the risks. However, information sometimes requires efforts to develop or special expertise to evaluate. In this case, the regulatory authority might possess superior information, and thus regulation would be more desirable.17
The second determinant concerns the issue of capability to pay for liability.
It is often argued that private parties might be incapable of paying the full magnitude of harm done. The problem of judgment proof will significantly undermine liability rules because it inefficiently reduces the injurer’s incentive to take the optimal level of precaution.18This especially holds in cases under strict liability, because if the injurer’s assets are less than the harm, the injurer will bear liability that is less than the actual harm, hence he will take less than the optimal precaution.19
Under a regulatory approach, the question about a party’s capability to pay damage is irrelevant, since the parties could be required to take precaution as a precondition for engaging in their activities.
If the potential injurer decides to purchase liability insurance against liabil- ity that significantly exceeds his assets, the question remains as to whether the insurer can easily determine the risk-reducing behaviour of the potential injurer and correlate such behaviour with the premium charged. If the insurers are not able to fully control the behaviour of the insured parties, it might be expected that the insured party (the injurer) would take less precaution that he would do if he was not covered by insurance. In this case, regulation is still more desirable than liability.20
The third determinant that might cause liability to be preferred less than regulation is the possibility of not being sued under a liability system.21If the
17 Shavell (1983, pp. 4–7).
18 In addition, the injurer’s activity level will also tend to be socially excessive and contribute too much to risk. See Shavell (2003, p. 5).
19 Under a negligence rule, the injurer may continue to take optimal precaution, as long as his assets are greater than the costs of precaution. Hence, we could conclude that, in this case, the negligence rule is superior to the strict liability rule. See Polinsky and Shavell (1992, pp. 7–8).
20 Shavell (1983, pp. 7–9).
21 Lawsuits will not materialize for several factors. First, the harm might be dispersed over many victims, so that there will be no victim that will find it beneficial to bring a case to court. Secondly, the harm might occur after a long time period, so that it would be very difficult for the victims to adduce evidence of their damage. Thirdly, it could also be the case that the victims will have difficulties in attributing the harm to the responsible party (to prove the causal link between the harm and the injurer).
Fourthly, even if harms can be linked to the actions of firms and suits successfully brought, the effect of suits on the behaviour of decision-makers within firms may be
injurer realizes that he does not face the threat of suit for harm done, he will take less precaution than he would do if he faced such threat. Such a possibil- ity, however, will be irrelevant in the case of regulation.
The fourth determinant is related to the administrative costs incurred by private parties and by the public. Under a liability system, the administrative cost is borne only if harm occurs. Hence, if harm is unlikely, the administra- tive cost will be low. In addition, if an accident occurs, the administrative cost is still low because sometimes there will be no suit against such an accident.
Under regulation, however, the administrative cost will be incurred whether or not the harm occurs. It is also often argued that under regulation, all parties are equally subject to verification procedures in the absence of specific informa- tion about their category of risk. Conversely, the administrative cost from a liability rule could be focused on controlling the group of parties that are most likely to cause harm, since under a liability rule the administrative cost is incurred by parties who cause the harm.22
2.2.1.3. Liability and insurance
As mentioned in the preceding subsection, the judgment proof problem has impacts that could significantly undermine the effectiveness of liability. In this regard insurance could be considered as an efficient tool to deal with the judg- ment proof problem. Some economists argue that insurance has proved to be an effective tool for providing victims with compensation and for modifying behaviour related to environmental risks.
In order to make an activity insurable, two conditions should be met from the perspective of insurance company.23 First, the insurer should be able ex anteto identify and quantify the risk. The insurer should have enough infor- mation to enable it to estimate what losses the insurer is likely to incur when providing different levels of coverage. Secondly, the insurer should also have knowledge about the risk of a particular injurer in relation to other injurers’
risks when setting the premium for each potential injurer or class of injurers.
If the insurer is able to meet such conditions, we could say that an activity in question is insurable.
The first condition is concerned with the predictability of probability and the magnitude of damage. Some authors consider it as a crucial element in making the activity insurable. However, the insurer’s knowledge depends on the availability of statistical data concerning the probability and the magnitude
slight, because with the passage of time, it would also be difficult to identify which among the employees of the firms were the responsible parties. See Shavell (1983, p. 10).
22 Shavell (1983, pp. 11–13).
23 Kunreuther and Freeman (2001, pp. 305–6).
of damage. This creates difficulties for the insurer in insuring environmental risks, since ex ante information on the predictability of environmental risks and its magnitude of damage is often very limited. In addition, the generally accepted techniques to quantify environmental damage may also be absent.24 The second condition deals with the issue of moral hazard and adverse selection. The insurer’s ability to control the behaviour of injurers after they buy insurance determines the effectiveness of insurance. If the insurer does not possess enough control and information about injurers’ behaviour, it might be the case that injurers will no longer have an incentive to take the optimal level of precaution as they would do without insurance. They would do so because with the availability of insurance coverage, the injurers will no longer have to bear the burden of paying full compensation. Since it is assumed that the like- lihood of damage occurring depends heavily on the injurer’s level of care, we could predict that the number of accidents will rise with the availability of insurance. In literature, this problem is referred to as moral hazard.
On the other hand, the insurer’s failure to meet the second condition will create the problem of adverse selection. Since insurance premiums are related to expected losses, the insurer must be able to differentiate some of the injur- ers who are more likely to have losses from those who are less likely. If the insurer is unable to make such differentiation, he will assume the worst scenario and charge a high premium equally for all injurers within the same group. Hence, insurance will no longer be attractive for those who are compar- atively good risks, because the premium becomes too expensive for them. If they leave the insurance, only those with comparatively bad risks will stay.
Finding that only bad risks are left, insurer will further increase the premium, inducing those who have better risks to leave the insurance. At the end, insur- ance will no longer be beneficial for the insurer, and, in the most extreme situ- ation, the insurance market will no longer be available.25