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Calculating economic damages in litigation matters

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Calculating economic damages in litigation matters

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Content INFORMATION TO USERS This manuscript has been reproduced from the microfilm master. UMI films the text directly from the original or copy submitted. Thus, some thesis and dissertation copies are in typewriter face, while others may be from arty type of computer printer. The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleedthrough, substandard margins and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send UMI a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. Oversize materials (e.g^ maps, drawings, charts) are reproduced by sectioning the original, beginning at the upper left-hand comer and continuing from left to right in equal sections with small overlaps. Each original is also photographed in one exposure and is included in reduced form at the back of the book. Photographs included in the original manuscript have been reproduced xerographically in this copy. Higher quality 6” x 9" black and white photographic prints are available for any photographs or illustrations appearing in this copy for an additional charge. Contact UMI directly to order. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. A Beil & Howell information Com pany 300 North Z eeb Road. Ann Arbor. M l 48106-1346 USA 313/761-4700 800:521-0600 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CALCULATING ECONOMIC DAMAGES IN LITIGATION MATTERS by Mark Mckinley Gilbreth Copyright 1996 A Thesis Presented to the FACULTY OF THE GRADUATE SCHOOL UNIVERSITY OF SOUTHERN CALIFORNIA In Partial Fulfillment of the Requirements for the Degree MASTER OF ARTS (Economics) August 1996 Mark Mckinley Gilbreth Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Number: 1381585 UMI Microform 1381585 Copyright 19%, by UMI Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. UMI 300 North Zeeb Road Ann Arbor, MI 48103 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UNIVERSITY OF SOUTHERN CALIFORNIA THE GRADUATE SCHOOL UNIVERSITY PARK LOS ANGELES. CALIFORNIA 8 0 0 0 7 This thesis, written by Mark McKinley Gilbreth_________ ________ under the direction of h. is. Thesis Committee, and approved by all its members, has been pre sented to and accepted by the Dean of The Graduate School, in partial fulfillment of the requirements for the degree of Mftstgrs , o.f. . Economics____________________ D tan T in t, August 6, 1996 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS First of all I would like to thank Dr. Nake Kamrany and Dr. Michael DePrano for their support and guidance in the preparation of this thesis. I also would like to express my gratitude to Cindy P. Wilson, without whose loving support this thesis would not have been possible. Additionally, I would like to thank my parents, Stephen M. Gilbreth and Dene Gilbreth, for their continued support of all of my endeavors. A special thanks is addressed to my associates, Darryl R. Zengler, Marianne Inouye, Dan Braun and Kirsten Gormly for putting up with me for the last three years. ii Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS ACKNOWLEDGEMENTS......................................................................... ii LIST OF TABLES...................................................................................... iv LIST OF FIGURES..................................................................................... vi Chapter Page 1. INTRODUCTION.............................................................................. 1 2. INTEREST RATES AND PRESENT VALUE................................ 7 3. ESTIMATING NOMINAL WAGE GROWTH................................ 23 4. WORKLEFE EXPECTANCY VERSUS PROBABILITY OF EMPLOYMENT............................................... 32 5. ESTIMATING EARNINGS BASES................................................. 39 6. FRINGE BENEFITS......................................................................... 46 7. HOUSEHOLD SERVICES............................................................... 55 8. HEDONIC DAMAGES.....................................................................64 9. CONCLUSION.................................................................................. 70 BIBLIOGRAPHY....................................................................................... 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES Table Pa] 1. Nominal Low, Medium and High Risk Rates.......................................8 2. Nominal Annual Earnings Growth by Sector..................................... 26 3. Weighted Versus Straight Average of Historical Earnings Growth................................................................ 29 4. Age Earnings Profile.......................................................................... 34 5. Present Value of Lost Earnings Assuming Zero Growth and Interest Rates (Probability of Employment Approach)............................................ 35 6. Present Value of Lost Earnings Assuming Zero Growth and Interest Rates (Worklife Expectancy Approach)..................................................... 35 7. Present Value of Lost Earnings Assuming No Growth and 3% Interest (Probability of Employment Approach)............................................ 37 8. Present Value of Lost Earnings Assuming No Growth and 3% Interest (Worklife Expectancy Approach)..................................................... 37 9. Mean Annual Earnings....................................................................... 43 10. Age Earnings Index............................................................................. 