punitive damages: an economic justification

Punitive Damages: An Economic Justification

Cedric Duvinage

July 17, 2009

This is a Bucerius/WHU MLB thesis 14.047 words (excluding footnotes) Supervisor 1: Prof. Dr. Peter-J. Jost Supervisor 2: Dr. Carsten Jungmann

PunitiveDamages:AnEconomicJustificationCedricDuvinage

Lastmodified14.07.09 i

TableofContents

1.Introduction..................................................................................................................................1

2.AnIntroductiontoPunitiveDamages..................................................................................42.1.WhatarePunitiveDamages? ........................................................................................................ 42.2.WhencanPunitiveDamagesbeAwarded?AndHowMuch? ............................................. 52.3.ArePunitiveDamagesOutofControl? ...................................................................................... 92.4.TheMcDonald’sHotCoffeeCase................................................................................................10

3.TheDeterrenceFunctionofPunitiveDamages ............................................................. 133.1.TheBasicDeterrenceTheoryofTortLaw .............................................................................133.1.1.Whatiseconomicallyefficientintortlaw?.....................................................................................133.1.2.Doesthestrictliabilityruleleadtoefficiency?.............................................................................173.1.3.Doesthenegligencerulepromoteefficiency?...............................................................................19

3.2.RelatingPunitiveDamagestotheDeterrenceTheory.......................................................223.2.1.Whatiftheharmisnotcorrectlyinternalized?............................................................................223.2.2.Whytheprerequisiteofa“willful,malicious,wantonorreckless”conduct? .................243.2.3.Whatiftheinjurer’sgainsaresociallyillicit?................................................................................263.2.4.Whatiftheinjurercanescapeliability?...........................................................................................283.2.5.WhatwouldhavebeenefficientintheMcDonald’sHotCoffeeCase? ................................33

4.ThePunishmentGoalofPunitiveDamages .................................................................... 374.1.WhatistheRoleofPunishmentinTortLaw? .......................................................................374.2.WhoisBeingPunished?................................................................................................................38

5.TheBehaviorofAmericanJuries........................................................................................ 415.1.HowDoJuriesPerforminAwardingPunitiveDamages? .................................................415.2.WhereDoesThisLeavePunitiveDamages? ..........................................................................43

6.Conclusion .................................................................................................................................. 45Bibliography................................................................................................................................... 47

Annex................................................................................................................................................ 51


Lastmodified14.07.09 1

1.Introduction

The imposition of punitive damage awards is one of the most controversial

featuresoftheUnitedStateslegalsystem.Duetoitsdivisivecharacter,punitivedamage

awards are not observed inmany other countries, especially not in civil law systems.

Indeed,thewidemediacoverageofsomeseeminglyexcessivelyhighpunitivedamages

initiallyawardedtoindividualplaintiffs1hasestablishedanimpressionofanunreliable,

unfair and inefficient American legal system among the public. As courts have yet to

comeupwitharationalandconsistentwayofcomputingtheirexactamount,punitive

damages generate a significant financial risk for American defendants. Arbitrary

punitive damages make precise predictions about the outcome of court trials nearly

impossiblesothatdefendantshaveahighinterestinavoidingthem.However,plaintiffs

areawareofthedefendants’concernandcanthereforeexploittheirstrongbargaining

positiontoobtainhigherout‐of‐courtsettlements.2

Commentators use the uncertainty associated with punitive damages as their central

point of attack in their attempt to realize a statutory limitation, or even banning, of

punitive damages.Most commonly, antagonists try to build a case on the grounds of

constitutionality. Such objections generally focus on the Excessive Fines Clause of the

EighthAmendmentand/ortheDueProcessClauseoftheFourteenthAmendmenttothe

United States Constitution.3 Thus, without doubt punitive damages have to stand up

againstarangeofstrongbutyetmostlyunsuccessfulcounterarguments.

Inorder tounderstandwhypunitivedamagesstillprevailoveralldisagreements, this

paperwill lookattheothersideofthestory.Morespecifically, itwill lookattheissue

from an efficiency perspective to arrive at an economic justification for punitive

damages in tort liability cases. Following an explanatory methodology, it will be

discussedwhycertain cases require the impositionofpunitivedamagesandwhat the

optimalamountofpunitivedamagesshouldbetopromoteeconomicefficiency.1Seee.g.BMWNorthAmericaInc.v.Gore,No.94‐896,517U.S.559,116S.Ct.1589,134L.Ed.2d809(May

20, 1996);State FarmMutualAutomobile Ins. Co. v. Campbell,No. 01‐1289, 538U.S. 408, 123 S.Ct.1513,155L.Ed.2d585(April7,2003);orLiebeckv.McDonald’sRestaurants,P.T.S., Inc.,No.CV‐93‐02419,1995WL360309(Judgment,BernalilloCounty,N.M.Dist.Ct.Aug.18,1994)

2CooterandUlen(2007),pp.393‐3943WangandPeterson(2000),p.5



Based on established models in the literature, this paper will present its own

comprehensive approach. The aim is to clarify that it is not the punitive damages in

themselves that are problematic. In fact, the opposite is true. In some circumstances

punitive damages are needed to support the efficiency of the American legal system.

Instead,aswillbeillustrated,themainproblemlieswithanothercharacterizingfeature

oftheU.S.judicialsystem:TheAmericanjury.

Following this introduction, the paper will explain in Section 2 the rationale behind

“punitive”damages.Thefirstsubsectionclarifieswhat ismeantby“punitive”damages

and identifies two main objectives of punitive damages: Deterrence and punishment

(2.1).Afterwards,somegeneralrulesonwhenandhowmuchpunitivedamagescanbe

awarded in the United States are reviewed (2.2). Only under special circumstances

punitivedamagesareableandnecessarytoachievetheirintendedpurpose.Thepaper

isthengoingtolookatsomeempiricalevidenceregardingthelikelihoodandtheextent

of punitive damages (2.3). This subsection ismeant to review the rightfulness of the

notionofanarbitraryandinefficientAmericanlegalsystem.Thereafter,thefactsofthe

case Liebeck v. McDonald’s Restaurants, P.T.S, Inc. (hereinafter also referred to as the

“McDonald’sHotCoffeeCase”)willbeintroduced(2.4),asitwillbeusedforillustrative

purposesthroughoutthediscussion.TheMcDonald’sHotCoffeeCaseisoneofthemost

controversialcasesknownthatantagonistsofpunitivedamagesliketorefertoinorder

toargueforanabolishmentofpunitivedamages.4

Section 3 of this paper will then establish the economic reasoning behind punitive

damages.Attheoutset,twobasicassumptionswillbemadeinordertoinitiallyplacethe

economicanalysistofollowinanidealworldoftortlaw.Inthissetting,anexplanation

of the basic deterrence theory in tort law will set the economic foundations of this

analysis. Itwill be clarifiedwhat economic efficiencymeans in tort law, and how the

incentives for precautions are affected under a strict liability rule aswell as under a

negligencerulebecausethesearethetwomostprominentrulesusedintortcases(3.1).5

Having laid out the economic ground works, the discussion will then point out why

punitivedamages can indeedbeefficiencyenhancingby relaxingoneassumptionat a

4http://www.arktimes.com/blogs/hoglawyer/2007/11/tort_reform_and_mcdonalds_coff.aspx5CooterandUlen(2007),pp.333‐334



time (3.2). In this process, the paper will outline a simple method of computing an

efficientlevelofpunitivedamages,whichwasfirstintroducedbyBecker6inacriminal

law context and which has been widely analyzed by scholars.7 The McDonald’s Hot

Coffee Case will then be used to apply this theory in a real setting, where a few

additionalproceduralsuggestionswillbemade.

Section 4 will provide some comments on the punishment objective of punitive

damages, even though the emphasis of this paperwill be on the deterrence function.

Aftertheroleofpunishmentintortlawisbrieflydiscussed(4.1),selectedobservations

will be made regarding how punishment affects companies compared to individuals

(4.2).

Section5willprovideashortreviewofhowthebehaviorofAmericanjuriesaffectsthis

analysis.ThisdiscussionwillbebasedonanexperimentalstudyconductedbyProfessor

Viscusi showing how American juries grant punitive damages in a real setting (5.1).

Finally, a few commentswill bemade onwhat the results of this study imply for the

impositionofpunitivedamagesinpractice(5.2).

ThepaperwillendwithsomeconcludingremarksinSection6.

6SeeBecker(1968)7Seee.g.PolinskyandShavell(1998),Sharkey(2003)orHylton(1998)



2.AnIntroductiontoPunitiveDamages

2.1.WhatarePunitiveDamages?

Inordertofullycomprehendthemeaningandpurposeof“punitive”damages,it

isfirstnecessarytodistinguishthemfrom“compensatory”damages.

Compensatorydamagesareawardedtomakethevictimwhole.That is, thewelfareof

the injuredparty is toberestoredascloselyaspossibletothe levelatwhich itwould

havebeenwithouttheillicitactofthedefendant.Suchcompensatorydamagesinclude

two kinds of damages: (1) “Economic” damages, such as past and future medical

expenses,past lostwagesandthe future lostearningcapacity;and(2) “noneconomic”

damages, meaning past and future mental and physical pain, disfigurement and

disability,andtheplaintiff’slostabilitytoenjoysomeaspectoflife.8Thus,compensatory

damagesareawardedwheneveraplaintiffharmedbythedefendantprevailsincourt.

Punitivedamages,on theotherhand,area formof “tort fine”9awarded inaddition to

compensatory damages. They may therefore be interpreted as “extra‐compensatory”

damages.Itisimportanttorecognize,however,thattheyarenotgrantedtomakeupfor

intangiblelossesandtherebytoreplacenoneconomiccompensatorydamages,whichis

sometimessimplyassumedtobe themainobjectiveofpunitivedamages.Moreover,a

mere look at the terminology of “punitive” damages does not suffice to identify the

whole rationale behind punitive damages. This is because punitive damages are

designedonlypartly,andfromtheeconomist’spointofviewnotevenmainly,topunish.

Thesecond,andforthiseconomicanalysisthemorerelevantgoalofpunitivedamages,

isdeterrence.10

Thetwoobjectives,punishmentanddeterrence,refertotwoverydifferentpurposes.By

the“punishment”objectivewegenerallymeantheimpositionofappropriatesanctions

onsocialwrongdoersfortheharmthattheirillicitconductcauses.“Deterrence”,onthe

otherhand,referstosanctioningdefendantsinordertopreventthem(andothers)from

8Clurg,KoyuncuandSpriovieri(2007),pp.169‐1709Calabresi(2005),p.33710PolinskyandShavell(2000),p.764



doing similar acts in the future. In other words, deterrence is used to optimize the

individual behavior so that social welfare – the defendant’s benefits obtained from a

wrongful conductminus the costs of precautions, the cost of the harm, and the legal

expenses–ismaximized.11Asmentionedabove,themainfocusofthiseconomicanalysis

will be the deterrence objective. Nevertheless, a few remarks on the punishment

objectivewillalsobemade.

2.2.WhencanPunitiveDamagesbeAwarded?AndHowMuch?

Allbutfourofthe50U.S.statesallowtheimpositionofpunitivedamagesunder

state law. Louisiana (unless expressly authorized by statute),Nebraska,Michigan and

Washington(alsounlessexpresslyauthorizedbystatute)aretheonlyfourstatesthatdo

notallowforpunitivedamagestobeawarded.12Amongthosestatesthatpermitpunitive

damages, the specific rulesprescribingwhenandhowmuchpunitivedamages canbe

awardedintortlawvaryfromstatetostate.Yet,generallyspeaking,thedefendantmust

have acted more than “grossly negligent” before punitive damages are justifiable. In

most states the plaintiff has to prove some type of “willful, malicious, wanton or

reckless” conduct by the defendant in order to be able to ask for punitive damages.13

Thus,therequiredminimumstandardofconduct,forpunitivedamagestobeawarded

atall, is setatahigh level.However, theseareonlyguidelines thathavenotbeenput

within a defined frame of precise rules.14 Thus, there still remains some uncertainty

aboutwhenpunitivedamagesmaybeawarded.

Inordertodeterminewhetheranindividualcasefulfillstheaforementionedminimum

standard, the reprehensibility of the defendant’s actmust first be evaluated. The U.S.

