A new case for a higher standard of care:The uncompensated tertiary and third-party costs

The standard economic analysis of liability rules primarily focuses on the direct accident costs eligible for compensation. However, accidents often create other costs that are as large as, or even higher than, the direct accident costs, which remain uncompensated because their compensation is legally inadmissible or impracticable. In this paper, we present a simple model of the uncompensated tertiary and third-party costs associated with accidents. We show that including these costs in the conceptualization of the due level of care, even without increasing compensation, significantly improves the relative efficiency of fault liability over strict liability. We show that if the due care level is enhanced appropriately to account for the uncompensated costs, fault liability yields higher social welfare than the standard strict liability. This claim holds even under variable activity levels. We show that the welfare-maximizing and incentive-compatible due care level is higher than what Hand’s rule will suggest. Further, the superiority of fault liability with enhanced care standard over strict liability increases with the importance of uncompensated costs relative to direct accident costs. Moreover, the fault-based liability, we propose, provides an “error-tolerant” mechanism and performs better than the alternatives across several categories of accidents. Thus, we provide a new case for the high-standard-based fault liability vis-à-vis strict liability.