44 11. Employee Benefits Expressed as a Percentage of Payroll........................................................................ 49 12. Treatment of Non-Wage Fringe Benefits as an Addition to Lost Gross Earnings in Wrongful Death........................................... 50 13. Average Number of Hours Devoted to Household Services by Working Couples......................................... 60 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF TABLES Table Page 14. Average Number of Hours Devoted to Household Services in Female Headed Households......................... 61 15. Average Number of Hours Devoted to Household Services for Couples with the Male Only in Labor Force................. 62 16. Estimates of the Value of Life in Wage-Risk Studies (Thousands of 1988 Dollars)............................................................ 65 17. Values of Life from Studies of Consumer Behavior (Thousands of 1988 Dollars)............................................................ 66 18. Value of Life in Surveys (Thousands of 1988 Dollars)............................................................ 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. LIST OF FIGURES Figures Page 1. Treasury Yield Curve..........................................................................9 2. Present Value Versus Interest Rates................................................... 13 3. Present Value of Earnings Discounted at 10 Percent Per Annum 18 4. Present Value Bias Associated with Annual Discounting When Individuals are Paid Weekly or Monthly.................................. 20 5. Present Value Bias of Half-Year Approximation When Individuals are Paid Weekly or Monthly.................................. 21 6. Present Value of $25,000 Per Annum For 40 Years Discounted at 6 Percent Per Annum...................................................24 7. Probability of Employment (White Female College Graduate)...................................................... 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 1 INTRODUCTION Forensic economics is a burgeoning field. The role of the forensic economist is to assist juries in quantifying the economic damages sustained by individuals or businesses due to specific injuries or incidents. This thesis is an in-depth investigation and analysis of the methodologies of forensic economists. Economists were first introduced to the courtroom in the early twentieth century to testify on matters regarding patent infringement and antitrust legislation. Later, in the early 1950's, economists began to be called upon to quantify damages regarding injuries to people and/or businesses. Today there are many practicing forensic economists each of whom, at times, seemingly has his or her own method for calculating losses. It is the role of the forensic economist to provide an estimate of the amount of money necessary to make an individual (or family) who has suffered a life-altering injury economically whole again. Accurate methods for calculating losses, then, are crucial to the comfort, or even survival, of those affected by such injuries. In the case of an individual who is completely disabled and confined to a wheelchair for the rest of his life, a slight error in an economist's judgement could lead to the injured party not having enough money to feed or house himself as time passes. If Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. this individual were to require 24-hour assistance, for example, and were to run out of money, it could cost him his life. Another example illustrating the importance of the accuracy of the forensic economist is that of a young family that has lost its primary wage earner. It is then the responsibility of the economist to calculate the amount of money necessary to ensure that the family will retain the same standard of living the deceased parent would have provided. In this case, an error in the economist's judgement could mean the difference between the children receiving a high school versus college education, or growing up in safe versus a dangerous neighborhood. These two examples underscore the importance of the role of the forensic economist. Small errors can drastically affect the lives of those who have already suffered losses. A forensic economist is faced with the difficult tasks of forecasting future wage increases, estimating individuals' earning capacities, calculating the replacement value of work done around the house, dividing household consumption among its members and putting a dollar sign on human life, to name a few. The methods used in tackling these tasks are somewhat varied due to the lack of standardized training in this field. Even the National Association of Forensic Economists, NAFE, has no regulatory role and the sole requirement for becoming a member is a $52 annual fee. The lack of standards or regulations combined with the fact that Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. most universities do not offer a course in forensic economics means that the requirements for becoming a forensic economist are, at best, weak. While the practices of current forensic economists can be very divergent, there are only a handful of generally accepted methods currently in use. This thesis is both a study of these methods and a guide to projecting future losses. In it, the following topics are covered: the choice of an appropriate interest rate in calculating present values; estimating inflation and wage growth; the use of worklife expectancy versus probability of employment; generally accepted methods of estimating earnings bases and fringe benefits; the value of household services; and hedonic damages. Although forensic economics is an emerging field there is already an abundance of publications, predominantly in the Journal of Forensic Economics, on each of the above-mentioned topics. Although industry leaders such as Michael L. Brookshire, Peter C. Eisemann, William F. Landsea, W. Cris Lewis, and Ted R. Miller have covered all of the topics that are discussed in this thesis, there exists no text which covers most of the topics in forensic economics and is designed to introduce economists to this field. In an attempt to set forth some guide to calculating economic damages, this thesis compiles, compares and builds upon historical research on each of these subjects. 