Regulation versus Litigation: Perspectives from Economics and Law

Regulation versus Litigation: Perspectives from Economics and Law

by Daniel P. Kessler

The efficacy of various political institutions is the subject of intense debate between proponents of broad legislative standards enforced through litigation and those who prefer regulation by administrative agencies. This book explores the trade-offs between litigation and regulation, the circumstances in which one approach may outperform the other, and

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The efficacy of various political institutions is the subject of intense debate between proponents of broad legislative standards enforced through litigation and those who prefer regulation by administrative agencies. This book explores the trade-offs between litigation and regulation, the circumstances in which one approach may outperform the other, and the principles that affect the choice between addressing particular economic activities with one system or the other. Combining theoretical analysis with empirical investigation in a range of industries, including public health, financial markets, medical care, and workplace safety, Regulation versus Litigation sheds light on the costs and benefits of two important instruments of economic policy.

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University of Chicago Press
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National Bureau of Economic Research Conference Report Series
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Regulation versus Litigation

Perspectives from Economics and Law

The University of Chicago Press

Copyright © 2011 National Bureau of Economic Research
All right reserved.

ISBN: 978-0-226-43218-2

Chapter One

Regulation (Agencies) versus Litigation (Courts)

An Analytical Framework

Richard A. Posner

1.1 Introduction

Economic analysis of law treats common law fields, especially tort law—which provides legal remedies for physical, mental, or financial injuries caused by negligence, medical malpractice, nuisance (which includes pollution), defamation, defective products, misrepresentation, or other wrongful conduct—as forms of regulation. The emphasis is thus on the deterrent effect of the threat of liability, rather than on the compensatory role of liability; compensation is thought better provided for by insurance. Common law is thus conceived of as regulation by judges—by judges not only because common law remedies are obtained by means of lawsuits against injurers but also because common law doctrines are made by judges.

My objective in this chapter is to compare common law (including federal common law; i.e., the body of common law made by federal judges—indeed, my primary concern is with federal regulation) with administrative regulation as methods of social control. More precisely, my objective is to compare common law regulation with administrative regulation, while giving due recognition to the fact that administrators often use common law methods of regulation and that judges sometimes use methods similar to those of administrative agencies. (The principal example is the "regulatory decree," under which courts will administer rules, often agreed to by the parties—governing institutions, such as school systems or prison systems—that have been determined to have violated constitutional law.) Nevertheless, judges are considerably more comfortable with the common law approach, and agencies that rely on common law methods to regulate are generally thought to have forgone the distinctive advantages of administrative regulation. So there is some utility to contrasting "litigation" with "regulation" as alternative methods of social control, while recognizing the overlap.

But besides noting the overlap, I need to point out an intermediate position between common law and administrative regulation. In common law adjudication, the judges make as well as apply the doctrine. In administrative regulation, the judges play a limited role of deferential judicial review of the administrative agency's decision. But in between is the judicial enforcement of statutes that are not administered by a regulatory agency. For example, although the Federal Trade Commission has antitrust enforcement authority, most antitrust cases are brought by public officials or private firms in federal courts that interpret and apply the antitrust laws without the intervention of an administrative agency. The judges' role is nominally interpretive but owing to the age and vagueness of the antitrust statutes in fact resembles common law lawmaking. But for simplicity I will focus on the contrast between pure common law adjudication and administrative regulation.

My analysis is normative; the question I address is what the better method—litigation or (administrative) regulation—would be, from the standpoint of economic efficiency, for regulating a particular activity. I leave to other work (some in this volume) positive questions about the choice between litigation and regulation, such as the political and cultural forces (including legalistic and individualistic traditions, and the influence of the legal profession, which has been said to be the American counterpart of European aristocracy and elite bureaucracy) that shape American government. No competent student of regulation thinks that the line between common law and regulation has been drawn primarily on the basis of comparative economic advantage.

From a normative economic standpoint the goal of regulation, whether by courts or by agencies, is to solve economic problems that cannot be left to the market to solve—such as problems created by positive or negative large externalities that market forces cannot internalize because transaction costs are too great for the Coase theorem to apply. Even so, it is still necessary to consider whether public control is justified, because the costs may exceed the benefits from internalizing the externalities, or because an intermediate form of regulation between pure market forces and public control may be superior to both; I refer to industry self- regulation, illustrated by board certification of physicians, hazing- type medical education to instill norms and create a "high commitment" environment ("professionalism"), contracts between patients and physicians and between consumers and producers, rulemaking and standards-setting by trade or professional associations, and arbitration or mediation to resolve disputes. If public control is not superior to private ordering, the next question—the positive one—is why the private alternative has been rejected.

