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Chapter 14

Improving institutions of risk management: Uncertain causality and judicial review of regulations
This chapter continues to consider questions of applied benefit-cost analysis and effective risk management, building on themes introduced in the previous two chapters. It expands the scope of the discussion to include a law-and-economics perspective on how different institutions – regulatory and judicial – involved in societal risk management can best work together to promote the public interest. In the interests of making the exposition relatively self-contained, we briefly recapitulate distinctions among types of causality and principles of causal inference that are discussed in more detail in Chapter 2, as well as principles of benefit-cost analysis and risk psychology, including heuristics and biases, from Chapter 10. In this chapter, however, the focus is less on individual, group, or organizational decision-making than on how rigorous judicial review of causal reasoning might improve regulatory risk assessment and policy.

Law-and-economics suggests principles for deciding how best to allocate rights, duties, and legal liabilityfor actions that cause harm or that fail to prevent it. These principles can be applied to suggest how to coordinate the overlapping activities of regulators and the courts in constraining and penalizing individual behaviors and business activities in an effort to increase net social benefits. This chapter reviews law-and-economics principles useful for benefit-cost analysis (BCA) and judicial review of regulations and public policies; highlights the crucial roles of causation and uncertainty in applying these principles to choose among competing alternatives; and discusses how net social benefits can be increased by applying these same principles to judicial review of regulations that are based on uncertain assumptions about causation of harm.

The real-world examples of food safety regulation and air pollution regulation introduced in Chapters 5 and 10, respectively, illustrate that deference by the courts (including administrative law judges) to regulators is not likely to serve the public interest when harmful effects caused by regulated activities are highly uncertain and are assessed primarily by regulatory agencies. In principle, responsibility for increasing net social benefits by insisting on rigorous analysis of causality and remaining uncertainties by both plaintiffs and defendants should rest with the courts. In practice, failure of the courts to shoulder this burden encourages excessive regulation that suppresses socially beneficial economic activities without preventing the harms or producing the benefits that regulators and activists project in advocating for regulation. Stronger judicial review of regulations by courts that require sound and explicit reasoning about causality from litigants is needed to reduce arbitrary and capricious regulations, meaning those in which there is no rational connection between the facts found and the choice made, and to promote the public interest by increasing the net benefits from regulated activities.
Introduction: Principles of Law-and-Economics and Benefit-Cost Analysis of Regulations
Building on principles of benefit-cost analysis (BCA) introduced in Chapter 12, a common normative principle for defining “good” laws and regulations and institutions to administer and enforce them is that they should be designed and operated to maximize net social benefits, defined as the sum over all individuals of the difference between expected total benefits and expected total costs (including opportunity costs) received. If time is important, expected net present values of costs and benefits are used. We will call this the benefit-cost analysis (BCA) principle. It has been widely used in engineering economics to identify the most beneficial project scales and portfolios of projects to undertake, given budget constraints; in public policy to justify proposed regulatory initiatives and policy interventions; and in healthcare to recommend technologies and practices that are most worth adopting. As illustrated in this section, it can also be viewed as a framework motivating and unifying various law-and-economics principles for using the law to maximize widely distributed social benefits from economic transactions. Later in this chapter, we will propose that it can also fruitfully be applied to the problem of determining how judicial review can and should be used to increase the net social benefits – henceforth called simply the net benefits – of regulations.

More rigorous theoretical formulations often replace expected net benefits with expected social utility (also called social welfare), usually represented as a weighted sum of individual utilities following a theorem of Harsanyi (Harsanyi, 1955; Hammond, 1992). Various proposals have been advanced for scaling, weighting, eliciting, and estimating individual utilities, despite an impressive body of theory on incentive-compatibility constraints and impossibility theorems for voluntary truthful revelation of private information about preferences, and despite progress in behavioral economics showing that elicited preferences do not necessarily reflect rational long-term self-interest or provide a secure normative foundation for decision-making. Whether the normative criterion is taken to be expected net benefit or expected social utility, its maximization is usually understood to be subject to constraints that protect individual rights and freedoms by preventing systematic exploitation of any individual or class of individuals to benefit others. In the simplest cases, risk-aversion and other nonlinearities are ignored throughout, and decisions are made simply by comparing the expected net benefits of the alternatives being considered, summed over all the parties involved.