Supreme Court proposed in State Farm Mutual Automobile Ins. Co. v. Campbell the

followingaspectstobeconsideredintheassessmentofthedefendant’sreprehensibility:

(1)Whethertheharmwasphysicaloronlyeconomic;(2)whetherthedefendant’sact

showedan indifferencetoorarecklessdisregardof thehealthorsafetyofothers;(3)

whethertheinjuredpartywasfinanciallyvulnerable;(4)whethertheconductinvolved

11PolinskyandShavell(2000),p.76512WilsonElser(2006),pp.I,53,76,81,13113WilsonElser(2006),p.III14Cooter(1989),pp.1145‐1146



a repeatedactionorwasan isolated incident; (5)whether theharmwas the resultof

intentionalmalice,trickeryordeceit,ormerelyanaccident.15

The burden of proof respectively usually lies with the party that wants to rely on a

particularelementofevidence.16Itisworthmentioning,however,thatpunitivedamages

areacivilremedyandarenottobeconfusedwithcriminalcharges.Whilecriminalcases

require proof “beyond a reasonable doubt”, for civil law cases “clear and convincing

evidence”orinsomestatesa“preponderanceofevidence”,suffices.17

Once it has been established that punitive damages may be granted, the question of

“Howmuch?”stillremains:

In general, before punitive damage awards are granted, states require that

compensatory damages be awarded first. This in turn means that the plaintiff must

prove actual damage. In addition, U.S. states usually require a “reasonable relation”

betweencompensatorydamagesandthepunitivedamageaward.Butstatelawdoesnot

prescribeaspecificratioofpunitivedamagestocompensatorydamages.18

Besides,somestateshavenowintroducedcapsonpunitivedamages,whileothersstill

prescribe no limits. NewMexico, for instance,where theMcDonald’s Hot Coffee Case

was filed in 199319, has not yet instituted a cap on punitive damages.20 On the other

hand,Arkansas,forexample,leviedalimitonpunitivedamagesin2003,whichcapsthe

award at the greater of $250,000 or three times the compensatory damages, where

punitivedamagescangenerallynotexceed$1million.21

Another ongoing discussion that ultimately affects the limitation of punitive damages

concerns the constitutionality of punitive damage awards. The two most important

15 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003),p.616Clurg,KoyuncuandSpriovieri(2007),p.10017WilsonElser(2006),p.III18WilsonElser(2006)pp.1‐139,seee.g.‘NewMexico’pp.86‐88;‘California’pp.12‐1519 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1993WL 13651163 (Trial Pleading,

BernalilloCounty,N.M.Dist.Ct.Oct.5,1993)20WilsonElser(2006)pp.86‐8821WilsonElser(2006)p.11



casesofthemorerecenttimesregardingthis issuewereBMWNorthAmericav.Gore22

andthealreadymentionedStateFarmMutualAutomobileIns.Co.v.Campbellcase.23In

BMWNorthAmericav.Gore, the jury initiallyawardedpunitivedamagesof$4million

together with $4,000 in compensatory damages. Even though the Alabama Supreme

Courtreducedthesepunitivedamagesto$2million,whichstillreflectsaratioof500to

1,theUnitedStatesSupremeCourtclassifiedthisadjustedamountas“grosslyexcessive”

andthereforeasaviolationoftheDueProcessClauseoftheFourteenthAmendment.24

Consequently, the Alabama Supreme Court further reduced the punitive damages to

$50,000onremand.25 InStateFarmMutualAutomobile Ins.Co. v.Campbell, theUnited

StatesSupremeCourtfurtherclarifiedtheguidepoststhatithadputforthinitsrulingof

BMWNorthAmericav.Gore.26

TheDueProcessClauseoftheFourteenthAmendmentrequiresthatnoperson“[...]shall

be deprived of life, liberty or property without due process of law […]”.27 Courts

frequentlyassessdueprocess jointlywith theExcessiveFinesClause imbedded in the

EighthAmendment to theUnitedStatesConstitution,whichstates that “excessivebail

shallnotberequired,norexcessivefinesimposed,norcruelandunusualpunishments

inflicted”.28

In order to base an argument on the Eighth Amendment, however, one first has to

determineatwhatpointafinebecomes“excessive”:

Arguing in State Farm Mutual Automobile Ins. Co. v. Campbell that “few awards [of

punitive damages] exceeding a single‐ratio between punitive damages and

22BMWNorthAmerica Inc. v.Gore,No.94‐896,517U.S.559,116S.Ct.1589,134L.Ed.2d809 (May20,

1996)23 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003)24BMWNorthAmerica Inc. v.Gore,No.94‐896,517U.S.559,116S.Ct.1589,134L.Ed.2d809 (May20,

1996),pp.1,2225See______‘AlabamaCourtSlashesPunitiveAwardinCaseInvolvingRepaintedBMWCar’,TheWallStreet

Journal,May12,199726 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003),pp.6‐7,1427TheConstitutionoftheUnitedStates,Amendment1428TheConstitutionoftheUnitedStates,Amendment8



compensatory damages, to a significant degree,will satisfy due process”29, the United

StatesSupremeCourtproposedthatanyratioequaltoandabove10:1betweenpunitive

damagesandcompensatorydamagesmaybedeemedunconstitutional.However,asthe

SupremeCourtitselfrecognized,thisshouldonlyserveasaguidancesince“theprecise

award in any case, of course,must be based upon the facts and circumstances of the

defendant’sconductandtheharmtotheplaintiff.”30Ahigherratiomay,forexample,be

justifiable in cases where “a particularly egregious act has resulted in only a small

amount of economic damages”31 or where the defendant’s conduct was extremely

reprehensible.32

Nevertheless,theU.S.SupremeCourtwentevenfurtherinPacificMutualLifeIns.Co.v.

Haslip arguing that punitive damages amounting to four times the compensatory

damagesmaycomeclosetotheboarderlineofconstitutionality.33Thus,thejointreview

of whether punitive damages are in accordance with the Eighth and the Fourteenth

Amendmentcanultimatelyalsohavealimitingfunction.Evenafterajuryhascalledits

verdict,thetrialjudgeandappellatecourtscantherebyreducethefinalaward.34

Note, however, that the guidance of a single‐digit ratio by theUnited States Supreme

Court does not entirely protect defendants from arbitrarily high awards. A jury that

insists on levying high punitive damages on a defendant could simply raise

compensatorydamagestoahigherlevelsothatthesingle‐digitratiostandardcanstill

besatisfiedevenwithalargepunitivedamageaward.35

Eventhoughpunitivedamagesmaybelimitedthroughcapsbystatelaw,orreadjusted

bythetrialjudgeoronappealtoaccordthemwiththeUnitedStatesConstitution,there

29 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003),p.730 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003),p.1331 State Farm Mutual Automobile Ins. Co. v. Campbell, No. 01‐1289, 538 U.S. 408, 123 S.Ct. 1513, 155

L.Ed.2d585(April7,2003),p.1332WilsonElser(2006)p.IV33 See e.g.PacificMutual Life Ins. Co. v. Haslip, No. 89‐1279, 499U.S. 1, 111 S.Ct. 1032, 113 L.Ede.2d 1(March4,1991),pp.6‐7

34Seee.g.StateFarmMutualAutomobileIns.Co.v.Campbell,No.01‐1289,538U.S.408,123S.Ct.1513,155L.Ed.2d585(April7,2003);orBMWNorthAmericaInc.v.Gore,No.94‐896,517U.S.559,116S.Ct.1589,134L.Ed.2d809(May20,1996)

35WilsonElser(2006),p.V



areyetnoformalstandardsprescribingthecomputationofpunitivedamagesappliedby

American courts. Surprisingly enough, courts that claim to know when awards are

excessive cannot come upwith a clear standardizedway of computing them. In fact,

typicaljuryinstructionsdonotatallinformjurorshowtocalculatepunitivedamages.36

Given that juries donot have to provide any explanation for their verdicts, juries can

freelydecideonanyamount,whichevertheyspontaneouslythinkisappropriateinthe

particularcase.37

The fact that there are no common legal standards for computing punitive damages

considerably contributes to their arbitrariness. Yet, does this justify an elimination of

punitivedamagesthemselves?Theanswershouldbe“No”.Wecanstillplayagameof

basketballwithoutrules,althoughsuchagameplayedbyself‐interestedindividualscan

be spiteful. But if everyone would agree on consistent rules, a great game could be

playedproperly. The same applies to punitive damages. Juries have imposedpunitive

damageswithoutrules.Theunsatisfyingresultsarethereforenotsurprising.

Theuncertaintyassociatedwithpunitivedamagesneedstobe(andcanbe!)mitigated

byaclearsetofrules.Onlywhensuchrulesare inplace,punitivedamageawardscan

fulfilltheireconomicallyusefulpurposeofdeterrence.Ifitisunclearhowillegalactswill

be remedied, how should the rational individual/entity determine how to behave

optimally?Therefore,asimplewayofcomputingtheoptimalamountofdamagesthatis

widelyacceptedamongeconomistswillbediscussedinthelatersectionofthispaper.

2.3.ArePunitiveDamagesOutofControl?

Many people seem to think that the U.S. tort liability system is anarchic and

unjust.Variousmediareportsaboutplaintiffscollectingmillionsofdollarsintheformof

punitive damages keep growing newwaves of hypes among critics. Critics argue that

punitive damages are granted too easily and too generously. But their evidence is

anecdotalatbest,eventhoughatfirstsightsuchevidencecanbepersuading.38InBoeken

36CooterandUlen(2007),p.39537Clurg,KoyuncuandSpriovieri(2007),p.5938CooterandUlen(2007),p.398



v.PhilipMorris,Inc.39,forexample,theplaintiffofatobaccolawsuitintheyearof2001

was initially granted $3 billion in punitive damages. However, what the layperson is

probablynotawareofisthatthisamountwasreducedto$50millionintheend,roughly

8.5 times thecompensatorydamagesof$5.5million.Thus,eventhough$50million is

stillalargeamount,theultimateawardwasmerely1/60thofwhatthepublicheardofin

thenews.40

Punitivedamages in theUnited States are in fact the exception rather than thenorm.

The empirical data shows that punitive damages were awarded in only about five

percentofallstatetortlawcasesin2001,andthisnumberhasnotchangedmuchover

theyears.41Ofallproduct liability casesbetween1965and1990, inonly353of them

punitive damages were awarded, where these awards averaged $625,000 in 1990

dollars.Aftertheadjustmentsbyappellatecourtsthisaveragewasreducedto$135,000.

Furthermore, closer investigations revealed that the ratio of punitive damages in

product liability cases at the trial level was approximately 1.2 to 1. Besides,

compensatory damages exceeded punitive damages in more than one third of the

cases.42Thus,acloserlookattheempiricalevidenceonpunitivedamagesshowsthatthe

excitementaboutexcessivepunitivedamagesislargelyunjustified.

2.4.TheMcDonald’sHotCoffeeCase

The notorious product liability case of the mid‐1990s Liebeck v. McDonald’s

Restaurants,P.T.S., Inc.,alsowidelyknownas“TheMcDonald’sHotCoffeeCase”, isone

that many critics view as the perfect illustration of the “American run‐away tort

system”43.Thus,itwasfrequentlyusedtoprovokeatortsystemreform.44Atitssurface,

itdoesindeedseemoutrageousthatawomanmakesalmost$3milliononlybecauseshe

39Boekenv.PhilipMorris,Inc.,26Cal.Rptr.3d638(Cal.Ct.App.2005)40Clurg,KoyuncuandSpriovieri(2007),p.15641Clurg,KoyuncuandSpriovieri(2007),p.15642CooterandUlen(2007),p.398‐40043JohnsandPerschbacher(2002),p.21744http://www.arktimes.com/blogs/hoglawyer/2007/11/tort_reform_and_mcdonalds_coff.aspx



burned herself by spilling herMcDonald’s coffee on herself.45 But a closer look at the

factsofthecaseputsthecaseintoadifferentlight.

On February 27, 1992, the plaintiff,Ms. Stella Liebeck ‐ a 79 years oldwoman –was

sittingonthepassengerseatofhergrandson’scarafterhergrandsonboughthera¢49

coffee fromthedrive‐throughwindowofa localMcDonald’s restaurant.Hergrandson

pulledthecarovertoaparkinglotsothatMs.Liebeckcouldaddsomecreamandsugar

tohercoffee.Sincetherewasnocoffeecupholderinhergrandson’sFordProbeandshe

needed both hands to remove the plastic lid from the coffee cup, she placed the cup

between her knees to keep it steady. While she was attempting to remove the lid,

however, the coffee spilled onto her lap.46 The coffee soaked itself into her cotton

sweatpants and severely burned her skin within seconds. After her grandson

immediatelydrovehertothehospital,shewasdiagnosedwithsecondandthird‐degree

burns over four percent of her body causing permanent injuries on her inner thighs,

buttocks and genital area.47 She had to undergo several skin grafts causing great

consciouspainandlossoflife’senjoyment.48

McDonald’s required its franchisees to sell their coffeeat a temperatureof180‐190°F

(~82‐88°C). This, as McDonald’s admitted, is about 40°F (~24°C) hotter than fit for

human consumption49, and at least 30°F (~18°C) hotter than the industry average of

147.25°F (~64°C). McDonald’s claimed that the high temperature was required to

maintain optimal taste.50 The twelve jurors were presented evidence that a coffee at

185°F (~85°C) could cause third‐degreeburnswithin3 to10 seconds.51Furthermore,

45Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1995WL360309(Judgment,Bernalillo

County,N.M.Dist.Ct.Aug.18,1994)46 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777831 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.July13,1994),pp.1‐247Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1997WL34674058(ExpertReportand

Affidavit,BernalilloCounty,N.M.Dist.Ct.Jan.19,1997),p.2‐348 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1993WL 13651163 (Trial Pleading,

BernalilloCounty,N.M.Dist.Ct.Oct.5,1993),p.349 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777831 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.July13,1994),pp.2‐650 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),pp.7‐851 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),p.12



McDonald’sadmittedthat,eventhoughthecorporationwaswellawareoftherisk,itdid

notwarnthegeneralpublicofthenatureandtheextentoftherisk.52

Ms.Liebeck,whohadnevergonetocourtbefore,askedMcDonald’stosettlefor$20,000.

