Fault-Based Liability for Harm Based on Wrongdoer’s Gains

Very often legal sanctions are focused on disgorgement of ill-gotten gains. In other words, a wrongdoer “bears a sanction equal to his gains.” It does discourage undesirable behavior, but only to a limited extent as compared to a rule that sets the penalty to the level of harm caused. It can, for example, still leave an incentive to act harmfully.

Shavell says, “Suppose, for example, that an act creates a gain of $1,000 and harm of $1,000,000. If the gain is estimated to be $950, a party would have an incentive to engage in it, because the sanction would be $950 so that he would profit by $50.”
I must admit that this is not 100% clear to me. Does Shavell mean to bring in the idea that the court may underestimate the gain, thus making it potentially profitable to engage in the activity?

Steven Shavell, Foundations of Economic Analysis of Law, pp. 476-78 (2004).

Damage measures and incentives to perform

When contracts are completely specified, a high damage measure would be best, in order to give a strong motivation to obey the contract—but only if it is truly completely specified. Then it would be in both parties interest because they could rely on the exact contract they wrote being obeyed.

After all, if the contract is truly complete, then there is no chance of onerous performance because that eventuality would have been deal with by contract. So performance is always guaranteed and there is no reason to breach.

When contracts are incomplete, too-high damages may lead to undesirable performance. Moderate damages are better, since that will lead to breach when performance becomes too difficult or excessive. Thus, in certain circumstances, parties will simply receive expectation damages when it makes sense.

Thus, moderate damages allow for breach when performance would be expensive, and induce performance when it would not be expensive. This leads to performance closest to those under mutually beneficial completely specified contracts. In other words, moderate damage measures serve as substitutes for more complete contracts.


There is a qualification that comes in when contractual duties are purely financial, as damage measures cannot completely substitute for more completely specified contracts.

Steven Shavell, Foundations of Economic Analysis of Law, pp. 305-309 (2004).

Why are contracts enforced

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Why do parties want their contracts to be enforced by courts? Without such enforcement, why would parties break their contracts and why would that be bad for the parties?

1. Without enforcement, a party could appropriate funds that had been paid before contract performance (i.e., borrowers would be able to refuse to repay loans, insurers could keep premiums, etc.), rending the entire system unworkable.
2. A party might not deliver a promised good or perform a promised service.If there is failure to perform even though performance would be best because its value exceeds its true cost, then the value of the contractual arrangement is diminished for the parties. This is avoided if contracts are enforced.
3. Price cannot be fixed in advance, and parties can bargain opportunistically, changing prices later. This is price holdup and will result in underinvestment in the contractual enterprise.

Steven Shavell, Foundations of Economic Analysis of Law, pp. 297-299 (2004).

Why contracts are made

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1. Future provision of goods, especially for custom or specialized goods or services where a well-organized and routine market does not exist.
2. Mutually beneficial reallocation or sharing of risks, including insurance contracts or partnerships for sharing of profits.
3. Differences of opinion regarding future events. Thus each side “bets” on their outcome. Found especially in deals around securities and durable assets.
4. Timing of consumption, i.e., borrowing or lending, which allows shifting the time a purchase is made.

Steven Shavell, Foundations of Economic Analysis of Law, pp. 296-97 (2004).

Mutually beneficial contracts are Pareto efficient

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A contract is mutually beneficial or Pareto efficient:

• If it cannot be modified so as to raise the well-being (or “expected utility”) of each of the parties to it.

We expect contracts to tend toward this state, since we think that if a contract can be altered that would raise the expected utility of both parties, then that would be done.

From Steven Shavell, Foundations of Economic Analysis of Law, p. 293 (2004).

Use vs. Creation Without Property Rights

1. In the absence of property rights in information, that information will tend to become available at the cost of production. Since anyone who valued the book (for example) more than the cost to print it would then buy it, this would result in an "optimal" number of books being printed.

2. Again, without property rights, creation of new information tends to be inadequate. Creators will be rewarded with less than the full social value of their work. In some cases, virtually no profit could be realized by creators. This would result in a low amount of incentive for new creation.

Qualifications: it takes time for competitors to copy, thus original creators may enjoy a monopoly position for a certain period of time. Also, creators will have an incentive to make copying difficult (as with Digital Rights Management, for example).

Steven Shavell, Foundations of Economic Analysis of Law, pp. 140-141 (2004).

I would add, too, that it is possible that rewards exist for creators outside of "property," such as reputation or the joy of creation. However, if no property rights exist, attribution (which builds reputation) might well be lost too. Joy might still exist anyway, however!

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Value of Information

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In general, the social value of information that can be reused (words of a book, for example) often exceeds cost of development. This makes it socially desirable to generate.

If it can be copied at low cost by others, the first developer will have few buyers as these initial buyers can resell or disseminate the information themselves, usually at a lower cost. All other things being equal, this will tend to undesirably hamper the development of new information.

To deal with this, we can (1) grant property rights (patents, trade secrets, copyright) or (2) create a system of state rewards for creators.

Steven Shavell, Foundations of Economic Analysis of Law, p. 138 (2004).

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Mutually beneficial contracts and Pareto efficiency

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In the language of economics, a contract is Pareto efficient, and mutually beneficial, if it cannot be modified so as to raise the well being (or the expected utility) of each of the parties to it. If such a modification could be done to improve the contract for both parties, we would rationally expect this to be done.

Steven Shavell, Foundations of Economic Analysis of Law, pp. 293 (2004).

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Strict Liability and Liability Insurance

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When liability is strict, victims are insured by the legal system, but risk-averse potential injurers may wish to insure against liability. There are two situations that may occur that will have an impact on the situation: (1) where insurers can observe the level of care and (2) where they cannot observe the level of care.

(1) Insurers can observe the level of care:

• Thus, they can reduce premiums to reflect risk reduction that care engenders.
• Insureds will thus purchase full coverage to cover risk and
• Insureds will take care to avoid risk in order to keep premiums as low as possible.

The outcome will be socially optimal: risk-averse injurers will be fully protected against risk and victims will be protected against risk by strict liability rules. Because of this, liability is socially desirable in this situation. In other words, without insurance, victims would be just as well off, but injurers would be worse off because they would bear too much risk (and would modify their actions in socially undesirable ways that do not benefit society as a whole).

(2) Insurers cannot observe the level of care:

• Insureds will purchase incomplete care because full coverage would be too expensive (since there is no way to account for different levels of risk, everyone has to pay to cover risky behavior).
• This results in lessened risk that induces less than optimal precautions.

This is thus not socially ideal because (a) injurers are only partly protected against risk, and their level of care is less than optimal; but (b) victims are still protected by strict liability.

Steven Shavell, Foundations of Economic Analysis of Law, pp. 262-263 (2004).

What is a "tangible employment action"?

Unfavorable Action

• Firing
• Demotion
• Possibly transfer
• Often has economic impact
• Everyone agrees that this is a Tangible Employment Action

Unfavorable Inaction

• Denial of raise
• Must show connection between the inaction and the conduct
• Likely sufficient, but still unclear that this is a Tangible Employment Action

Favorable Action

• "Give me a kiss and I'll promote you," then employee gives kiss and boss promotes
• Clearly involves use of power
• Courts are unclear if this is a Tangible Employment Action

Favorable Inaction

• "I'm going to fire you unless you give me a kiss," then employee gives a kiss and is not fired
• Least successful of the four, as courts often don't think this is a Tangible Employment Action