3 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 1 discusses California judicial instructions concerning interest rates and the wide range of rates of return offered in financial markets, concluding that insurance company annuities offer a prime choice of interest rates when calculating the present value of economic losses. Additionally, the importance of intra-year discounting is demonstrated in a discussion of the time value of money and in exposing the common error of assuming individuals get paid once a year when calculating present values. Two opposing views on the necessity of intra-year discounting are discussed in a review of articles by Peter C. Eisemann and William F. Landsea. Chapter 2 examines the differences between industry-specific and economy-wide nominal earnings growth rates when forecasting future earnings streams. This chapter also discusses some generally accepted methods of forecasting future nominal earnings growth rates. Additionally, this chapter covers the topic of inflation and its role in nominal earnings growth, concluding that as long as both the nominal growth rate and interest rate contain similar estimates of inflation, the accuracy of the estimated present value is not affected by unforeseen swings in inflation. Both the use of worklife expectancy and probability of employment statistics in calculating economic losses are acceptable under certain circumstances; however, Chapter 3 concludes that the use of worklife expectancy in calculating an Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. individual's economic losses, at times, provides a different present value than the use of the probability of employment. Chapter 4 examines different methods of estimating earnings bases concluding that it is best to use an earnings base as specific to the individual as possible. Additionally, this chapter covers the importance of using age earnings indices when projecting earnings bases into the future. When calculating the value of lost fringe benefits, forensic economists debate whether to use the employer cost or the employee utility method. Chapter 5 covers the debate between Robert Rosenman, a proponent of the employee utility method, and Thomas J. Romans and Frederick G. Floss, proponents of the employer cost method, concluding that using employer cost is the most practical method. This chapter also discusses which benefits to include and which benefits, if included, would result in double counting. Chapter 6 examines the direct output method, supported by J. Thomas Romans and Frederick G. Floss, and labor value method, advocated by Thomas R. Ireland and John O. Ward, of calculating the value of lost household services and concludes that the labor value approach, while not without flaws, is the most appropriate method. This chapter also evaluates the relationship between family Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. structure and size and the average number of hours contributed to household services. There are several prevalent methods of calculating hedonic damages. Chapter 7 describes each of these methods, concluding that currently no method exists that can provide an estimate of the value of life on more than a speculative basis. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 2 INTEREST RATES AND PRESENT VALUE Choice of interest rates in discounting future payment streams is the most highly contested topic in forensic economics. This chapter first introduces a wide variety of interest rates, illustrating the importance in the choice of a discount rate in calculating present values. Second, it describes the factors that contribute to an economist's choice of interest rate. Third, it discusses the need for intra-year discounting to more accurately calculate present values. Interest Rates and Present Value When calculating future losses an economist must do so in present value terms. The present value of a future stream of income is the value that if invested today would replicate the future stream. This leads economists to perhaps their most challenging task, choosing appropriate interest rates for the purposes of calculating present values. When choosing future interest rates economists look at both current and historical returns offered by a wide range of investments. The nominal rates associated with these investments can be divided into three categories: low risk; medium risk; and high risk. Some of these rates are illustrated in Table 1. with permission of the copyright owner. Further reproduction prohibited without permission. Table 1: Nominal Low, Medium and High Risk Rates Low Risk Standard Savings Discount Rate 3-Month Treasury Bills Federal Funds Rate 2.00% 5.25% 5.28% 5.75% Medium Risk Insurance Company Annuities AAA Corporate Bond Rates 10-Year Treasury Bonds 5.90% 6.15% 5.92% High Risk Credit Card Rates Junk Bonds 21.00% 21.00% Source: Wall Street Journal, November 1995. Examples of low risk rates are the discount rate, treasury bill rates, savings account rates, NOW account rates and the federal funds rate. NOW accounts, c Negotiable Order of Withdrawal accounts, are simply interest bearing checking accounts from which withdrawals can be made. The standard savings