1.2 Characterizing the Differences between Regulation and Litigation

Regulation and litigation tend to differ along four key dimensions: (a) regulation tends to use ex ante (preventive) means of control, litigation ex post (deterrent) means; (b) regulation tends to use rules, litigation standards; (c) regulation tends to use experts (or at least supposed experts) to design and implement rules, whereas litigation is dominated by generalists (judges, juries, trial lawyers), though experts provide input as witnesses; and (d) regulation tends to use public enforcement mechanisms. Litigation more commonly uses private enforcement mechanisms—private civil lawsuits, handled by private lawyers although the decision resolving the litigation is made by a judge (with or without a jury), who is a public official (the jurors are ad hoc public officials).

1.2.1 Ex Ante versus Ex Post

The first method is illustrated by speed limits, the second by personal-injury suits for negligence. As in this example, the two types of regulation are frequently conjoined. The regulation of highway safety is a complex mosaic of ex ante regulation (including speed limits and other safe driving rules, federal safety design standards, standards for the design and maintenance of highways, and the licensure of drivers) and ex post regulation (such as suits for negligent driving, product liability suits for defects in the design or manufacture of motor vehicles, and criminal prosecutions for drunk or other reckless driving).

Ex ante regulation can, as I said, be judicial as well as administrative, as in preventive detention, injunctions, and regulatory decrees, and ex post regulation can be administered by agencies as well as courts, such as the Federal Trade Commission and the National Labor Relations Board, which operate mainly by trial-type proceedings conducted after a violation of the laws administered by the agency has occurred.

Ex ante: pros. The ex ante approach promotes clarity of legal obligation and therefore presumably better compliance (fewer inadvertent violations) by laying down rules in advance of the regulated activities. Ex ante regulation is activated before there is a loss, unlike a lawsuit; it can be centrally designed and imposed (for example, by a single agency such as the Food and Drug Administration, as opposed to a decentralized judicial system); and it is enforceable by means of light penalties, because the optimal penalty for creating a mere risk of injury is normally lighter than the optimal penalty for causing an actual injury. This means, however, that ex ante and ex post regulation actually are inseparable; because compliance with rules is never 100 percent, there must be a machinery for punishing violators, though the machinery may involve penalties meted out by the regulatory agency itself, with judicial involvement limited to judicial review of the penalty proceeding. But while rules involve heavy fixed costs (i.e., designing the rule in the first place), if they are very clear and carry heavy penalties compliance may be achieved without frequent enforcement proceedings, so marginal costs may be low. Rules are therefore attractive when the alternative would be vague standards, resulting in frequent actual or arguable violations and hence frequent enforcement proceedings.

As this discussion shows, ex ante regulation and rules have an affinity. Ex ante regulation enables exploitation of the economizing properties of rules as preventives. With vague standards, the regulatory emphasis shifts to seeking deterrence by proceedings to punish violators.

But the affinity between ex ante regulation and rules requires a qualification. Consider the criminal penalties for the sale of illegal drugs. The underlying criminal prohibition is a fl at, clear rule, but compliance is achieved almost entirely by threat of punishment, which is ex post. Contrast that with the regulation of legal drugs, where, although there is ex post enforcement, including products liability suits, the emphasis is on testing new drugs in advance for safety and efficacy and refusing to allow drugs to be sold that flunk the tests.

Ex ante: cons. Ex ante regulation narrows the information base because when it takes the form of rules, it buys precision at the cost of excluding case-specific information that the promulgators of the regulation either did not anticipate or excluded in order to keep the regulation simple (i.e., to keep it a rule). Standards (such as negligence) versus rules (such as a numerical speed limit) allow much more information to be considered in particular cases. In doing so, however, standards not only reduce predictability; they also, as noted before, veer into ex post regulation, because vague standards beget disputes that require litigation over alleged violations to resolve. In addition, ex ante regulation, like preventive care in medicine, can burden much harmless activity, such as safe driving in excess of the speed limit. (Compare screening the entire population for medical conditions that afflict only a few people.) This is related to the fact that rules exclude relevant circumstances for the sake of clarity.

When ex ante regulation takes the form of licensure rather than merely prohibition—compare a requirement of a building permit to a speed limit—costs of compliance may soar, along with an increased risk of bribery if the permit is highly valuable.