This amount was meant to recover her medical bills of $10,000 and out of pocket

expensesaswellaslostwagesofherdaughterwhotooktimeoffherjobtotakecareof

Ms.Liebeck.ButMcDonald’swasonlywillingtogiveher$800atmost.53Consequently,

Ms.LiebeckfiledsuitinaNewMexicoDistrictCourtclaimingthatMcDonald’sisacting

grosslynegligentlybyselling“unreasonablydangerous”and“defectivelymanufactured”

coffee.54 The evidence showed that between 1982 and 1992McDonald’s had received

about 700 complaints by peoplewho suffered varying degrees of burns from the hot

coffeesoldbyMcDonald’s.55ButMcDonald’sdidnotreacttoanyofthesecomplaints.

Thus, the jury awarded Ms. Liebeck compensatory damages of $200,000 and $2.7

million (equaling two days of McDonald’s coffee revenues) in punitive damages.

However,asMs.Liebeckwasfoundtohavebeen20percentatfault,thecompensatory

damageswerereducedbythispercentageto$160,000.56Thefollowingday,McDonald’s

reduced the temperature of its coffee by 30°F (~18°C). Furthermore, the trial judge

reduced the punitive damage award to $480,000, a ratio of 3 to 1,which in factwas

neverreportedinthemedia.57Thus,thefinaldecisionoftheMcDonald’sHotCoffeeCase

isnotasunjustifiedascriticsmightthinkatfirst.

52 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),pp.4‐653JohnsandPerschbacher(2002),p.21754 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1993WL 13651163 (Trial Pleading,

BernalilloCounty,N.M.Dist.Ct.Oct.5,1993),p.255 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),p.1456Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1995WL360309(Judgment,Bernalillo

County,N.M.Dist.Ct.Aug.18,1994)57JohnsandPerschbacher(2002),pp.217‐218



3.TheDeterrenceFunctionofPunitiveDamages

3.1.TheBasicDeterrenceTheoryofTortLaw

Thefollowingsubsectionswilloutlineandexplainthebasicdeterrencetheoryof

tort law, on which the economic justification of punitive damages builds. Two basic

assumptions are made. First, it will be assumed that an injurer has to pay damages,

wheneverheinflictedharmonsomeoneelse.Inotherwords,wrongfulactsareperfectly

enforced.Second,avictimthatprevailsincourtwillbefullycompensated.Accordingly,

the totaldamageawardwillexactlyequal theharmincurredby thevictim.These two

assumptionsplacetheanalysisintoanidealworld,inwhichavictimwillbeindifferent

astowhetheranaccidentoccursornot.Indeed,thisshouldbetheultimategoaloftort

law.Nevertheless,suchaperfectworlddoesnotexistinpractice.Thus,asthediscussion

progresses, these two assumptions will be relaxed in order to reveal the economic

reasoningbehindpunitivedamages.

3.1.1.Whatiseconomicallyefficientintortlaw?

In a tort law context, an economically efficient legal system is a system that

minimizesthetotalsocialcostsofallaccidents.Thisideacanbeillustratedinasimple

model.58Inthismodel,itwillbeassumedthatthereareonlytwobasiccostelementsof

accidents: the cost of harm inflicted on the plaintiff by the defendant and the cost of

precautionstakentoavoidtheaccident.59Eventhoughat firstsight thisseemstobea

strong assumption, itwill not influence the conclusions thatwill be derived from the

followinganalysis.

Let p be the probability that an accident occurs. This probability depends on two

variables:(1)Thelevelofprecautionexertedtoavoidanaccident,and(2)the levelof

activity. The term “precaution” canbe interpreted inmanyways. Onemight think of

precautionasdrivingmoresafely,usingconsumerproductsintheapprovedmanneror

conducting quality controls in a pharmaceutical company, for example. The level of

58Theanalysisbuildson theeconomic theoryof tort lawas it isdescribed in:CooterandUlen (2007),

Chapter8,pp.336‐337,andCooter(1983),pp.79‐8659CooterandUlen(2007),p.336



“activity”, on the other hand, refers in this framework to the extent that parties

participateinactivitiesthatimposerisksonothers.60Itwillfurtherbeassumedthatthe

levelsofprecautionandactivitycanbemeasuredinunits.

Thus,lettheamountofprecautionberepresentedbyxjandthelevelofactivitybyaj,so

that the levelofprecautionperunitofactivity isdenotedbyxj/aj.61Notethatxjandaj

haveseparateandoppositeeffectsontheprobabilityofanaccidentp.Thegreaterthe

levelofriskyactivitiesaj, thehigherwillbetheprobabilityofanaccident.Conversely,

thehigher the levelofprecaution, the lowerwillbe the likelihoodofanaccident.This

meansthattheprobabilityofanaccidentisadecreasingfunctionintheprecautionper

unitofactivity,i.e.p(xj/aj).62

Now, assumean accident causes a harmof amonetary valueH to theplaintiff,which

includes both economic and noneconomic damages. Consequently the expected harm

causedbytheaccidentisrepresentedbyp(xj/aj)H.Forthesakeofsimplicity, itwillbe

assumed that the harm H remains constant for every accident and is thereby

independentofthelevelofprecaution.63

Inaddition,precautionispresumedtobecostly,whichwillbereflectedintheunitcost

cj.Again,inordertokeepthisanalysisassimpleaspossible,itwillbeassumedthatthe

cost of precautioncj remains constant for allmarginal units of precaution.64Thus, the

totalcostofprecautionperunitofactivitycjxj/ajisalinearfunctionofxj/aj,asillustrated

inFigure1.

60PolinskyandShavell(2000),p.765‐76661j∈{i,v}={injurer,victim}62Intechnicalterms,p’(x/a)<0;p’’(x/a)>0;CooterandUlen(2007),p.33663CooterandUlen(2007),p.33664CooterandUlen(2007),p.336



Figure1–TotalExpectedSocialCost65

Giventheassumptionthattherearenoothersocialcostsofaccidents,thetotalexpected

socialcostE(SC)isthesumofthetotalcostsofprecautionperunitofactivitycjxj/ajand

theexpectedharmp(xj/aj)Hthatisinflictedontheplaintiffbytheaccident.Inthegraph,

this is illustrated by the U‐shaped curve E(SC) that is derived by adding the curve

p(xj/aj)H and the straight line cjxj/ajvertically.66 As the precaution per unit of activity

increases, theE(SC)curve initiallyslopesdownwards indicatingthatthecostsofmore

precaution is less than the reduction in costs due to fewer accidents. However,

eventuallydiminishingreturnskickinsothatafterreachingaminimum,theE(SC)curve

startsslopingupwardsagain.Thismeansthatatthatpointthecostofanextraunitof

precaution per unit of activity exceeds its benefit from fewer accidents.67 The level of

precaution (xj/aj)* is the level minimizing the expected social costs. In other words,

(xj/aj)*isthesociallyefficientcombinationofprecautionandactivity.68

Themathematical rationale behind Figure 1 is also known as the “Hand Rule”.69 It is

helpful inprovidingmoresophisticatedinsightsaboutrationaldecision‐makingintort

law.

65ThegraphillustratesamodificationofthefigureinCooterandUlen(2007),p.33666CooterandUlen(2007),p.33767Cooter(1989),p.116268CooterandUlen(2007),p.33769FormulatedbyJudgeLearnedHandinUnitedStatesv.CarrollTowingCo.,159F.2d169(2dCir.1947).

ForamoredetaileddiscussionoftheHandRule,seee.g.CooterandUlen(2007),pp.349‐353



Wealreadyknowthateveryotherunitofprecautionhasamarginalcostofcj.Similarly,

one more unit of precaution reduces the expected harm p(xj/aj)H by lowering the

likelihood of an accidentp(xj/aj). The reduction inp(xj/aj)H is therefore themarginal

benefit of precaution.70 Taking the first derivative of the expected social costE(SC) =

cjxj/aj+p(xj/aj)Hwithrespecttoxj/ajandsettingitequaltozerominimizesthisfunction.

Thisresultsinthefollowingequation:

€

dE(SC)

dx j

a j

= c j − p'x j

a j

*

H = 0 (1)

Remember that the expected harm p(xj/aj)H is decreasing in xj/aj, so that its first

derivativeisnegative.Rearrangingequation(1)gives:

€

c j = p'x j

a j

*

H (2)

Thesolutionofthisequationresultsin(xj/aj)*.71

Equation (2) illustrates that the optimal level of precaution sets themarginal cost of

precautionequaltoitsmarginalbenefit.Whenprecautionxj/ajisbelowitsoptimallevel

(xj/aj)*, themarginal costwillbe lower than themarginalbenefit. Inotherwords, the

benefitofincreasingtheamountofprecautionbyonemoreunitisgreaterthanitscost.

Conversely,ifxj/ajisabove(xj/aj)*,efficiencyrequirestotakelessprecautionsincethe

marginalcostexceedsthemarginalbenefit.Therefore,fromanefficiencypointofview

taking more units of precaution per unit of activity is required and justified until

Equation2issatisfied.72

Notethat,asindicatedbythesubscriptj73,theremaybecircumstancesinwhichboth‐

thepotentialinjurerandthepotentialvictim‐cantakeprecautionandtherebyinfluence

the probability of an accident (“bilateral accidents”), and other situationswhere only

70CooterandUlen(2007),p.33771CooterandUlen(2007),p.33772CooterandUlen(2007),p.33773Recallj∈{i,v}={injurer,victim}



one party can take the necessary precaution (“unilateral accidents”).74 Every timewe

participate in public traffic, for example, we can exert care and choose the level of

activityourselves,althoughwealsorelyontheprecautiontakenbyothers. Whenthe

dentist operates on an anaesthetized patient, on the other hand, only the dentist can

operatewiththenecessarycare.Itisworthmentioning,however,thateveninbilateral

accidents the legallyrequiredprecautionmaysometimesbehigher foroneparty than

fortheother.Inproductliabilitycases,forinstance,theproducersareofteninabetter

positiontotakesuchprecautionbecausetheconsumermaynotbeawareofthehidden

risksofaproduct.Dependingonthesituation,differentlegalrulesmaybeapplied.Due

tothelargevarietyofpossiblecircumstances,Americancourtscanmakeuseofseveral

variationsoflegalrulescombinedwithlegaldevicesthatshifttheburdenofproof,such

asresipsaloquitur.75

Forthepurposeofthisanalysis,however,afeweconomicinsightstothestrictliability

(3.1.2) and thenegligence rule (3.1.3)will suffice.The following sectionsdiscusshow

thesetwoindividuallegalrulesaffectbehavioralincentives.

3.1.2.Doesthestrictliabilityruleleadtoefficiency?

Thestrictliabilityrule,oftenappliedbyAmericancourtsinmanufacturingdefect

cases,holdsthattheinjurerisliablewheneverhecausesharmtothevictim.Thevictim

doesnothavetoprovethattheinjurerwasatfault.Therefore,thelevelofprecautionis

irrelevant for the determination of fault under the strict liability rule. Instead, it is

sufficient to prove a causal link between the defendant and the harm inflicted on the

plaintiff.Inmanufacturingcases,forexample,theplaintiffwouldhavetoprovethatthe

product was defective, that this defect caused the injury and that the defect existed

beforetheproductleftthecontrolofthedefendant.76However,especiallythelastaspect

maysometimesbeverydifficulttoprovefortheplaintiff.Consequently, insuchacase

thecourtmaydecideunderthegivencircumstancestoshifttheburdenofprooftothe

defendant.74Foradetailedanalysisofunilateral accidentsandbilateral accidents, see alsoe.g. Shavell (2004),pp.

177‐20775Formoredetailsonlegalrulesandlegaldevices,seee.g.Clurg,KoyuncuandSpriovieri(2007),Chapter

8,pp.107‐11876Clurg,KoyuncuandSpriovieri(2007),pp.111‐112



Howdoesthisruleaffectbehavior?First,lookatthesituationfromtheperspectiveofa

potential victim. Recall the assumption that the prevailing plaintiff fully recovers

wheneverheincursharm.Ifthedamageawardreceivedbythevictimisrepresentedby

D,thissuggeststhatD=H.Consequently,thecostofanaccidentforthevictimchoosing

aprecautionperunitofactivityxv/avatthecostofcvcanbeexpressedas

€

cvxvav

+ p xvav

H − p xv

av

D =

cvxvav

. (3)

Therationalvictimthereforemerelyminimizeshistotalcostofprecautioncvxv/av.Asa

result,thevictimwillnevertakeanyprecautionwhateverhislevelofactivity,i.e.xv/av=

0.77

However,theoppositeistrueforinjurers.Theinjurercanchoosehisprecautionperunit

ofactivityxi/aiatacostofci.Giventheassumptionthatdamagesequalharm,theinjurer

expects liability damages equal to the total expected harm p(xi/ai)H so that his total

expectedcostsofanaccidentarerepresentedby

€

cixiai

+ p xiai

H . (4)

Following the rationale leading to a socially efficient level of precaution per unit of

activity(xi/ai)*,asdescribedintheprevioussection,theinjurerwillalwayschoosehis

levelofprecautionsuchthatthemarginalcostofprecautionequalsthemarginalbenefit:

€

ci = p' xiai

*

H . (5)

Thus,iftheinjureralwayshastoperfectlycompensatethevictim,wheneveranaccident

happens, the injurer will choose an efficient level of precaution per unit of activity

(xi/ai)*. If damages would exceed harm, precautions taken by the injurer would be

excessiveand/orhisactivitylevelwouldbetoolow.Equally,ifdamagesarelowerthan

77CooterandUlen(2007),pp.338‐339



theharmcaused,theinjurerwouldtaketoolittleprecautionand/orengageintoomany

riskyactivities.78

As a result, the injurer will internalize all marginal costs and benefits of precaution

leading tosociallyefficient incentives for the injurer to takeprecautionandengage in

risky activities. The victim, on the other hand, has no incentive to take precaution

because,knowingthathewillbeperfectlycompensatedunderthestrictliabilityrule,he

hasnoreason to incur theextracostofprecaution.Thismeans that thestrict liability

rule is optimally applied only in situations where solely the injurer is able to take

precautions,orat leastwherethevictim’spossibleprecautionsareminimalcompared

to those of the injurer. This explains why American courts so often apply the strict

liabilityruleinmanufacturingdefectcases.