account allows an investor to retrieve his investment upon demand and is backed by the government up to $100,000. Consequently, the standard savings account yields a very small return on investment. Treasury bills are also relatively risk-free investments. They are backed by the government, but differ from the standard savings account in that they require an investment for a pre-determined period of time. The rate of return on treasury Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 1: Treasury Yield Curve. Treasury Yield Curve 7.0% 6.5% .a 6.0% 5.5% ■ 5.0% 30 10 5 7 0.5 1 2 3 Maturity in Years Source: Wall Street Journal, November 1995. securities varies with the maturity date of the investment. Typically the yield on treasury securities increases with the maturity date, as seen in Figure 1. The discount rate is another example of a low risk rate. The discount rate is the rate charged by the Fed to banks that borrow from it to meet temporary needs for reserves. However, this rate is not available to the public. The federal funds rate can also be considered a low risk rate and is the rate charged by banks to other banks. Federal funds are federal reserves that some Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. banks have in excess and allow others to borrow in order to meet deposit requirements by the Fed. However, this rate is not available to an individual. Insurance company annuity rates, AAA corporate bond rates, and long-term treasury bonds are examples of medium risk rates. Insurance company annuities "traditionally provide fixed-income payments for an individual's remaining lifetime in exchange for a lump-sum cash payment."1 Insurance company annuity rates are a function of both the expected life of the annuity, or annuitant, the rating of the insurance company issuing the annuity and the market rate of interest. As in the case of T-bills, the longer the expected life of the annuity, or annuitant, typically the greater the yield on investment. While it is impossible to precisely predict the remaining life of individuals purchasing annuities, insurance companies use mortality statistics to calculate their remaining life expectancy. Additionally, the stronger the rating of the insurance company offering the annuity, the lower the rate of return offered on the annuity. This inverse relationship reflects the willingness of the investor to accept a lower rate of return on investment for the opportunity to invest in a more financially sound company. 1 John Downes and Jordan Elliot Goodman, Finance & Investment Handbook, Barron (1990), 9. 10 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The fact that the income stream provided by an insurance company annuity typically does not terminate until the death of the investor is a benefit unique to this instrument. This is beneficial because while economists can calculate the average life expectancy of an individual, they cannot pinpoint precisely how long an individual will live. Investing in insurance company annuities ensures that an impaired individual, incapable of working, will continue to receive income even past his 100th birthday should he live that long. Structuring an investment portfolio with instruments other than insurance company annuities fails to protect an impaired individual from the possibility that he will live a long life. AAA corporate bonds are bonds issued by corporations enjoying a Standard & Poor's AAA rating. A bond is a special kind of promissory note which promises to pay interest, every six months or so, for a number of years until it matures. At maturity, the corporation promises to pay off the principal of the bond at its face value. The rate of return offered on corporate bonds is also a function of the rating of the corporation, in this case AAA, offering the bond, the time to maturity of the bond, and the market rates of competing instruments. While long-term treasury bonds are similar to short-term treasury bills in that they are backed by the government, they also include an inflationary risk. This inflationary risk is the result of the longer period of investment typical of T-bonds. 11 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Following the purchase of any fixed return investment, its value varies inversely with fluctuations in inflation. The rates charged by credit card companies exemplify high risk rates. These high rates are necessary to offset the risk involved in lending money to individuals without collateral or a guarantor. Junk bonds also offer high rates of return. These high rates of return are consistent with the high level of risk facing corporations issuing these bonds. Table 1 shows that, as of July, 1996, these rates ranged from a low risk rate of 2 percent to a high risk rate of 21 percent. The importance of the choice of interest rate is shown in figure 2, based upon the following present value formula: n Present value = £ [C/(l+r)‘ ] (1.0) t=l where C is the annual payment and r is the annual interest rate. Figure 2 is a graph of the present value of a future stream of payments, $25,000 per annum over 40 years, against the interest rate used in calculating the present value. It is obvious from Figure 2 that the choice of interest rate is of utmost importance in calculating the present value of a future stream. Choosing a 5 percent rather than 7 percent interest rate, for example, increases the present value of a stream of payments by over 26 percent. In Figure 2 the choice of a 5 percent rather than 7 12 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 2: Present Value versus Interest Rates. Present Value versus Interest Rates $900,000 $800,000 $700,000 „ $600,000 a | $500,000 1 $400,000 Present Value of $25,000 Per Annum over 40 years $300,000 $200,000 $100,000 $0 o o O ' Interest Rates percent interest rate increases the present value from roughly $356,000 to $450,000. An economist must be extremely careful to consider a number of critical factors when selecting an appropriate discount rate. The factors that play a part in an economist's choice of an interest rate in California are: BAJI guidelines; risk criteria; and time horizon. BAJI, Book of Approved Jury Instructions, is the set of jury instructions set forth by the supreme court of the State of California. BAJI includes basic guidelines for, among other things, the calculation of economic losses. BAJI instructs the following: Factors in Choice o f an Interest Rate 13 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Present cash value is the present sum of money which, together with the investment return thereon when invested so as to yield the highest rate of retum.QflnsistsDtwilh reasonable .s^aiDly, will pay the equivalent of lost future benefits at the times, in the amounts, and for the period that you find such future benefits would have been received.2 Although the "highest rate of return consistent with reasonable security" leaves a great deal to the interpretation of individual economists, it excludes those high risk rates offered by credit cards and junk bonds as they are not consistent with reasonable security. Additionally, BAJI instructs that an investment vehicle "pay the equivalent of the lost future benefits at the times, in the amounts, and for the period that you find such future benefits would have been received." This limits economists to investments available to an injured party that could replicate the pre-injury probable payment schedule. This includes T-bills, AAA corporate bonds and insurance company annuities. The federal funds rate and the discount rate do not apply to investments available to the public and therefore could not be used by plaintiffs to reconstruct a future payment schedule. A forensic economist must also consider the time horizon when choosing an interest rate. As illustrated earlier in Figure 1, the rate of return on an investment varies with the maturity date of the investment. Typically, the rate of return 2 Paul G. Breckenridge, California Jury Instructions, 8th Edition, West Publishing Company (1994), 14.70. 14 with permission of the copyright owner. Further reproduction prohibited without permission. increases as the maturity date moves further into the future. An economist must therefore evaluate each case individually when choosing an interest rate. For example, while a rate of return consistent with a 3 month investment might be the best choice when projecting earnings over the next couple of months, it would not be the most accurate choice when discounting a stream of earnings over the next 50 years. The choice of interest rate can therefore be narrowed to four medium to low risk investments: medium to long term treasury securities; long-term treasury bonds; insurance company annuities; and, AAA corporate bonds. Each of these investments is available to individuals, falls into the broad category of "reasonable security", and is able to reflect the time period of the earnings to be replicated. The majority of forensic economists choose one of these four rates when calculating present values. These choices, as illustrated in Table 1, provide a range of 5.28 percent to 6.15 percent. Although this range is much reduced, it still provides a difference of approximately one percent. The significance of this difference is easily seen in Figure 2. The statement "consistent with reasonable security" can be interpreted further to mean that a rate of return consistent with a risk-free investment should not be among our interest rate choices. Since short-term treasury bills are backed by the government and its ability to print money and include virtually no inflationary risk, 15 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. they are generally considered to be a relatively risk free investment and can therefore be dropped from our investment choices. This leaves us with the rates on insurance company annuities, AAA corporate bonds and long-term treasury bonds, currently providing a range of about one quarter percent as seen in Table 1. All of these rates meets the criteria discussed above and can be averaged to arrive at a final interest rate. However, insurance company annuities are used much more frequently than the others when actually replacing an injured party's lost payment stream. Many forensic economists also incorporate historical rates of return in their choice of an interest rate. For example, economist A may average the past 20 years of insurance company annuity rates to arrive at an appropriate rate. The work done by these economists is merely redundant at best. Historical data has already been incorporated in the rates currently available. Every workday, Monday through Friday, the many finance minds in the world use all the resources available in predicting future rates of return. Their predictions are an implicit part of the rates of return offered on all investment vehicles. Therefore, historical information has already been incorporated in the rates we find everyday in the Wall Street Journal. 