Example: The Learned Hand formula for liability due to negligence
The Learned Hand formula in law-and-economics holds that a defendant should be considered negligent, and hence liable for harm that his failure to take greater care in his activities has caused to a plaintiff, if and only it would have cost the defendant less to take such care than the expected cost of harm to the plaintiff done by not taking it, namely, the probability of harm to the plaintiff times the magnitude of the harm if it occurs. In symbols, the defendant should be found negligent if and only if C < pB, where C is the cost to the defendant of taking an expensive action to prevent the harm from occurring, p is the probability of harm occurring if that action is not taken, and B is the cost, or severity of the harm to the plaintiff expressed in dollar, if it does occur – and hence the benefit from preventing it if it would otherwise have occurred. The Learned Hand rule defines negligence as failure to take care not to harm another when the expected net social benefit of doing so is positive. It encourages each participant in a society of laws to consider the expected cost of one’s actions to others as of equal weight in deciding what to do as costs or benefits to one’s self. This dispassionate, equal weighting of the interests of all is precisely what is required for individual choices tomaximize net social benefit, i.e. the sum of the gains and losses of all participants.
The Learned Hand rule encourages economic agents to act as utilitarians in decision-making, counting the consequences to others as of equal weight with consequences to self. By doing so, it also provides a utilitarian rationale for the calculus of negligence in tort law as promoting the public interest, construed as maximizing net social benefit. In other words, the rationale for individual choices promoted by the rule of negligence law and the rationale for adopting that law itself are the same: to maximize total (and hence average) net benefits from interactions among individuals in society. If each individual is as likely to be a potential defendant as a potential plaintiff in the many individual transactions and situations to which the law of negligence applies, then each expects to gain on average from the rule of this law.

The BCA principle of deciding what to do by comparing expected net social benefits from alternative choices (see Chpater 12) can be used by individuals to choose among different actions and levels of care, given a legal and regulatory system. It can also be used as a basis for designing institutions, for example, by choosing among alternative liability rules and regulations based on the behaviors that they are expected to elicit in response to the incentives they create, with the goal of maximizing the estimated net social benefits arising from those behaviors. The BCA principle can be generalized well beyond the domain of negligence liability. BCA comparisons provide a widely applicable rationale for determining the legal duties of economic actors to take due care in their activities, refrain from excessively hazardous behaviors, provide pertinent information to others about risks, and bear liability for harm arising at least in part from their activities.

