Notes Optimal Subsidies and Damages in the Presence of Judicial Error

Many regulations and legal rules are framed in terms of standards of behaviour; regulators and courts are liable to make mistakes in enforcing such standards. For instance, some firms that did not emit more pollutants than the standard may be fined while others that did violate the standard escape unpunished. Similarly, a court may find a defendant in breach of contract when in fact, he had performed, and, vice versa, find a defendant who had breached his contract not in breach. The essential problem is that the standards are set in terms of behaviour that is difficult for the regulator/court to observe. So errors will be made in enforcement. The question is then how to adjust for the likelihood of error. One method is to switch to another instrument.’ Another is to vary the standard.* In this paper, I shall present a third alternative: it is to couple an adjustment to the sanction with an appropriate subsidy. The model will refer to judicial error, but is equally applicable to regulatory mistake. In a trial, a court may err in favour of the defendant (Type-I error) or in favour of the plaintiff/prosecutor (Type-II error). These errors impose direct costs on the parties before the court. An example of such a direct cost is the cost of imprisonment of a person mistakenly convicted of a criminal offence. Equally important, since the legal system exists to influence individuals’ choices of activity and care, the prospect of court errors will give rise to indirect costs by affecting such choices. The objective of this paper is to focus on the indirect costs and in particular, to propose methods to correct for both types of error so as to ensure that individuals will make socially efficient choices of activity and care.3 The main results of this paper may be summarized as follows. First, to the extent that an individual who has not violated the law will be made to pay damages, the cost of violating the law, relative to not doing so, will be reduced. The result will be more violations of the law. Hence, to ensure that the choice between violation and non-violation reflects the social cost, it