16 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Intra-Year Discounting The need for intra-year discounting is a topic that has been very heavily debated over the past five years. The issue was brought to the forefront of the field in a 1992 article published by Peter Eisemann. In that article Eisemann demonstrated and measured the bias in calculating the present value of lost income when an economist ignores the usual income streams, such as weekly, monthly, etc., and simply assumes that the individual's annual income is received in a one lump sum at the end of the year. Eisemann concluded that because of these biases, and the complicated nature of intra-year discounting, there is a need for an adjustment table to eliminate these biases. The biases calculated by Eisemann resulted from the fact that employees are traditionally paid weekly, bi-weekly or monthly but economists predominantly discount on an annual basis. The bias associated with discounting on an annual basis is easily illustrated. For example, imagine deceased individual A would have earned $1,200 the first day of each year for 10 consecutive years, while deceased individual B would have earned $100 on the first day of each month for 10 years, but for their deaths. Each of the decedents would have earned the same amount, $12,000, over the 10 year period. However, as seen in Figure 3, the present values of their earnings, discounted to the present using an annual interest rate of 10 percent, are substantially different. 17 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Although in the past, discounting on an annual basis was much less time- consuming than intra-year discounting, with today's technology intra-year discounting can be just as easy and is much more accurate. The bias associated Figure 3: Present Value of Earnings Discounted at 10 Percent Per Annum Piesent Value of Earnings Discounted at 10 Percent Per Annum E 5 o o jS > g a. SI 8,000.00 SI 6,000.00 514,000.00 SI 2,000.00 S 10,000.00 $8,000.00 $6 ,000.00 $4,000.00 $2 ,000.00 O ~ <N o Year -[Deceased Individual A $12,000 Earned the First Day of Each Year - Deceased individual B : $1,000 Earned the First Day of Each Month with discounting on an annual basis is a function of the intra-year pay period and the interest rate used to discount earnings to the present. Incorporating a growth rate, the present value formula can be written as follows: n Present value = £ [CO+g^'VO+r)*] (2.0) t=l 18 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. where C is the annual payment, r is the annual interest rate, g is the annual growth rate and n is the number of years. This formula precisely calculates the present value of a future annual payment stream. However, discrepancies arise when this formula is used to calculate the present value of future streams of payments that are not made on an annual basis. The following formula, published by Eisemann (1992), allows us to take into consideration payment periods of other than an annual basis: n m Present value = £ [ £ C/( 1 H -r* )1 ] [(1 +g),l/( 1 H -r)1 1 ] (3.0) t=l i=l where m is the number of payments per annum and r* is the intra-year interest rate found by solving (l+r')m = (1+r) for r . The bias caused by using equation (2.0) can be determined by solving the following equation for a. n m n I [ £ C/(l+r*)i][(l+g),-1 /(l+r)-1 ] = a£ [C(l+g)‘ -V(l+r)T t=l i=l t-1 The result is as follows: a = r/r*m Figure 4 is a graph of the bias associated with discounting on an annual basis when payments are actually received either weekly or monthly. 19 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 4: Present Value Bias Associated with Annua] Discounting when Individuals are Paid Weekly or Monthly. Present Value Bias Associated with Annual Discounting when Individuals are Paid Weekly or Monthly 6.00% 5.00% 4.00% CQ 2.00% - 1.00% 0.00% o NP O ' * © © 00 -weekly pay frequency -monthly pay frequency Interest Rate An alternative method, also discussed by Eisemann, to using intra-year discounting is to rely on annual discounting and adjust the timing assumption to reduce any bias. The most prevalent example of this is the half-year approximation method. Under this method the economist calculates the present value assuming the first payment is in 0.5 years, rather than 1.0 year. This method implies that the injured party would have received one paycheck in the middle of every year. Figure 5 shows the bias associated with using the half-year approximation method. Under the weekly pay frequency, the half-year approximation method shows almost no bias. The monthly pay frequency provides a slightly larger difference, but still falls within .5 percent of the intra-year discounted present value. 20 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 5: Present Value Bias of Half-Year Approximation When Individuals are Paid Weekly or Monthly. Present Value Bias of Half-Year Approximation When Individuals are Paid Weekly or Monthly 0.50% 0.45% 0.40% 0.35% • °-30% J 0.25% 0.20% 0.15% 0.10% - I 0.05% 0.00% Interest Rate —♦ — Monthly Pay Frequency — ■— Weekly Pay Frequency The article written by Eisemann, as well as a similar article by Gary A. Anderson and Joel R Barber (1992), was commented on in the 1995 edition of the same journal in articles by William F. Landsea, Robert D. Foster and Richard L. Ruth. Landsea rejected Eisemann's conclusion that economists should maintain the imprecise practice of discounting on an annual basis and applying adjustments to account for the imprecision. He concluded that with today's technology it is easy enough to incorporate individual's actual pay periods when calculating present values. Foster and Ruth came to similar conclusions rejecting the idea that using an adjustment table is preferred to incorporating the actual pay period. 