3.1.3.Doesthenegligencerulepromoteefficiency?

Thenegligenceruleisafault‐basedrule,wheretheinjurerisonlyheldliableifhe

failedtofulfillthelegalstandardofcare.Thus,thenegligencerulerequirestheplaintiff

toproveessentiallyfouraspects:(1)Thatthedefendantowedtheplaintiffalegalduty;

(2)thatthedefendantbreachedthatduty;(3)thatthisbreachwasthefactualandlegal

causeof theharm inflictedon theplaintiff; (4) that theplaintiffwas in fact harmed.79

This makes it more difficult for the plaintiff to deliver the necessary proof under a

negligencerulethanunderthestrictliabilityrule.

Thesecondofthefouraspectslistedabove,i.e.whenthedefendantbreachedhisduty,is

for this analysis the important criterion.80 The question is whether the defendant

compliedwiththe legalstandardofcare, tobedeterminedbythecourtof jurisdiction

for each individual case.Onlywhen thedefendant fulfills this standardhe can escape

liability.Suchlegalstandardwillberepresentedby(xj/aj)S.

Theexpectedcostsunderanegligencerule,again inasettingwhere the liable injurer

hastopaydamagesequaltoharm,areillustratedinFigure2.

78CooterandUlen(2007),pp.339‐34079Clurg,KoyuncuandSpriovieri(2007),p.10980Allothercriterionsareforthefollowinganalysisassumedtobesatisfied.



Figure2–ExpectedCostsundertheNegligenceRule81

ThesolidlinesinFigure2showthatiftheinjurer’slevelofprecautionfallsshortofthe

requiredlegalstandard(xi/ai)S,hewillhavetopayforhisowncostsofprecautionplus

theexpectedharmto thevictim.On theotherhand, if the injurer’sprecautionexactly

matchesorexceedsthelevelrequiredbylaw,hewillonlyhavetopayforhisowncosts

ofprecautioncixi/aisinceheisnotheldliable.82

Thus, the injurer faces a jump in expected costs at the legal requirement equal to the

expected harm still existing when the legal standard is satisfied, i.e. p((xi/ai)S)H.

However, if the assumption, that the total social costs of accidents only includes the

costsofprecautionandtheexpectedharmcausedbytheaccident,isrelaxed,therecan

alsobeothercoststhatcontributetothisjumpinexpectedcosts.Thismay,forexample,

includelitigationcoststhataremorelikelytoariseifthedefendantfallsbelowthelegal

standard, or the negative publicity for a blameworthy defendant. This can especially

play a big role for corporationswhose profitswill be adversely affected if themedia

reports to the public that the company sells products that can be dangerous for

consumers.83 As a result, the injurer has efficient incentives to exactly fulfill the legal

requirement of care, i.e. (xi/ai)* = (xi/ai)S. Intuitively, it does not make sense for the

81ThisgraphillustratesamodificationofthefigureinCooterandUlen(2007),p.34282CooterandUlen(2007),p.35683Cooter(1989),p.1156



injurer to take more precaution than necessary in order to escape liability because

precautioniscostly.

Now, what does this imply for the victim’s incentives under a negligence rule? The

rationalvictimknowsthattheinjurerhasefficientincentivestofulfilltherequiredlegal

standard. Therefore, the victim recognizes that if an accident occurs, he will not be

compensated because the injurer cannot be held liable. Hence, the victim also has

efficientincentivesforprecaution,leadingtoanoverallsociallyefficientoutcomeinthe

caseofbilateralaccidents.84

However,suchasociallyefficientoutcomeisconditionedonthecourt’sabilitytosetthe

legalstandardatasociallyefficient level.AsshowninFigure2, this iswherethetotal

expected social costs curve E(SC) is minimized. If the court does not set the legal

standard at this level, the levels of precaution chosen by the respective parties will

resultinasociallyundesirableoutcome.85

As pointed out earlier, courts sometimes apply variations of the negligence rule.

Especially in bilateral accidents, as for instance in product liability cases, the courts

oftenapplya“comparativenegligencerule”thatismeanttoprotectcompaniesfromany

misuseoftheirproducts,forwhichthecompanyshouldnotbeheldliable.Ifbothparties

arefoundtohaveactednegligently,thecompensatorydamagesawardedtotheplaintiff

canthenbereducedbythepercentageoftheplaintiff’sfault,asitwasestimatedtohave

contributed to the accident.86 Since a negligence rule results in efficient incentives to

takereasonablecarenotonlyby the injurerbutalsoby theplaintiff, suchruleshould

bestbeapplied insituationswhere the injurerandtheplaintiffbothareable toavoid

accidentsbytakingprecautions.

ThiswasalsothecaseinLiebeckv.McDonald’sRestaurants,P.T.S.,Inc.,wherebyspilling

hercoffeeonherselfMs.Liebeckwasfoundtohavebeen20%atfault.Asaresult,her

compensatory damage awards were reduced by this percentage from $200,000 to

84CooterandUlen(2007),p.34485CooterandUlen(2007),p.35686Clurg,KoyuncuandSpriovieri(2007),p.142‐144



$160,000.87However,eventhoughMs.Liebeckcouldpresumethatthecoffeeishot,she

should not have been required to anticipate the unreasonably dangerously high

temperature of the McDonald’s coffee. Due to this hidden risk that only McDonald’s

knewabout,thejuryassignedmostoftheresponsibilityfortheharmtoMcDonald’s.

3.2.RelatingPunitiveDamagestotheDeterrenceTheory

3.2.1.Whatiftheharmisnotcorrectlyinternalized?

Theprecedinganalysisshowsthatthestrictliabilityruleandthenegligencerule

(assuming that the legal standard is set at the socially efficient level) lead to efficient

incentives.However,rememberthatthisresultisbasedontwonecessaryprerequisites,

theassumptionsofperfectcompensationandperfectenforcement.

With these assumptions in mind, the foregoing discussion provides a fundamental

insightforthecomputationofliabilitydamages:Iftheinjurerisalwaysfoundliablefor

hiswrongful act the optimal amount of total damages should equal harm in order to

achieve efficiency.88 However, perfect compensation is not always realistic. Often, for

example,informationnecessarytocomputetherightamountofdamagesisunavailable;

theexactamountoffuturemedicalexpensesmaybeunknown,oritmaybeunclearhow

to assign a monetary value to a victim’s future pain and suffering. Therefore, when

decidingonhisoptimalbehavior,therationalinjurermightnotinternalizethefullharm

causedbyhismisbehavior.Howdoesthisimpacttheincentivestotakeefficientcare?

Underthestrictliabilityruleitwasestablishedthattheinjurerchoosesanefficientlevel

of precaution where its marginal cost equals its marginal benefit. Recall that the

marginalbenefitwasthereductionintheexpectedharmbyonemoreunitofprecaution.

Therefore,iftheexpectedharmisnotcorrectlydetermined,itwillimmediatelyimpact

the level of precaution taken by the injurer. Suppose the courts repeatedly

underestimate the level of damagesH incurred by the plaintiff. Thiswould lower the

expectedharmp(xi/ai)Hinternalizedbytheinjurerandthereforetheinjurer’smarginal

87Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1995WL360309(Judgment,Bernalillo

County,N.M.Dist.Ct.Aug.18,1994)88PolinskyandShavell(1998),p.886



benefitofprecaution.Asa result, the injurerwouldreducehis levelofprecautionper

unit of activity below the efficient level. Similarly, if the court keeps overestimating

damages,theinjurerwillincreasehislevelofprecaution.Thus,ifthecourtconsistently

errsinsettingthecorrectamountofdamagesunderthestrictliabilityrule,theinjurer’s

precautionwilladjustinthesamedirectionasthecourt’serror.89Thiswouldleadtoa

sociallyinefficientoutcome.

Underanegligencerule,thisisnotnecessarilythecaseduetothecostthresholdalready

pointedout inFigure2. Suppose, for example, the courtsunderestimatedamages just

moderately.ThiswouldcauseadownwardshiftinthesocialcostcurveE(SC)toE(SC)’,

asillustratedinFigure3.

Figure3–IncorrectDamageEstimates90

Inthatcase,theinjurerstillminimizeshisexpectedcostsofanaccidentbychoosingan

efficientlevelofprecautionat(xi/ai)*=(xi/ai)S.However,ifthecourt’serrorissolarge

thattheminimumofthetotalexpectedcostsofanaccident,e.g.E(SC)’’,islessthanthe

totalcostsofprecautionatthelegalstandard,cj(xj/aj)S,theinjurerwillchoosealevelof

precaution that falls farbelow the legal standard, e.g. (xi/ai)’’.91Thiswouldbe socially

undesirable.

89CooterandUlen(2007),p.35490ThisgraphillustratesamodificationofthefigureinCooterandUlen(2007),p.35591Cooter(1983),pp.84‐85



Thus,anyerrorcausingtheinjurernottointernalizetheentirecostsofanaccidentwill

immediatelyimpacthisincentivesunderastrictliabilityrule.Thisiseventrueforsmall

deviations fromsocial efficiency.Underanegligence rule,however, theerrormustbe

sufficientlylargeinordertoaffecttheinjurer’sincentives.Thismeansthatanegligence

rule can be efficiency enhancing even though the injurer internalizes only part of the

total harm. This is an important insight that justifies the relatively high threshold of

recklessnessthatthedefendant’sunlawfulacthastoovercomebeforepunitivedamages

maybeawarded.

3.2.2.Whytheprerequisiteofa“willful,malicious,wantonorreckless”conduct?

The analysis on efficient incentives under the negligence rule revealswhy tort

law generally requires a “willful, malicious, wanton or reckless” conduct by the

defendant before punitive damages can be imposed.92 Itwas established that the cost

threshold,asitwasdescribedabove,generallyensuresthatthepotentialinjurerhasan

incentive to adhere to the legal standard. If the injurer nevertheless decides not to

complywith the law,his level ofprecautionwill fall far short of the legal standardof

care.

What does this observation imply with regard to when punitive damages should be

imposed? Imagine a situation where court errors are minimal but the injurer

nevertheless chooses a level of care far below the legal standard of care. Thiswould

meanthattheinjurermustattainagreaterbenefitbybreachingthelegalstandardthan

the jump incostshe incurs through thecost threshold.Even thoughwrong intentions

mightbedifficult toprove incourt, socialbehavioralguidelinesmayhelpdetermining

whether a conduct was intentional or unintentional. Whereas unintentional behavior

generallyonlycausesasmalldeviationfromthelegalstandard,intentionalwrongdoing

usuallyinvolvesaconsiderablenoncompliance,whichcanonlybedeterredbypunitive

damagesinadditiontocompensatorydamages.93

It is easy tounderstand,whypunitivedamages shouldnotbe imposedondefendants

that unintentionally failed to comply with the legal requirement of precaution. An

92WilsonElser(2006),p.III93Cooter(1983),p.86



injurermayunintentionallybeatfault,forexample,ifhewasmistakenaboutthelegal

standard (xi/ai)S. This may not be so unusual given the generally vague standard of

“reasonablecare”intortlaw.94

Economistsrefertosuchsituationasagameof“incomplete”information,meaningthat

oneplayerofthegamedoesnotknowthebasicconditionsofthegame.95Thiscanleadto

aneconomicdisequilibriumsincetheunintentionalinjurerwouldchangehisbehaviorif

hewerecorrectlyinformedabouttherulesandthereforeabouttheconsequencesofhis

actions.Theuninformedinjurerbelievesthatheiscomplyingwiththelaw,butfindsout

attrialthat infacthewasnot.Suchmistakesgenerallyonlyresult inminordeviations

from the legal standard. Such an economic disequilibrium can easily be corrected by

merely awarding compensatory damages. This will give sufficient incentives to the

unintentionalwrongdoertoaccordhisbehaviortothe law.The impositionofpunitive

damagesinsuchacasewouldnotonlybeunjustbutalsoineffectiveinachievingtheir

aimoffuturedeterrence.Awrongfulactofapotentialinjurercannotbedeterredifthe

injurerisnotawareofthefactthathisbehaviorisunlawful.96

In Liebeck v. McDonald’s Restaurants, P.T.S., Inc. it would be difficult to argue that

McDonald’sreallyintendedtohurtMs.Liebeckbysellinganextrahotcoffeetoher.The

intention of McDonald’s was to make profits, not to cause harm on their customers.

