Legal economics

Legal economics is the study and practice of making laws that are economically efficient. The application of economic principles adds a theoretical, predictive element by which the effects of a particular law or sanction can be estimated and quantified.[1]

Efficient Level of Precaution

Safety is on such area where economic principles can apply to law, when considering how many safety mechanisms to install on a nuclear power plant or oil pipeline. The first consideration is the basic legal requirement that apply to the industry. Above and beyond that, the considerations pertain to the additional amount of precaution that are required to ensure efficient safety standards. The question is, to what extent should a firm take additional safety measures to ensure an efficient level?

If an oil company has a pipeline, how often should the company survey the pipeline to ensure that there are no leaks in addition to the pipeline being built to the legally required standard? In the event that there is a leak in the pipeline, a large amount of environmental damage could be done and if the oil leaks into the ground water or a river, it could affect human populations as well. Consider the following table:

Level of Precaution Change of Accident Cost of Precautions Cost of Damage
1 95% $1,000 $100,000
2 85% $2,000 $90,000
3 75% $3,000 $80,000
4 65% $4,000 $70,000
5 55% $5,000 $60,000
6 45% $6,000 $50,000
7 35% $7,000 $40,000
8 25% $8,000 $30,000
9 15% $9,000 $20,000
10 5% $10,000 $10,000

The table above illustrates how a firm can determine the efficient level of safety precautions to protect against legal action stemming from a pipeline leak despite the construction meeting the legal standard. This scenario is a case of negligence and the level of precautions is used to mitigate the claim of negligence against the firm.

Each successive level of precaution represents another check of the pipeline for leaks in a week. As there are more precautions taken, the company has to hire more employees or pay the same employee a more to check more often which is a higher cost to the firm.

When there is only one check per week there is a very high chance of a leak, because there are so few checks the chance of a leak being discovered quickly is also low and the damage will be worse the longer it takes to discover the leak.

As the level of precaution increases, the chance of a leak decreases as does the amount of damage that a potential leak would cause. When the level of precaution is 10 checks per week, the precautions taken is considered efficient because the cost of the extra checks ($10,000) is equal to the cost of the damage from a potential leak. The principle of the cost of precautions being equal to the level of damage is known as the Learned Hand Principle.[2]

Graphical Expression

Figure 1. This graph shows the efficient level of precaution taken by a firm to avoid excess damage and legal trouble stemming from a pipeline leak.[3]

This graph shows where the efficient level of precautions is in regards to the cost of a potential or expected leak in a pipeline and the damage resulting from a leak:

  • The Blue Line represents the cost to the firm of adding additional weekly checks for pipeline leaks, as the number of checks increases so does the cost to the firm (see the first two columns in the table above).
  • The Red Curve indicates the cost is a potential leak, as the level of precaution increases the curve slopes downward and the expected cost decreases.
  • At Point A the cost of the precautions is equal to the cost of the expected accident.
  • At any point above the Blue Line the cost of a potential accident exceeds the cost of precautions. Likewise, at any point below the Blue Line the cost of a potential accident is less than the cost of precautions.
  • Point A corresponds to the last row of the table above where the cost of the precautions taken is $10,000 as is the cost of a potential accident.

The graph extrapolates beyond the last row of the graph, if the next row was:

Level of Precaution Change of Accident Cost of Precautions Cost of Damage
11 3% $11,000 $9,000

The cost of the precautions is more than the cost of the damage from a potential leak. This corresponds to Point B on the graph. As Point B is below the Blue Line it is an inefficient level of precaution because it overcompensates for a potential leak.

United States v. Carroll Towing

The legal case United States v. Carroll Towing is the case that established the Learned Hand rule.[4] Justice Learned Hand established an algebraic formula for determining the efficient amount of precaution a person or firm should take to avoid an accident. The Justice concluded that the level of precaution should be equal to the cost of an expected accident in order to avoid a successful charge of negligence against the firm.[5] The idea being that the cost of avoiding the accident should equal the cost of the accident. This rule has the effect of inducing people and firms to take the appropriate level of precaution above and beyond the legal minimum.

See Also


  1. R. Cooter and T. Ulen. Law & Economics. Boston: Pearson Education Inc., 2008, pp. 3.
  2. S. Shavell. Foundations of Economic Analysis of Law. Cambridge: Harvard University Press, 2004, pp. 191.
  3. Created internally by a member of the Energy Education team
  4. United States v. Carroll Towing Co., 159 F.2d 169 (2d Cir. 1947)
  5. A.M. Feldman and J. Kim. "The Hand Rule and United States v. Carroll Towing Co. Reconsidered." American Law and Economics Review, vol. 7, pp. 528, Oct. 2005.