Tort law and internalization: The gap between private loss and social cost

Abstract

A central theme in the economic analysis of tort law is that the imposition of tort liability on injurers is a mechanism for internalizing harmful externalities that emerge whenever injurers fail to take into account the loss they inflict on victims. These externalities create divergence between the higher social cost of the damaging activity and the lower private cost to the injurer. This divergence may violate the marginal conditions of optimal resource allocation, and become a major cause of inefficiencies. Tort law solves the problem, so goes the argument, by imposing liability that internalizes the externalities and eliminates the divergence. This article examines and questions the basic assumption on which the whole concept of internalization through tort law is predicated, namely, that the loss for which liability is imposed is basically equal to the harmful externality that should be internalized. The main argument is that, contrary to the above assumption, tort law may often internalize a private loss in excess of externalized social cost. This gap between the higher private cost to victims (that tort law actually internalizes) and lower externalized social cost (that should be internalized) may lead to over-internalization and consequently to over-deterrence of injurers and under-deterrence of victims. The article detects the origins of this distorting gap, focusing on disregarded positive externalities. It concludes that the Hand Formula and the pure economic loss rule (the exclusionary rule) fail to cope with the gap. The analysis of the gap and its implications offers a new explanation of Coase’s contentious arguments concerning the reciprocal nature of causation and the need to tax victims (double taxation), and leads to the conclusion that Coase would have objected to the mechanism of internalization endorsed by Posner.