However,McDonald’scouldneitherhaveclaimedthatitwasuninformed.Thefast‐food

restaurantchainwaswellawareoftherisksthattheirexcessivelyhotcoffeeimposedon

customers due to themore than 700 previous complaints between 1982 and 1992.97

McDonald’srefusaltoadjustitspolicydespitethisknowledgemustthereforeadequately

be classified as reckless behavior. A testimony by the McDonald’s safety consultant

Robert Knaff, stating that the number of burned victims was “statistically trivial”98,

thereby further validating McDonald’s disregard of the health and safety of its

94Cooter(1983),p.8595HargeavesHeapandVaroufakis(1995),p.6296Cooter(1983),pp.85‐8697 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),p.1498 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994 WL 16777828 (Trial Motion,




customers99, must have sent an alarming message to the twelve jurors. Thus, even

thoughMcDonald’sbehaviorfellsomewhereinbetweenthetwoextremesof intention

andmistake,itseemsmuchclosertotheintentionalend.

Asaresult,thecostthresholdimpliesthatifinjurerschoosetoexertlessthanthelegal

standardof “reasonable care”, injurersdo so at least consciously.The rational injurer

wouldneverwillfullychoosealevelofcarejustbelowthestandardofprecautionsince

the marginal costs of doing so would dominate the marginal benefit. Certainly, the

“willful,malicious,wanton or reckless” ‐ standard applied by courts does not draw a

bright line that clearly defines the behavior deserving the imposition of punitive

damages.Butitprovidesaguidepostthathelpstoensurethatpunitivedamagesareonly

appliedtogrosslynegligentdefendants,andnottodefendantsthatwereunintentionally

atfault.

3.2.3.Whatiftheinjurer’sgainsaresociallyillicit?

Asjustpointedout,aninjurerwhoconsciouslybreacheshislegaldutydoessoto

obtainabenefitfromhiswrongfulact.Thereare,forexample,someunusualindividuals

who see some type of personal, not necessarily economic, benefit by intentionally

harmingsomeoneelse.Whenan individualpunchesanother inthe facehemost likely

has noneconomic reasons for doing so. Such a person deliberately exposes himself to

liabilitymeaning thatmerelyhaving topaycompensatorydamageswillnotcomeasa

surpriseforhim.100

Until now, it was implicitly assumed that all the injurer’s benefits attained from his

unlawfulconductwereincludedintheoverallsocialwelfare.However,thegainthatan

individual gets from intentionally harming someone else is typically considered to be

“socially illicit”.101Thepublicsocietydoesnotvaluethepleasurethatonememberhas

fromhurtinganother.Therefore,society’swelfareonlytakesthesocialcostsbutnotthe

personal benefits of a socially illicit act accruing to the injurer into account. In other

words,thesocialcostsexceedthepersonalcostsfortheinjurer.

99 Recall the Supreme Court’s guidelines regarding the assessment of reprehensibility in State Farm

MutualAutomobileIns.Co.v.Campbell,seeaboveSection2.2,pp.5‐6100Cooter(1983),p.86101PolinskyandShavell(2000),p.770



Let b(xi/ai) be the socially illicit benefit of the injurer. The injurer’s illicit gain is a

decreasingfunctionoftheprecautionperunitofactivity.Recallthattheexpectedsocial

costsofanaccidentisE(SC)=cjxj/aj+p(xj/aj)H.Now,takingaccountofthesociallyillicit

benefit,thecostfromtheinjurer’sperspectiveequalscixi/ai–b(xi/ai)+p(xi/ai)H.102This

isillustratedinFigure4.

Figure4–SociallyIllicitGains103

Ifthesociallyillicitgainb(xi/ai)issolargethattheinjurerhasanincentivenottocomply

with the legal standard,hewill fall far shortofhis legalduty.This is the resultof the

discontinuityofthecostfunctionatthelegalstandardduetothecostthreshold.Thus,

punitivedamagesinadditiontocompensatorydamagesareneededinordertorestore

thestatewherecompliancebecomestheinjurer’soptimalbehavior.104

NotethatFigure4suggestsasimilarconclusionasFigure3.However,thederivationof

theconclusiondiffers.Figure3denotedadownwardshiftintheexpectedcostcurvedue

toanimperfectinternalizationofthecostsofanaccidentbytheinjurerbecauseofcourt

errors, for example. Figure 4, on the other hand, emphasizes a shift in the injurer’s

expected cost curve due to the socially illicit gain that the injurer values, but not the

society.Hence,theshiftofthesocialcostcurveinFigure4couldalsooccurifthereare

nocourterrorsso.

102Cooter(1983),p.87103ThisgraphillustratesamodificationofthefigureinCooter(1983),p.88104Cooter(1983),pp.88‐89



Whatshouldtheamountofpunitivedamagesinthiscasebe?Lookingatthecauseofthe

inefficiency, namely the socially illicit gain, the answer to this question is

straightforward.Inordertore‐aligntheinjurer’scostcurvewiththeoriginalsocialcost

functionE(SC),asshowninFigure2,punitivedamagesequaltotheillicitbenefitb(xi/ai)

mustbeimposed.Thisamountwillaccomplishcompliancebyensuringthattheinjurer

minimizes his cost function at the legal standard. This also implies that punitive

damagesmustbelargebecausetheillicitbenefithastobelargefortheinjurertobreach

his duty in the first place.105 Thus, the minimum amount of punitive damages is

determined by the size of the cost threshold because the illicit benefit must at least

coverthisthresholdfortherationalbreachingdecisionmaker.

This discussion on socially illicit gains also requires a qualification of the earlier

established conclusion that punitive damages should only be levied on reckless and

intentionalwrongdoing.106 From the economic point of view punitive damages should

only be imposedwhen the social costs of intentionalwrongdoing outweigh the social

benefits.Therefore,aslongassocietydoesnotweightthebenefitofnoncompliance,as

in the case of socially illicit gains, punitive damages need to be imposed to deter

unlawfulbehaviorandtherebyrestoreefficiency.However,ifanindividualperformsan

unlawful actwhere its social benefit exceeds its social cost, levying punitive damages

would be undesirable. This may be the case, for example, when the situational

circumstancesgivetheindividualnochoicebuttobreachhislegalduty.Forinstance,a

lost individualwhopurposely breaks into a cottage somewhere in thewoods tokeep

himselffromstarvingshouldnothavetoexpecttopaypunitivedamages.107Thebenefit

ofsavinghislife,whichcertainlyisnotconsideredtobesociallyillicit,clearlyoutweighs

the cost of the food he ate to do so. Thus, compensatory damages to compensate the

ownerofthecottageforthefoodwillsuffice.

3.2.4.Whatiftheinjurercanescapeliability?

Rememberthat intheprecedinganalysison incentivestwostrongassumptions

were made. One of them was already relaxed, namely that victims are always fully

105Cooter(1983),p.89106SeeaboveSection3.2.2,p.24107Cooter(1983),p.89



compensated.Thissectionwillnowturntothesecondassumption,whichsupposedthat

theinjurerhastopaydamageswheneverhecausesharm.

Inpractice, itmayhappenthataninjurerwhotechnicallyshouldbeheldliableforthe

harm inflicted on a victim nevertheless escapes his liability. There are a number of

possible reasonswhy thismightbe the case: (1) Itmightbehard for thevictim tobe

abletoprovewhoreallycausedtheharm.Afrequentlyobservedexampleinpracticeisa

case of hit‐and‐run driving. The victim knows his car was damaged but without a

witness he cannot identify the injurer. (2) The victimmight not be able to determine

whether the harm sufferedwas the result of someparty’swrongful act or simply the

resultofbadluck.Foranindividualwhodevelopedcanceritmaybeimpossibletotell

whether thecancerdevelopednaturallyorwhetheran injurerwhoreleasedsynthetic

carcinogeninthevictim’senvironmentcausedthecancer.(3)Evenifthevictimknows

whocausedtheharmhemightnonethelessbeunwillingtosuetheinjurerbecausethe

costsoflitigationoutweighthepotentialbenefitsofgoingtocourt.108Thisisparticularly

true forminor harms incurred. (4) The victimmay not prevail in court because it is

difficult forhim toprove important aspectsnecessary to trigger the injurer’s liability.

For example, a victim might be unable to prove that the injurer violated his legal

standardofcareiftheexactstandardisnotclearlyidentified.109

Havingthispossibilityoftheinjurerbeingabletoescapeliabilityinmind,whatshould

now be the optimal amount of total damages? It is important to understand that the

rational injurerwill include thispossibilityofescaping liability inhisdecisionmaking

process.Forthisreason,damagesequalingtheharmcannotleadtoefficientincentives

fortakingprecautionsandparticipatinginriskyactivitiesanymore.Inordertomitigate

this incentive problem the computation of total liability damages has to incorporate

such “enforcement errors”.110More specifically,when injurers are indeed found liable,

damagesmustbesufficientlyhighsothatinjurersindirectlyalsopayforallharmsthey

108PolinskyandShavell(2000),p.768109Cooter(1989),p.1149110CooterandUlen(2007),p.396



have not been held liable for. In other words, total damages should equal the harm

dividedbythelikelihoodthattheinjurerisheldliable.111

Thus, letq be theprobability that the injurer canescape liability, i.e. theenforcement

error.Generally,thecourtshouldbeabletoderivethisprobabilityfromtheevidenceof

the case, expert opinions or the number of similar previous victim complaints, for

example. Having established the enforcement error, the optimal amount of total

damages, D*, which is the sum of optimal compensatory damages, DC*, and optimal

punitivedamages,DP*,shouldbecomputedviathefollowingequation.

€

D* = H 11− q

=

H1− q

(6)

Theterm(1‐q) is the likelihoodthat the injurer is found liablesothat(1/1‐q)maybe

referredtoasthe“totaldamagesmultiplier”.112Forexample,assumetheprobabilityof

escaping liability equals 50%.This results in a total damagesmultiplier equal to 2 (=

1/1‐0.5).Consequently,aninjurerwhoinflictsaharmof$50,000ontheplaintiffshould

pay$100,000(=2x$50,000)intotaldamages.Thisinturnmeansthattheinjurerpays

$50,000incompensatorydamagesand$50,000inpunitivedamages.Thus, the injurer

indirectlyalsopays$50,000fortheotherstatisticalharmthatheisnotheldliablefor.

Aswell, note that under the assumption of perfect enforcement q= 0, so that under

perfectenforcementoptimaltotaldamagesequalharm,i.e.D*=H.113

The optimal level of punitive damages could be computed by subtracting the optimal

amount of compensatory damages from the optimal total damages. Alternatively, the

optimalamountofpunitivedamagesmaybedirectlycalculatedby

€

DP* =q1− q

H (7)

111PolinskyandShavell(2000),p.768112PolinskyandShavell(2000),p.768113Recall,thiswasthefirstfundamentalinsight(giventheassumptionofperfectenforcementandperfect

compensation)introducedinSection3.2.1,p.22



where (q/1‐q) is the “punitive damages multiplier”.114 In the previous example, the

optimalpunitivedamagesof$50,000arederivedfromadamagesmultiplierequalto1

(=0.5/1‐0.5)multipliedbytheharmof$50,000.Similarly,iftheprobabilityofescaping

liabilitywere0.75,thepunitivedamagesmultiplierwouldbeequalto3(=0.75/1‐0.75).

Thisresultsinoptimaltotaldamagesamountingto$200,000(=$50,000/1‐0.75),where

$150,000 (= 3 x $50,000) of this amount comprises optimal punitive damages. These

examples illustrate that the higher the enforcement error, the higher should be the

amountofpunitivedamages.

Yet, recall that this computation of optimal punitive damages applies the harmof the

enforcedcasealsotoallotherunenforcedcases,inwhichtheinjurertechnicallyshould

havebeenliable.115Butthereisnoreasonwhythesamewrongfulconductshouldalways

causethesameharm.Therearetoomanyotherexternalfactorsthatcouldinfluencethe

extent of the harm. It would therefore be more accurate to use the average of the

individual harms as the basis for the punitive damage calculation.116 This, of course,

requires detailed information on individual cases, which the court might be able to

attainbyconsultinginsurancecompanies.

