Law and Macroeconomics as Aggregate Demand Externalities: An Application to Optimal Tort Law

Abstract

This paper presents one method for introducing macroeconomic concerns into the standard microeconomic models of law, using the canonical economic model of tort law as an example. When an economy suffers from inadequate aggregate demand, expendi-tures on precautions to avoid injuries have aggregate demand externalities. In addition to reducing damages from injury, expenditures on precautions raise incomes for the sellers of precautions (e.g., car brake mechanics). With higher incomes, the sellers, in turn, con-sume and invest more. This multiplier effect of the original expenditure on total spending and output can be modelled as an aggregate demand externality and incorporated into the standard economic models of law. When I introduce aggregate demand externalities into the seminal economic model of tort law, we come to very different conclusions than is standard. Specifically, the strict liability rule and the Hand Rule for negligence both pro-duce inefficient outcomes with respect to expenditures on precaution and activity levels. Instead, negligence rules with more stringent standards of care than the Hand Rule be-come more efficient. If standards of care get too high, however, then an enhanced negligence rule no longer yields a better outcome than strict liability or the Hand Rule. Optimal tort law therefore looks very different when we introduce aggregate demand ex-ternalities. If efficient tort law changes when we introduce macroeconomic effects, then we can presume that our law and microeconomic conclusions regarding other areas of law will change as well.