Ex post: pros. Ex post regulation may require only rare interventions (again compare screening for medical conditions with treatment if and when a condition produces symptoms) and zero in on the limiting case in which a rule or standard achieves 100 percent compliance, though there may of course be costs of compliance. Ex post regulation economizes on administrative expense because intervention is sporadic, and utilizes both case-specific information (including information about causation and victim fault, and other information obtained after regulation is promulgated and in the context of a particular injury) and adversary procedure, which may increase accuracy. There is more information, including up-to-date and case-specific information, and it is screened and weighed more carefully because it is presented in a contested proceeding. In its private (as distinct from public) and adversary character, litigation as a regulatory approach borrows the methods of competitive markets.

The information advantage of ex post regulation is especially pronounced when the ex post standard is strict liability, meaning that the injurer is obligated to pay damages even if he or she could not have avoided at reasonable cost inflicting the injury. An example is an injury caused by the use of explosives, viewed as an ultrahazardous activity, in building a tunnel. Potential injurers have a strong incentive to balance the costs and benefits of the hazardous activity in order to decide whether or on what scale or in what circumstances engaging in the activity is cost-justified, and they have ready access to the necessary information.

The earlier example of illegal drugs illustrates the case in which ex post regulation does not refine a preexisting rule or standard. The laws are clear and their enforcement is concerned simply with punishing violations. The enforcement is also, however, largely ineffectual. For although the penalties are stiff, the expected cost of punishment is for many potential offenders low relative to the expected profits of drug trafficking because of the ease of concealment of illegal activity—a general problem with "victimless" crimes, since there is no one to complain to the authorities. But this is a case where both ex ante and ex post regulation are failures, and the best solution would be decriminalization coupled with excise taxation—though that could be considered a form of ex ante regulation, though remote from the usual examples.

Ex post: cons. Ex post regulation, typified by common law adjudication, with its heavy emphasis on standards (such as negligence and good faith) in preference to rules, involves high costs per case compared to adjudicating a speeding ticket. This is partly because of the additional information generated by a proceeding focused on a specific injury inflicted in particular circumstances. More information cannot only make a proceeding more costly but also create more uncertainty and as a result more variance in outcome; uncertainty also makes it more difficult to monitor the performance of the judge or other regulator to make sure he or she is competent and honest. Furthermore, a point related to the fact that the optimal penalty when an injury has occurred is greater than when a risk has been created that has not yet materialized, the injurer may not have sufficient resources to pay the penalty. There are also problems of proof when the cause of an injury must be proved. The problems are illustrated by cases in which exposure to radiation increases the incidence of cancer, but it is impossible to determine whose cancers were due to the radiation and whose would have occurred anyway. This particular problem, however, can be solved, at least in principle, by class actions that amalgamate claims of probabilistic injury of all persons who had been exposed to the hazard in question.

Since deterrence is unlikely to be 100 percent effective, ex ante regulation is strongly indicated when the regulated activity can give rise to catastrophic injury. The greater the injury if deterrence fails and the likelier deterrence is to fail, the stronger the case for ex ante regulation. Even if 99 percent of building collapses, but only 10 percent of drug offenses, can be prevented by ex post regulation (suits for negligent design or construction in the first case, criminal punishments in the second), the social cost of the 1 percent of building collapses may exceed the social cost of the 90 percent of drug offenses. If it also exceeds the cost of prevention by the enactment and enforcement of building codes, then ex ante regulation is justified in the building's case. Reinforcing this conclusion is the fact that positive correlation between the gravity of the injury and the likelihood that deterrence will fail. They are positively correlated because the limited solvency of potential injurers is likely to make the expected cost to them of the injury (for remember that we are assuming a grave injury) lower than the expected social cost.

A similar example is public inspections of restaurants and food-processing plants versus relying entirely on threat of negligence suits to prevent food poisoning. In the case of restaurants, the owners would often be judgment-proof, so in the absence of a system of public inspections people would be very reluctant to patronize a small or new restaurant. In the case of food-processing plants, carelessness can result in mass injuries the costs of which to the victims might exceed the ability to pay of the negligent food processor.

This point also helps to explain the different regulatory systems for new drugs and for medical procedures. A drug sold to millions of people can, if it is unsafe, wreak enormous harm, whereas individual cases of medical malpractice injure only one patient. Moreover, it is feasible to test every new drug, and thus determine safety in advance, but infeasible to require physicians to seek approval from a regulatory agency for every procedure they perform. Consistent with this analysis, ex ante regulation is the dominant mode of regulation of new drugs, while ex post regulation in the form of medical malpractice suits is the dominant mode of regulation of medical treatment. Medical education and apprenticeship (residency) also play a major role in preventing malpractice, but that is not the focus of the training.


Excerpted from Regulation versus Litigation Copyright © 2011 by National Bureau of Economic Research. Excerpted by permission of The University of Chicago Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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