Example: The Cheapest Cost-Avoider Principle when Liability is Uncertain
Suppose that either of two parties, a producer and a user or consumer of a potentially hazardous product such as a lawnmower, an electrical hair dryer,or a medical drug, can choose between takingmore care or less care to prevent harm to the consumer from occurring. Taking more care is more costly than taking less care to the agent making that choice. If harm occurs that either party could have prevented by taking more care in manufacture or use, respectively, then how should liability for the harm be allocated between them? A standard answer when the respective costs for each party to have prevented the harm are common knowledge is the cheapest cost avoider principle: the party who should bear liability for the harm is the one who could have prevented it most cheaply. Like the Learned Hand principle, this again requires each agent, i.e., each of the two parties, to consider a dollar of cost to another to have the same importance as a dollar of cost to one’s self in calculating net social benefits. This implies that the agent who can most cheaply avoid a harm or loss should do so. When the relevant costs are not common knowledge, however, this simple principle does not necessarily hold. For example, if each agent assesses a positive probability that the other will be found liable in the event of an accident that harms the consumer in using or consuming the product, then both may under-invest in safety, increasing the probability of harm above what it would be if costs and liability were common knowledge, and thereby reducing net social benefit. In this case, a regulation that requires the producer to use the higher level of care, combined with credible enforcement of the regulation via random inspections and large penalties for detected violations, can in principle increase the net benefits to both producers and consumers by making it common knowledge that it is in the producer’s best interest to take a high level of care. Then consumers who might otherwise have been unwilling to buy the product because of fear that it is unsafe might be willing to buy it, and even to pay more for its higher level of safety, thus increasing both producer surplus and consumer surplus compared to the situation without regulation. A strict liability standard that makes it common knowledge that it is in the producer’s best interest to take a high level of care could create the same benefits. In both cases, however, shifting all responsibility for safety to the producer could make an otherwise beneficial product too costly to produce, even if both producer and consumer would benefit if the consumer could be trusted to take due care in using it. In general, designing liability standards and regulations to maximize total social benefits requires considering who knows what about care levels and product risks, the costs of acquiring such information, possibilities for credibly signaling it, and moral hazard and incentives. In practice, a mix of market, liability, insurance, warranty, and regulatory instruments is used to deal with these realistic complexities.
More generally, not only producers and consumers of potentially hazardous consumer products or services, but also employers and employees in hazardous occupations, owners and renters or leasers of properties, sellers and buyers of used cars or mortgages or insurance products or collateralized debt obligations, and owners and neighbors of hazardous or noxious facilities, can all be viewed as making choices that jointly affect net social benefits. Theobligations and penalties imposed by legal and regulatory institutions can then be viewed from the law-and-economics perspective as seeking to promote choices to maximize widely distributed net social benefits. In turn, these institutions themselves, and the ways in which they interact with each other and with the public, canalso be designed and evaluated by this criterion.

A powerful intuition underlying these applications of BCA principles to liability and regulation of economic activities is that a nation of laws serves its citizens best by implementing just those laws and policies whose total benefits outweigh their total costs, including opportunity as well as implementation and enforcement costs. To protect the rights of individuals, costs and benefits should also be distributed so that everyone expects to gain over a lifetime from application of the adopted laws and policies, even though specific individuals lose in specific cases, as when a court determines that one litigant and not the other wins a tort law case. This distribution requirement prevents adoption of laws and policies that systematically exploit one individual or class of individuals to benefit the rest. It encourages laws and regulations that, arguably, might be collectively chosen from behind a Rawlsian veil of ignorance (Hammond, 1992). Identifying collective choices with positive net benefits and acceptable distributions of costs and benefits is a central goal of BCA.

Despite their intuitive appeal, making these principles precise is famously difficult. A vast literature in collective choice theory considers how to aggregate individual preferences, beliefs, and utilities to yield social utility functions to maximize, or at least decision rules for making Pareto-efficient collective decisions that would increase the net benefits to all individuals.This literature has yielded a rich variety of impossibility results and tradeoffs among proposed criteria for evaluating the performance of aggregation procedures. Criteria that have been considered include voluntary participation, freedom to have and to express any individual preferences or utility functions in a large set, incentive-compatibility in revealing the private information needed to make the process work (e.g., willingness-to-pay information), Pareto-efficiency of outcomes, complexity of the procedure (e.g., yielding a result in less than the lifetime of the participants), and balanced budget, if the procedure is costly to administer. For rational participants, only some subsets of such desiderata are mutually consistent. Some must be relinquished to obtain the rest.

As a practical matter, however, real people often do not reason or behave like the idealized rational agents to which such results apply (Thaler, 2015). They are often more altruistic and cooperative than purely economic or game-theoretic reasoning would predict (Kahneman, 2011). Thus, the question of how well different legal and regulatory institutions elicit choices and behaviors from real people that increase net social benefitsis worth empirical as well as theoretical investigation. Likewise, even if economic agents have little or no choice about how to comply with regulations, other than perhaps the option of suing for relief if the regulations seem arbitrary and capricious or otherwise unjust, how well regulatory and legal institutions succeed in developing and enforcing policies that increase net social benefits – and how they might work together to do so better – are questions well worth empirical as well as theoretical investigation.