Berkeley Program in Law and Economics

How should a court set legal standards of negligence or performance when one party to a potential future tort or contract case will be uninformed about the standards set by the court? Since the court cannot affect the behavior of the uninformed party, it might set the standard for the informed party at that level which is optimal given the behavior that can be expected of the uninformed. Thus, if the court expects the uninformed to take more than optimal care, it might set a lower than first best standard for the informed party. However, there are circumstances in which the court should maintain the first best standard for the informed party, namely when the uninformed party understands the risk and realizes that the informed party has an incentive to take due care to avoid liability. The uninformed party will then expect to bear the loss himself and will take adequate precautions. Hence, in the oft-occurring situation where the informed party is the injurer and acts first, it can be possible to induce the first best outcome under the negligence rule; the negligence rule may then, due to its discontinuity, be superior to strict liability. Maintaining the first best standard for the uninformed victim may, on the other hand, not be optimal; it is a weakly dominant strategy for the court to set a lower standard, since doing so will increase the informed party’s incentive to take due care without affecting the behavior of the uninformed party. When the conditions under which first best can (in theory) be realized are not met, as when it is not rational for the victim to believe that the injurer acts with due care, the task for the court is complicated by the fact that it may be optimal to either raise or lower the standard of due care for the informed party compared with the first best. As a further complication, which standards are optimal depend on whether the informed party is the victim or the injurer and on who acts first.