Nonetheless,byrelaxingthesecondassumptionofperfectenforcement, totaldamages

exceedingtheactualharmofthevictimarenotonlyjustifiedbutalsorequiredfroman

efficiencypointofview.Punitivedamagesarenecessary inorder toalignthe injurer’s

expected liabilitywith theactualharm inflicted.Onlywhen the injurer internalizesall

the harm he causes, he will have efficient incentives in choosing his optimal level of

precautionandactivity.Relatingthisresultwiththeearlierfindings,oneshouldbearin

mindthat theenforcementerrorhastobe largeenoughsothat the injurerwill find it

worthwhiletochoosealevelofprecautionbelowtheefficientlegalstandard.117

However, intuitively, if punitive damages are intended to make up for unenforced

harms, itshouldnotsolelybetheplaintiffcollectingallpunitivedamages.Whyshould

theplaintiffreceiveallthedamageawardsfortheharmthatwasinflictedonothers?A

114PolinskyandShavell(2000),p.768115RecalltheassumptionthattheharmHremainsconstantforeveryaccidentinSection3.1.1,p.14116PolinskyandShavell(1998),p.889117Cooter(1989),p.1148



fractionof thepunitivedamageawards should insteadbepaid to the state. SomeU.S.

states suchasGeorgia, Illinois, Indiana,Missouri, Iowa,OregonandUtahhave for this

reason formulated so called “split‐award” statutes. Such statutes require a certain

fractionofpunitivedamageswonattrialtobeallocatedtothestate.118Analternativeto

such statutes would be to make punitive damages taxable under the ordinary tax

scheme, even for private individuals.119 However, to mitigate the plaintiff attorney’s

undesirableincentives,namelytosuesimplyinordertocollecthighwindfallprofits,itis

important thatattorneyscanonlybase theircontingency feeson the finalnetamount

received by the plaintiff, i.e. after split‐award deductions or after tax payments have

beenmadetothestate.

The state can then recycle these awards back into society in the form of welfare

payments, or it might even create certain funds accessible by victims of similar

unenforced harms. The result of split‐award statutes or a tax on punitive damages

would be that the expected plaintiff award at trial is reduced, but the defendant’s

damage payments are not. This lowers the number of trials by reducing the possible

windfall for plaintiffs while increasing the number of out of court settlements. In

addition,thesizeofsuchsettlementswillbereducedbecauseplaintiffsfindthemselves

inaweakerbargainingposition.120

However,due toa lower filing rateand lowerexpectedoutof court settlements, such

regulationsalsoreducetheexpectedcostsofaccidentsfordefendants.Thisiswhyonly

partofthepunitivedamagesshouldbepayabletothestate:Topreserveadefendant’s

efficientincentivestotakeprecaution.121Moreover,otherthanallthesilentvictims,the

plaintiff at trial also incurs the litigation costs. Even thoughpunitivedamages arenot

meanttocoverlitigationcosts,itisonlyamatteroffairnessthattheplaintiffreceivesan

extra amount for taking the financial risk of going to trial, which all other (future)

victimsessentiallybenefit from.Thus, the legislaturemust strikeanadequatebalance

betweenefficiencyandfairnessviasplit‐awardstatutesorthroughataxationscheme.

118DaughetyandReinganum(2000),p.5119Foramoredetaileddiscussionon taxingpunitivedamages, see e.g.PolinskyandShavell (1998),pp.

928‐931120LandeoandNikitin(2004),p.1121LandeoandNikitin(2004),pp.1‐2



3.2.5.WhatwouldhavebeenefficientintheMcDonald’sHotCoffeeCase?

Having discussed the economic reasoning behind punitive damages it is

worthwhile‐withreferencetotheMcDonald’sHotCoffeeCase‐tonowlookathowthe

theoryestablishedabovecouldbeappliedinpractice.

Unfortunately, in the past courts have largely been economically inefficient in their

applicationofpunitivedamages.Asa result, importantaspects for thecomputationof

the right amount of punitivedamageshavebeenneglected andhave largely been left

unknown. Thus, a few informative assumptions have to be made. All the vital

information assumed here, however, should not be difficult for a court to acquire in

practice.

The protocols of the Liebeck v. McDonald’s Restaurants, P.T.S., Inc. trial reveal that

between 1982 and 1992 McDonald’s had received about 700 complaints of varying

degreeburns.122However,itisneitherdisclosedhowmanyoutofthe700actuallysued

McDonald’sfordamagesincourtnorhowmanysettledoutofcourt.Thisinformationis

required for the determination of the total damage multiplier. The ordinary person

would probably not think of suingMcDonald’swhen he spills his coffee over himself.

Due to thehidden risk, he typicallypresumes that the consequential harmof a coffee

spillisentirelytheresultofhisownfault.

Thus, letus firstassumethat1outof50hotcoffeevictimsactuallygo tocourt tosue

McDonald’s, which for coffee spills is believed to be a rather high number. The

probabilitythatMcDonald’sisbeingsuedforitsdangerouslyhotcoffeeistherefore2%

(=1/50).Accordingly,theprobabilityofescapingliabilityliesat98%(=1–0.02).

Remember,Ms.Liebeck initiallyasked forcompensatorydamagesof$20,000 tocover

hermedicalbills,outofpocketexpensesandlostwagesofherdaughterwhotooktime

122 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994WL 16777828 (Trial Motion,




ofherjobtotakecareofher.123Ms.Liebeck’scontributoryfaultof20%would,however,

reduceherreceivablecompensatorydamagesto$16,000.124

Thequestionnowis:Shouldthecontributoryfaultbeincludedinthepunitivedamage

calculation?Theanalysisabovesuggests:“No”.Anythingthatcreatesuncertaintyforthe

injurer in the computation of punitive damages must be avoided to preserve the

deterrence effect. This also includes the contributory fault. For deterrence to be

effective,theinjurermustbeabletocomputetheexpectedamountofpunitivedamages

before any accident has occurred. The contributory fault by the victimwould for the

injurerbeanunknownvariableinhispunitivedamagecalculation.Besides,recallingthe

rationale of punitive damages, punitive damages are not imposed to reimburse the

victim for the incurred harm. The contributory fault only affects the compensatory

damages to be paid in the case at trial and not that of unenforced cases. In fact, the

contributoryfaultinunenforcedcasesistypicallyunknown.

Thus,inanycase,theactualharm,andnottheoptimalcompensatorydamages,mustbe

the basis for the punitive damages calculation.125 Accordingly, in this example, the

unreducedamountof$20,000reflectingtheactualharmofMs.Liebeckshouldbeused.

Since total damages include punitive damages the same holds true for the optimal

amount of total damages, D*, although courts eventually have to adjust optimal

compensatorydamages,DC*,bythecontributoryfault.Thiscanbeachievedbyadjusting

Equation6to

€

D* =11− q

− FC

H (8)

whereFc126representsthecontributoryfault.NotethatifFC=0,Equation8isequivalent

toEquation6,whichdidnotaccountforthepossibilityofcontributoryfault.

123JohnsandPerschbacher(2002),p.217124Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1995WL360309(Judgment,Bernalillo

County,N.M.Dist.Ct.Aug.18,1994)125NotethatEquations6and7bothusetheharm,H, insteadofoptimalcompensatorydamages,DC*, to

prevent confusions in cases involving a contributory fault, FC, by the victim. In cases withoutcontributory fault, optimal compensatory damages equal harm; in cases with contributory fault,optimalcompensatorydamagesarelessthantheactualharm,i.e.DC*=H(1FC)



Intheexample,whereonly1in50victimssue,thisaccordinglyresultsinoptimaltotal

damagesamountingto$996,000(=[(1/0.02)–0.2]x$20,000)127,$980,000(=0.98/0.02

x$20,000)128ofwhichmakeuppunitivedamages.

Yet,noticethatthecompensatorydamagesthatMs.Liebeckaskedforonlyincludedher

economiclosses.Thenoneconomiclossesoffuturepainandsufferingasaresultofher

permanent injuries have not been accounted for yet. If we used the unadjusted

compensatorydamagesincludingnoneconomiclosses,i.e.the$200,000awardedbythe

jury,theoptimalamountoftotaldamageswouldamountto$9.96million(=[1/0.02–

0.2]x$200,000)andoptimalpunitivedamagesto$9.8million(=0.98/0.02x$200,000).

Thus,if1in50victimswouldsue,efficiencywouldhaverequiredmorethan3.5times

the$2.7millionofpunitivedamagesinitiallyawardedbythejury.Now,ifsayonly1in

100 victims sue, the optimal amount of total damageswould even increase to $19.96

million (= [1/0.01 – 0.2] x $200,000) and punitive damages to $19.8 million (=

$19,960,000–$160,000)tomakeupfortheother99unenforcedcases,i.e.$200,000x

99=$19,800,000.Ofcourse,ifoutofcourtsettlementshavebeenpaidinearliercases,

thefinalpunitivedamageamountshouldbereducedbythesizeofthesesettlements.

Havingdeterminedwhat the injurershouldoptimallyhave topay toensureeconomic

efficiency, thenextquestion is,howmuchof the$19.96millionshouldMs.Liebeckbe

entitledtokeep?Asmentionedearlier,itwouldbeunjustifMs.Liebeckweretokeepall

thepunitivedamagesthatareactuallymeanttomakeupforallunenforcedharms.Thus,

suppose the state law of jurisdiction contains a split‐award statute that requires Ms.

Liebecktopay50%ofthepunitivedamages,i.e.$9.9million(=$19,800,000x50%),to

the state. Hence, Ms. Liebeck would get to keep the other $9.9 million of punitive

damages.

However, from the author’s point of view, social fairness requires to also apply the

contributory fault to thepunitivedamages thatMs. Liebeck receives andmaykeep.129

126WhereFCisapercentagenumber,i.e.0

€

≤ FC

€

≤1127ApplyingEquation8128 Applying Equation 7, or simply by subtracting optimal compensatory damages,DC* = H(1FC), from

optimaltotaldamages;notethat0.98/0.02=49,i.e.tomakeupforalltheother49unenforcedcases129 Under the assumptionsmade above, the amount of punitive damages thatMs. Liebeckmay keep is

differentfromtheamountofpunitivedamagestobepaidbytheinjurer.



ThisisbecauseMs.Liebeckishypotheticallynotentitledtoanypunitivedamagessince

they are not meant to compensate for Ms. Liebeck’s harm. Thus, deducting the

contributory fault, Ms. Liebeck should only be allowed to keep $7.92 million (=

$9,900,000 x (1 – 20%)) of the $9.9million in punitive damages. But, unlike for the

compensatorydamages,thedifferenceof$1.98millionattributabletothecontributory

faultshouldbepayabletothestateontopofthesplit‐award,andnotforthedefendant

tokeep.Therefore,lettingSdenotethepercentageamounttobepaidtothestate130,the

finalawardthatMs.Liebeckisentitledtokeep,DV*,canbecalculatedbythefollowing

equation:

€

DV* =q1− q

1− S( ) +1

H(1− FC ) (9)

Summarizing, if 1 in 100 victims sued McDonalds, the corporation should have paid

$19.96million in total damages in order topromote economic efficiency, $160,000 in

compensatory damages and $19.8 million in punitive damages. This is more than 7

times the punitive damage amount initially imposed by the jury. However, under the

assumptionsmadeabove,Ms.Liebeckshouldonlybeentitled tokeep$8.08millionof

thetotalamount131,whereasthestateshouldreceivetheremaining$11.88million(i.e.

$11,880,000 + $8,080,000 = $19,960,000), which amounts to about 60% of the total

damagespaidbytheinjurer.132

Hence, the McDonald’s Hot Coffee Case that critics frequently use to argue against

punitive damages in fact illustrates the opposite: Some cases require large punitive

damages to enhance economic efficiency. This in turn suggests that limitations on

punitivedamagestoasingledigitpunitivedamagemultiplier,astheywereputinplace

insomeU.S.states,wouldclearlypreventefficiencyinthiscase.

130Eitherintheformofasplit‐awardorintheformofatax,where0

€

≤ S

€

≤1131DV=[(0.99/0.01)x(1‐0.5)+1]x$200,000(1–0.2)=$8,080,000132 For an overview of the important equations for the damages calculation established above, see the

Annex.



4.ThePunishmentGoalofPunitiveDamages

4.1.WhatistheRoleofPunishmentinTortLaw?

As mentioned at the outset of this paper, the second objective of punitive

damages, aside from deterrence, is the punishment of the injurer for his reckless

behavior.133 From an economic point of view, however, punishment plays only a

secondaryroleintortlawbecauseitmerelyservesasadisciplinaryfunctionratherthan

as a deterring one. Recall that punishment refers to society’s objective to impose

reasonable sanctions on social wrongdoers as a penalty for a reckless unlawful

conduct.134

Punitive sanctions as disciplinary measures were originally only implemented in

criminal law. However, as Judge Posner in Mathias v. Accor Economy Lodging, Inc.

explained,punitivedamageswere introduced in common tort law inorder “to relieve

thepressuresonanoverloadedsystemofcriminaljusticebyprovidingacivilalternative

to criminal prosecution of minor crimes”.135 Thus, in connection with its punishment

objective, punitive damages may be interpreted as “semi‐criminal enforcement

penalties”136imposedonminoroffenses.Forinstance,knowinglyexposingitscustomers

totheriskofseriouslybeingburnedbyitsdangerouslyhotcoffeemerelyforanincrease

insales,asMcDonald’sargued137,madeMcDonald’ssubjecttoappropriatepunishment.

PunishmentinthetortlawcontexthasespeciallythreatenedU.S.corporatedefendants.

Plaintiffs in product liability cases or cases of fraud, for instance, are frequently

successful in contending that the defendant’swrongful conduct deserves punishment.