21 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Conclusion Choosing interest rates when calculating present values can be very tricky. Economists must be aware of the law, the time horizon of the instrument and the nature of the instruments available in order to make an appropriate choice. This chapter has indicated that the guidelines set forth by B AJI along with the need to incorporate the time horizon of investments reduce the acceptable choices of an interest rate to AAA corporate bond rates, insurance company annuity rates and long-term treasury bond rates. Insurance company annuities are the optimal choice due to their flexibility with regard to choice of payment periods and termination of payment upon the date of death of the annuitant. Additionally, there is a need for intra-year discounting to accurately calculate the present value of an individual's losses. While there are adjustment tables available to reduce the bias associated with annual discounting, the ease with which an economist can incorporate the actual pay period of an individual and the resulting accuracy mandate the use of intra-year discounting over any table of adjustments. After all, the best any table of adjustment can do is replicate intra-year discounting. 22 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 3 ESTIMATING NOMINAL WAGE GROWTH The choice of a future rate of wage increases, though not as highly contested as the choice of an appropriate interest rate, plays an important role in determining the present value of a future stream of payments. This chapter first demonstrates the importance of nominal growth rates in calculating present values. Second, it describes the pros and cons of using industry-specific versus economy-wide growth rates. Third, it explains the most prevalent methods of estimating future nominal earnings growth rates. Fourth, it covers the question of whether or not the economist should remove inflation from nominal growth estimates. Earnings Growth and Present Value Similar to the choice of an interest rate, the choice of a future earnings growth rate plays an important role in determining the present value of a future stream of payments. For instance, recall the example from Chapter 1 involving a future stream of payments of $25,000 per annum over the next 40 years. Holding the interest rate fixed at 6 percent per annum, the present value of the stream of payments can be plotted against a range of future earnings growth rates as seen in Figure 6. The present value formula is written as follows: 23 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Present Value = £ [Cfl+g^'VO+r)1 ] t=l where C is the annual payment, r is the annual interest rate, g is the annual growth rate and n is the number of years. Figure 6: Present Value of $25,000 Per Annum For 40 Years Discounted at 6 Percent Per _______________Annum._____________________________________________________________ Present Value o f $25,000 Per Annum For 40 Years Discounted at 6 Percent Per Annum $ 1,000,000 $800,000 * 3 | $600,000 £ $400,000 $200,000 3% 5% 6% 7% 2% 4% 1% Growth Rate Figure 6 emphasizes the importance of accurately choosing a future growth rate when calculating the present value of a future stream of earnings. Choosing a 3 percent rather than 5 percent future growth rate, for example, decreases the present value by over 27 percent. In this case, that translates into roughly a $220,000 difference. An economist must therefore choose a growth rate very carefully. 24 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Industry-Specific vs Economy-Wide Nominal Growth Rates When choosing a future growth rate an economist has the choice of using an industiy-specific or economy-wide nominal growth rate. It has been argued that the general, all encompassing, economy-wide growth rate is most applicable because it allows for the possibility that the injured party would have changed professions, and possibly industries. Additionally, over the long-run (i.e. 30 years and up) earnings growth in all sectors of the economy tend to converge. On the other hand, an argument for the use of an industry-specific growth rate states that more often than not economists are valuing a lost stream of payments for the short-run and, in those cases, the injured party's earnings would certainly have experienced a growth rate similar to that of his or her economic sector. Table 2 illustrates the potential variance in industry-specific versus economy-wide growth rates. Table 2 shows that the economy-wide growth rate of 2.94 percent per annum was over 1 percent per annum higher than growth experienced in the construction sector and over 1.5 percent per annum lower than growth experienced in the finance, insurance and real estate sectors. The impact of this variance in industry- specific versus economy-wide growth rates is illustrated in the following example. 25 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 2: Nominal Annual Earnings Growth by Sector( 1984-1994). Total Private Mining Construction Manufacturing Non-Durable Goods Transportation & Public Utilities Wholesale Trade Retail Trade Finance, Insurance & Real Estate Services 2.94% 2.50% 1.93% 2.76% 2.99% 2.24% 3.07% 2.50% 4.48% 3.85% Source: U.S. Dept of Labor, "Employment and Earnings," (1996). Imagine a construction worker and an insurance salesman are completely disabled in 1984, at which time they were each earning $25,000 per annum. Also, imagine that economists in 1984 had perfect foresight for the 10-year period 1984 to 1994. Economist A employs the economy-wide total private sector growth rate of 2.94 percent per annum. Assuming a 6 percent interest rate and a 10-year period, economist A would arrive at a present value of $216,704 for both the construction worker and the insurance salesman. Conversely, economist B uses the industry-specific growth rates of 1.93 percent and 4.48 percent for the construction worker and insurance salesman respectively. These growth rates are taken from the construction and finance, insurance and real estate sectors in Table 2. Assuming again the 6 percent interest rate and ten year period, economist B would arrive at present values of $206,855 and $232,783 for the construction worker and the insurance salesman, respectively. Economist