Mostcommonly,theplaintiffarguesthatthedefendant’srecklessconductcausedharm

notonlyonhimasanindividual,butmoreimportantlyalsoonthepublicinterest.The

plaintiff’sattorneytriestoexplaintothejurythattheplaintiffisonlyarepresentativeof

133SeeaboveSection2.1,pp.4‐5134PolinskyandShavell(1998),p.948135Mathiasv.AccorEconomyLodging,Inc.,Nos.03‐1010,03‐1078,347F.3d672(Ill.App.Ct.7thCir.2003),

p.7136Calabresi(2005),p.337137 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994WL 16777828 (Trial Motion,




alargegroupofharmedindividuals.Thiswaytheplaintifftriestoconvincethejurythat

punitive damages should be imposed not only as ameans of deterrence but also for

punishment reasons.138 Consequently, corporate entities with a large customer base

havetobeparticularlyalerttotortlawliabilityissues.Thisisespeciallytruebecause,as

mentioned earlier, the standard of proof under tort law is much lower than under

criminallaw,makingpunitivesanctionsmorelikelyintortlaw.

However, the implicationsof imposingpunitivedamagesoncorporateentitieshaveto

becarefullyreviewed.This isbecause, ifpunitivedamagesare imposedona firm, it is

notalwaysclearwhoisreallybeingpunished.Consequently,thepunishmentobjective

maynotbereadilyachieved.Thisissueisbrieflyaddressedinthefollowingsection.

4.2.WhoisBeingPunished?

The ease of realizing the punishment objective varies considerably between

individualsandcorporateentities.

Generally, when the defendant is an individual, the punishment objective can be

achievedwithoutproblems.All it takes isanassessmentof thereprehensibilityof the

individual’s wrongful conduct and the imposition of suitable punishment. Yet, this

assumesthatthereisacorrectlevelofpunishmentthatdependsonthereprehensibility

ofthedefendant’sconduct.139

Achieving the same punishment effect on a corporate entity via punitive damages,

however, canbeproblematic forvarious reasons.Thesearemosteasilyunderstood if

weconsiderafirmasanexusofcontractsbetweendifferentgroupsofindividuals,each

ofwhichhasitsowninterestinthefirm:140

First,culpableemployeeswhoaredirectlyresponsiblefortheharmaremostlikelynot

goingtobedirectlypenalized.Oftentimes,firmsarenotabletoidentifytheresponsible

individuals, especially in larger entitieswith complex corporate structures. Themore

138Sharkey(2003),pp.357‐358139PolinskyandShavell(2000),p.772140 For a detailed discussion, see e.g. Jensen and Meckling (1976) and Alchian and Demsetz (1972),

viewing the firm as a set of contracts between its factors of production; and Bainbridge (2002)conceivingafirmasanexusofcontracts



employeesafirmemploys,theharderitisfortheownersofthefirmtosuperviseeach

and every employee, who might have an incentive to behave opportunistically. This

reflects the adverse effect of separations between ownership and control. Due to

different risk attitudes and information asymmetries between the owners and the

employeesofafirm,employeesmayprioritizetheirowninterestsoverthoseofthefirm

asawhole.141

But even if a firm can identify the culpable individuals, the effectiveness of the

punishment of blameworthyparties depends on the efficacy of the corporate internal

sanctions implemented. The disciplinary effect on the individual employee who, for

example,isdismissedasaresultofhiswrongfulactisrelativelysmallwhencontrasted

withtheoccasionallysevereconsequencesofindividualmisbehavior.142

Furthermore,theadditionalmarginalpunishmentimposedbypunitivedamagesonthe

responsibleindividualwillbealmostnegligiblecomparedtothatonthefirmasawhole.

Theinternalcorporatesanctionsimposedontheculpableemployeewillmostlikelynot

be much greater, if the company has to bear punitive damages in addition to

compensatory damages, than if the company merely had to pay compensatory

damages.143

Moreover,theremaybesituationswheretherearenoindividualemployeestobeheld

liable.Corporatedecision‐makingprocessestodayofteninvolvemultipleindividualsso

thattheremaynotbeanindividualassuchtoblame.Inaddition,ifthefinaljudgmentis

calledalongtimeafterthemisconductoccurred,theblameworthyindividualsmayhave

gone into retirement, switched jobs, ordied in themeantime.Note, however, that the

former employermight still be able to sue an employeewho retired or changed jobs

afterwards.144

All these difficulties of identifying culpable individuals within a firm and effectively

achievingthepunishmentobjectiveposeadebatablequestiontobeconsidered:Instead

141 Polinsky and Shavell (1998), p. 950; For a detailed discussion of the agency theory, seee.g. Eugene

(1980)andalsoBainbridge(2002)142PolinskyandShavell(1998),p.950143PolinskyandShavell(1998),p.950144PolinskyandShavell(1998),p.951



oftryingtopunishindividualemployees,shouldwepunishtheownersofafirmfortheir

failuretosupervisethem?

Interestingly enough, punitive damages already indirectly punish owners, i.e. the

shareholders, of corporate entities. If a firm has to pay large amounts of punitive

damages,thefirmvaluewillbereduced.Infact,themereexposuretotheriskofhaving

to pay punitive damages already reduces a firm’s value. This inevitably punishes the

shareholders being the residual claimants of the firm. Of course, shareholders may

actuallybetheblameworthypartiesthemselves.Iftheownershipstructureofthefirmis

concentrated and the major shareholder actively participated in the decision‐making

processthatledtothemisbehavior,theshareholdermustbetreatedasculpablehimself.

However,minorityshareholdersaretypicallynotinthepositiontobeabletoinfluence

the management of a firm. Thus, they neither have the incentive nor the power to

activelysupervisetheemployeesofthefirm.145

Hence, when the defendant is a corporate entity, imposing punitive damages as

punishmentposestechnicalproblems.Theeffectivenessofpunishingfirmsviapunitive

damages is clearly suboptimal.Thepunishmentobjectiveonlyprovideseagerplaintiff

attorneys another basis for arguing pro an imposition of punitive damages to collect

windfallprofitsunder theU.S. contingency fee system. Inany case, even though there

may be other social reasons for imposing punitive damages as punishment, the

punishmentobjectiveislargelyirrelevantfromaneconomicperspective.

145PolinskyandShavell(1998),pp.951‐952



5.TheBehaviorofAmericanJuries

5.1.HowDoJuriesPerforminAwardingPunitiveDamages?

Another distinct feature of the American legal system is the jury. It reflects its

emphasisondemocraticvaluesandaself‐governing tenet. Indeed,with the first three

words of the United States Constitution “We the People […]” the Founding Fathers

prioritized this fundamental democratic principle in theU.S. legal system.146However,

thejuryasafactfinderhasbeenwidelycriticized,especiallywhenitcomestoawarding

punitive damages. Critics of jury trials have a common perception that juries tend to

have“[…]abiasagainstcorporateandotherdefendantscreditedwithdeeppockets”.147

This suggests that juries impose punitive damages arbitrarily and emotionally driven

ratherthanbasedonaconsistentlyobjectiveconstruct.

InaninterestingexperimentalstudyconductedbyProfessorViscusi,anumberofjury‐

eligiblecitizenswerepresentedwithdifferentcasescenarios.Theywerethenaskedto

decide foreachscenariowhether theywould imposepunitivedamages,and if sohow

much.Theresultsshowedthattheresponsesofthedifferentparticipantsagreedfairly

well regardingwhetherpunitivedamages shouldbe imposedat all.Thus, theaverage

jurorseemstobeabletoconsistentlyevaluatewhetherpunitivedamagesarenecessary.

However, theextentofpunitivedamages imposedby thedifferentparticipants lacked

coherency.148 Why might this be the case? A few answers can be derived from the

participants’responsestothedifferentscenarios.Theyprovideinterestinginsightsasto

what kindof factors typically drive a jury’s verdict onpunitivedamage amounts. The

maindrivingfactorsthatwereobservedareoutlinedbelow:

First, the study showed that jurors actually punish firms for conducting costs‐benefit

analyses. Juries tend to impose more punitive damages on firms that systematically

performed risk analyses to attain an efficient balance between risk and costs. This is

because juries tend toviewsuchanalysesasan indicator for recklessbehavior rather

146TheConstitutionoftheUnitedStates,Preamble147Fleming(1988),p.111148Viscusi(2002),p.157



thanasa firm’seffort tomeet itsdutyof care.149 Supposeadetailed riskanalysiswas

carriedoutbeforeanaccidentoccurredandthefirmasaresultdecidedonanefficient

levelofrisk,i.e.wherethemarginalbenefitofreducingtheriskequalsthemarginalcost

ofdoingso.Itfollowsthatfirmstypicallyalwaysassumeatleastsomerisk,eventhough

itmaysometimesseem“statisticallytrivial”150,asintheMcDonald’sHotCoffeeCase.Yet,

oncethisremainingriskmaterializes,thejuryperceivesafirm’sconsciouschoiceofan

efficientriskasafundamentaldisregardofthecustomer’shealthandsafetybythefirm.

Thereasonisthatthefirmknewabouttheriskandunderstoodhowtoproduceasafer

product.151

This isalsowhatstruck the jury inLiebeckv.McDonald’sRestaurants,P.T.S., Inc..After

the trial, Jack Elliott, one of the jurors, remarked that McDonald’s demonstrated a

“callous disregard for the safety of the people”.152 Another juror, Betty Farnham,

commented“therewasapersonbehindeverynumberandIdon’tthinkthecorporation

wasattachingenoughimportancetothat”.153

However, it is important tonote that jurorsoften fail toput themselves into theante‐

accident position of the firm. Instead, they assess the reprehensibility of the firm’s

conductfromaretrospectiveview.Thus,ajury’sobjectiveviewisalreadyblindedbyits

hindsightbiasbeforeanyevidencehasbeenpresented.154

Moreover, theway a firmperforms its costs‐benefit analysis seems tomatter aswell.

Juriestendtobeparticularlyreceptivewithrespecttothevaluefirmsattachtoahuman

life intheirriskanalyses.However, juries irrationally imposehigherpunitivedamages

onfirmsthatuseahighervalueoflifethanonfirmsthatusealowervalueoflife.Thus,

ineffecta firmthatdemonstratesan increasedeffort tomoresafetybyusingahigher

149Viscusi(2002),p.140150 Liebeck v. McDonald’s Restaurants, P.T.S., Inc., No. CV‐93‐02419, 1994WL 16777828 (Trial Motion,

MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,1994),p.11151Viscusi(2002),p.144152http://www.arktimes.com/blogs/hoglawyer/2007/11/tort_reform_and_mcdonalds_coff.aspx153http://www.arktimes.com/blogs/hoglawyer/2007/11/tort_reform_and_mcdonalds_coff.aspx154Viscusi(2002),p.150



valueoflife‐therebyhypotheticallymakingtheriskanalysismoreacceptabletojurors‐

willlikelyhavetopaymorepunitivedamages.155

In addition, a jury seems tobehighly influencedby informationpresentedduring the

trialthatismeanttoguidethejuryinthecomputationofpunitivedamages.Thus,ifthe

plaintiff’sattorney,forexample,suggestsacertainamountofdamagesthatheconsiders

to be appropriate, jurors typically base their damage awards on such extraneous

submissions. Consequently, it is questionablewhether attorneys shouldbe allowed to

advocatetheamountofdamagesthattheythinkisappropriatetothejury.156Especially

underacontingencyfeesystem,attorneyshaveanincentivetomaximizethefinalaward

intheirowninterest.

Finally, the experimental study shows that even if a jury was provided with specific

instructionsonhowtocomputeoptimaldeterringpunitivedamages,jurorsfailtoapply

themcorrectly,orevenrefusetodoso.Thus,asimplemathematicalformulaforoptimal

punitivedamages,astheonediscussedabove(Equation7),isunlikelytoleadtoefficient

punitive damage awards as long as punitive damages are solely the jury’s

responsibility.157 Especially when noneconomic harms are involved, such as losing a

child in an accident or the permanent injuries suffered byMs. Liebeck, juries tend to

becomeemotionallyattachedtoacase.Itrestsinourhumannaturethattheobjectivity

of our judgment on social norms deteriorates, as personal sentiment takes over. As

Cooter states, “peoplewho internalize socialnorms feel righteousangeragainst those

who violate them”.158 Consequently, jurors sometimes feel the need to send a clear

messageof disallowance to thedefendant andpotential future injurersby refusing to

applyaconventionaldeterrenceformula.

5.2.WhereDoesThisLeavePunitiveDamages?

TheresultsofViscusi’sbehavioralstudyclearlyshowthat,whilethejuryseems

to be able to tell when punitive damages are appropriate, it is by no means able to

155Viscusi(2002),p.157156Viscusi(2002),p.164157Viscusi(2002),p.163158Cooter(1997),p.82



imposecoherentamounts.Ajurydoesnotappreciateafirm’sattempttomeetitslegal

duty as best as possible via costs‐benefit analyses, it puts too much weight on

extraneousinformationandittendstobecometooemotionallyinvolvedtoprovidean

objective verdict. Presumably, the main problem is that the average juror has no

experience as a fact finder.Therefore, hedoesnotknowhow to filter andadequately

weight the relevant information presented to him during a trial. So where does this

leavepunitivedamages?

Twoimportantpointsmustbemade:

(1) The image of an arbitrary, inefficient and unfair American legal system is not, as

criticsliketoclaim,theresultofpunitivedamages.Instead,itistheconsequenceofthe

fundamental principle of a democratic and self‐governing American legal system. In

otherwords,therealproblemrestswiththeirrationaljuriesthatareunabletocorrectly

apply an inherently efficient tool. Punitive damages only create a playground that, if

properly used, can improve society’swelfare. Unfortunatelymost critics only scratch

the surface of this playground and fail to identify the actual source of theproblem. It

wouldbeunwisetoeliminateawelfare‐enhancingtoolonlybecausecourtsdonotknow

howtouseitproperly.Itisthereforethelegislator’stasktomakesurethatsocietycan

benefitfromthislegalinstrumentbyensuringitsproperapplication.

(2)While juries should still be able to evaluatewhether punitive damages should be

imposed,thecomputationoftheoptimalamountofpunitivedamagesshouldbeleftto

the professional judges. Civil servant judges, who typically better understand the

economic implications of their judgments, aremore likely to compute consistent and

efficient punitive damage awards. Many scholars share this view arguing that tort

damages in civil law systems aremore consistent and objective than in common law

systems because in civil law systems experienced civil judges rather than a group of

laypersons are responsible for imposing damages.159 Transferring only some

responsibility from the jury to the judge will not onlymitigate the great uncertainty

aroundpunitivedamagesbutalsoformaneffectivecompromisebetweenademocratic

andaneconomicallyefficientlegalsystem.

159Markesinisetal.(2005),p.17



6.Conclusion

Punitive damages have been widely disputed among legal commentators. This

paper took an efficiency point of view in this debate to arrive at an economic

justificationforpunitivedamages.

Byinitiallyposingtheassumptionsofperfectcompensationandperfectenforcement,it

wasdemonstratedthatinaperfectlegalworldpunitivedamageswouldbesuperfluous.

Compensatory damages equaling harm would suffice to ensure social efficiency.

However,therealworldisfarfrombeingperfect.Ifappliedcorrectly,punitivedamages

helptomitigatesuchlegalimperfectionsandrestoreeconomicefficiency,i.e.minimize

thesocialcostofallaccidents.

If individuals fail to internalize the full costs of an accident, individuals have under

certaincircumstancessuboptimal incentivesforprecaution.It isonlyworthwhilefora

party to breach his legal duty if it chooses a level of precaution far below the legal

standard, which typically requires a deliberate wrongful conduct. This explains why

punitive damages are reserved for “willful, malicious, wanton or reckless” conducts.

Since the benefit that the wrongdoer obtains from his unlawful conduct, whether

socially illicit or not,must be large, sufficiently large punitive damages in addition to

compensatorydamagesareneededtorestoreefficiency.

Besides, themerepossibilityofescaping liabilityalreadyleadsto inefficient incentives

forprecaution.Therefore,injurersmustbeinducedtoexpectthattheywillalsohaveto

pay for all other unenforced harms in order to restore efficiency. Compensatory

damages alone cannot do so. Again, economic efficiency requires total damages

exceeding compensatorydamages,meaningpunitivedamages.Efficient incentives can

onlybereinstatediftotaldamagesequaltheharminflicteddividedbythelikelihoodof

being held liable. The higher the probability of escaping liability, the more punitive

damagesarenecessarytoenforceefficiency.Thus,anystatutorylimitationsonpunitive

damagesleadtoaninefficientlegalsystem.

Yet, efficient incentives can only be re‐established if all uncertainties regarding the

computation of punitive damages are eliminated.Anything elsewoulddeteriorate the



deterrence effect. Therefore, it is important to recognize that for the computation of

punitivedamagestobepaidbytheinjurerthecontributoryfaultmustnotbetakeninto

account.Onlythecompensatorydamagesportionoftotaldamagesawardedinthecase

attrialshouldbedeductedfromtheamountpayablebytheinjurerbythecontributory

fault percentage, not from the punitive damages to be paid. However, in order to

enhancesocialfairness,thecontributoryfaultcouldalsobedeductedfromtheamount

ofpunitivedamagesthatthevictimmaykeep.

Inanycase,itwouldbeadetrimenttosocialjusticeifonesuccessfulplaintiffcollectsall

thedamagesthatareactuallymeanttocompensateforunenforcedharms.Thus,someof

the punitive damages should be paid to the state to be redistributed to the general

societyviawelfarepayments,orwhereitispossiblethroughinstitutedfundsforsimilar

victims of unenforced harms. The state could collect these punitive damages either

throughstatutoryrequirements(“split‐award”statutes)obligingthesuccessfulplaintiff

topayacertainfractionofthepunitivedamageawardtothestate,orsimplybymaking

punitivedamagestaxable.

In thisway, fromaneconomicstandpointpunitivedamageshaveascertainedtobean

efficiencyenhancinglegal instrumentintort law.However,aslongasthecomputation

ofpunitivedamagesismoreorlesssolelyinthehandsofthejury,itisunlikelythatsuch

efficiencycouldbeimplementedinpractice.Whileitappearsthatjuriesareconsistently

abletotellwhetherpunitivedamagesaretobeimposed,theyillustratearatherrandom

choicewhenitcomestotheamountofpunitivedamages.Suchrandomawardsdonot

have the necessary deterring effect since potential future injurers cannot correctly

estimatethecostsofanaccidentiftheydonotknowhowlargetheirliabilitywillbe.

Asaresult,inordertobeabletobetterimplementtheefficiencyofpunitivedamagesin

practice,thelegislatorshouldtransferthequestionof“Howmuch?”totheexperienced

trial judges. Suchapolicy changewouldnotonlypromoteaproperapplicationof the

efficiency enhancing formulas (as summarized in the Annex of this paper) but also,

opposite to thecapsalready imposed insomeU.S. states, tackle thereal sourceof the

problem:TheAmericanrun‐awayjury.



Bibliography

Literature

Alchian Armen A. and Demsetz Harold (1972), ‘Production, Information Costs and

EconomicOrganization’,inTheAmericanEconomicReview,Vol.62,pp.777‐795

Becker Gary (1968), ‘Crime and Punishment: An Economic Approach’, in Journal of

PoliticalEconomy,Vol.76,pp.169‐217

BainbridgeStephenM.(2002),TheBoardofDirectorsasNexusofContracts:ACritiqueof

Gulati, Klein & Zolt's 'Connected Contracts' Model, UCLA School of Law Research

PaperNo.02‐05.

CalabresiGuido (2005), ‘TheComplexity of Torts –TheCase of PunitiveDamages’, in

Madden StuartM. (ed.),ExploringTort Law, CambridgeUniversityPress, pp. 331‐

351

CooterRobert(1983),‘EconomicAnalysisofPunitiveDamages’,inSouthernCalifornian

LawReview,Vol.56,pp.79‐102

Cooter Robert (1989), ‘Punitive Damages for Deterrence: When and How Much?’, in

AlabamaLawReview,Vol.40,pp.1143‐1196

CooterRobert(1997),PunitiveDamages,SocialNorms,andEconomicAnalysis;(available

at:http://works.bepress.com/robert_cooter/13)

Cooter Robert and Ulen Thomas (2007), Law & Economics, 5th Ed., Boston, Pearson

Education

Daughety Andrew F. and Reinganum Jennifer F. (2000), Found Money? Split Award

Statutes and Settlement of Punitive Damages Cases; (available at:

http://papers.ssrn.com/paper.taf?abstract_id=215732)

EugeneFamaF.(1980),‘AgencyProblemsandtheTheoryoftheFirm’,inTheJournalof

PoliticalEconomy,Vol.88,pp.288‐307

FlemingJohnG.(1988),TheAmericanTortProcess,Oxford,ClarendonPress



Hargreaves Heap Shaun P. and Varoufakis Yanis (1995), Game Theory: A Critical

Introduction,2ndEd.,NewYork,Routledge

Hylton Keith N. (1998), ‘Punitive Damages and the Economic Theory of Penalties’, in

GeorgetownLawJournal,Vol.87,pp.421‐456

Jensen Michael C. and Meckling William H. (1976), ‘Theory of the Firm: Managerial

Behavior,AgencyCostsandOwnershipStructure’,inJournalofFinancialEconomics,

Vol.3,pp.305‐360

JohnsMargaretZ.andPerschbacherRexR. (2002),TheUnitedStatesLegalSystem:An

Introduction,2ndEd.,NorthCarolina,CarolinaAcademicPress

LandeoClaudiaM.andNikitinMaxim(2004),SplitAwardTortReform,Firm’sLevelof

CareandLitigationOutcomes;(availableat:http://repec.org/esLATM04/up.14817.

1078453958.pdf)

McClurg Andrew, Koyuncu Adem and Spriovieri Luis E. (2007), Practical Global Tort

Litigation:UnitedStates,GermanyandArgentina,Durham,CarolinaAcademicPress

Markesinis Basil, Coester Michael, Alpa Guido and Ullstein Augustus (2005),

Compensation for Personal Injury in English, German and Italian Law, Cambridge,

CambridgeUniversityPress.

Polinsky A. Mitchell and Shavell Steven (1998), ‘Punitive Damages: An Economic

Analysis’,inHarwardLawReview,Vol.111,pp.869‐962

Polinsky A. Mitchell and Shavell Steven (2000), ‘Punitive Damages’, in Bouckaert,

BoudewijnanddeGeest,Gerrit(eds.),inEncyclopediaofLawandEconomics,Vol.II,

Cheltenham,EdwardElgar,pp.764‐781

SharkeyCatherineC. (2003), ‘PunitiveDamagesasSocietalDamages’, inTheYaleLaw

Journal,Vol.113,pp.347‐453

Shavell Steven (2004), Foundations of Economic Analysis of Law, Harvard University

Press



Viscusi W. Kip (2002), ‘Punitive Damages: How Jurors Fail to Promote Efficiency’, in

HarvardJournalonLegislation,Vol.39,pp.139‐167

WangJoyceC.andPetersonRobertM.(2000),DefendingAgainstPunitiveDamages,San

Francisco,Carlson,Calladine&PetersonLLP

WilsonElser(2006),PunitiveDamagesReview2006,NewYork,WilsonElserMoskowitz

Edelman&DickerLLP

CaseLaw

BMWNorthAmericaInc.v.Gore,No.94‐896,517U.S.559,116S.Ct.1589,134L.Ed.2d

809(May20,1996)

Boekenv.PhilipMorris,Inc.,26Cal.Rptr.3d638(Cal.Ct.App.2005)

Liebeckv.McDonald’sRestaurants,P.T.S.,Inc.,No.CV‐93‐02419,1993WL13651163

(TrialPleading,BernalilloCounty,N.M.Dist.Ct.Oct.5,1993)


(TrialMotion,MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.July13,

1994)


(TrialMotion,MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Aug.3,

1994)


(Judgment,BernalilloCounty,N.M.Dist.Ct.Aug.18,1994)


(TrialMotion,MemorandumandAffidavit,BernalilloCounty,N.M.Dist.Ct.Sept.12,

1994)


(ExpertReportandAffidavit,BernalilloCounty,N.M.Dist.Ct.Jan.19,1997)

Mathiasv.AccorEconomyLodging,Inc.,Nos.03‐1010,03‐1078,347F.3d672(Ill.App.

Ct.7thCir.2003)

PacificMutualLifeIns.Co.v.Haslip,No.89‐1279,499U.S.1,111S.Ct.1032,113L.Ede.2d

1(March4,1991)



StateFarmMutualAutomobileIns.Co.v.Campbell,No.01‐1289,538U.S.408,123S.Ct.

1513,155L.Ed.2d585(April7,2003)

UnitedStatesv.CarrollTowingCo.,159F.2d169(2dCir.1947)

NewspaperArticles

____________,(May12,1997)‘AlabamaCourtSlashesPunitiveAwardinCaseInvolving

RepaintedBMWCar’,TheWallStreetJournal

InternetSources

http://www.arktimes.com/blogs/hoglawyer/2007/11/tort_reform_and_mcdonalds_cof

f.aspx;lastvisitedon02.07.2009,1.06pm

Other

TheUnitedStatesConstitution;(availableat:http://frwebgate.access.gpo.gov/cgi‐

bin/getdoc.cgi?dbname=105_cong_documents&docid=f:sd011.105.pdf)



Annex

ToenhancetheeconomicefficiencyoftheU.S.legalsystem,thecomputationofoptimal

damagesistobetheresponsibilityofthetrialjudge.Basedontheanalysisofthispaper,

the trial judge should refer to the followingequations for the computationof efficient

damages:

Theoptimaltotaldamagestobepaidbytheinjureristobecomputedby:

€

D* =11− q

− FC

H

Thisamountshallinclude:

(a)Theoptimalpunitivedamagestobepaidbytheinjurer:

€

DP * =q1− q

H

(b)Theoptimalcompensatorydamagestobepaidbytheinjurer:

€

DC* = H 1− FC( )

andseparate:

(c)Thedamagesthatthevictimisentitledtokeep:

€

DV* =q1− q

1− S( ) +1

H(1− FC )

(d)Thedamagespayabletothestate:

€

DS* = D*−DV *

whereqistheprobabilitythattheinjurerescapesliability,Sthepercentagefractionto

bepaidtothestate(eitherintheformofasplit‐awardorintheformofordinaryincome

taxes),FCthepercentagecontributoryfaultbythevictimandHtheharminflictedonthe

victimbytheinjurer.

punitive damages: an economic justification

Documents