A 26 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. would have overestimated the construction worker's probable earnings by approximately 5 percent and underestimated the insurance salesman's probable earnings by over 12 percent. While the above example lends itself to the support of using industry-specific growth rates, the argument that wage growth in all sectors of the economy tend to converge in the long-run is widely accepted and strengthens the proposal of an economy-wide growth rate. One popular method used to account for both the variance of growth rates in the short-run and the lack thereof in the long-run is the use of industry-specific growth rates that approach an economy-wide growth rate over time. For example, economist A might employ a weighted average assigning an industry-specific growth rate for each of the first 15 years and an economy-wide growth rate for all years beyond the original 15. This incorporates the period of time into the choice of a growth rate and allows for a large, but decreasing, variance in sector growth rates. Unfortunately, the method of using a weighted average of industry-specific and economy-wide growth rates does not incorporate the possibility that an injured party would have changed industries. While this appears to strengthen the argument for the use of an economy-wide growth rate, statistics on the labor force indicate that although laborers change jobs, on average, every seven years, it is unlikely an experienced laborer will change industries. A computer technician may 27 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. become a computer programmer, but it is unlikely he will ever become an iron worker. Predicting Nominal Earnings Growth After having made the decision between industry-specific and economy-wide growth rates, an economist must choose the appropriate method of forecasting future wage growth. The two most common approaches to forecasting future nominal growth rates both entail examination of the historical increases in wages. The first method simply involves a straight averaging of the growth rates experienced in the past. The only variance among economists employing this technique is the length of time they choose to incorporate. While some economists calculate averages based upon the previous 5 years of earnings growth, others average the growth rates for the past 50 years. Another common method involves calculating a weighted average of the historical increases in wages. This method is inspired by the belief that while rates of growth experienced 10 to 15 years ago may be a good indicator of future growth, the growth rates experienced in the last five years is a great indicator. An example of this type of estimate of future growth would be to take earnings growth over the last 15 years, giving a 60 percent weight to earnings growth over the past five years, a 30 percent weight to earnings growth over the preceding five years, and a 10 percent weight to earnings growth over the initial five year period. 28 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 3 illustrates how both of the above mentioned methods would have fared at approximating future growth rates based upon the 15 years of data from 1969 to 1984. Neither of the methods accurately forecast future rates of growth as result of the substantial drop in inflation experienced over the last decade. While Table 3 does nothing to help the economist differentiate between the two methods of forecasting future wage growth, it poses the important question of whether or not economists should remove inflation and calculate real wage growth rather than nominal wage growth. Table 3: Weighted vs. Straight Average of Historical Earnings Growth. 6-3-1 15 Year Weighted Straight Actual Average Average Growth (1969-84) (1969-84) (1984-1994) Total Private 6.7% 6.9% 2.9% Mining 7.7% 8.1% 2.5% Construction 6.0% 6.4% 1.9% Manufacturing 7.2% 7.3% 2.8% Non-Durable Goods 7.1% 7.3% 2.7% Transportation & Public Utilities 7.2% 7.7% 2.2% Wholesale Trade 7.1% 7.0% 3.1% Retail Trade 6.1% 6.4% 2.5% Finance, Insurance & Real Estate 7.2% 6.6% 4.5% Services 7.3% 7.4% 3.8% Source: U.S. Department of Labor, "Employment and Earnings," (1996). 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Inflation As illustrated in Table 3, changes in inflation pose a significant problem to accurately predicting nominal wage growth. However, if the same estimate of inflation implicit in an economist's prediction of future nominal wage growth is also incorporated in the interest rate used in calculating present value, much of the error resulting from changes in inflation cancels out. For example, imagine economist A calculated the present value of $1 of earnings over the 10-year period, 1984-1994, using the 6-3-1 weighted average nominal growth rate, 6.7 percent per annum, for the Total Private Sector in Table 3. Also, imagine economist A used a 10-year insurance company annuity rate, which was roughly 9 percent in 1984, in discounting the future earnings to the present. He would have arrived at an estimated present value of $8.35. Now, imagine a world with perfect foresight in which both economists and insurance companies know what future inflation will be. First, economist A would have used the actual nominal growth rate experienced in the Total Private Sector, 2.9 percent per annum, over the period 1984-1994. Second, economist A would have again turned to the rate of return offered on 10-year insurance company annuities. However, this time insurance companies are aware of the approaching decline in inflation and offer the 6 percent per annum rate of return consistent with 30 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. the market today. In this world economist A would arrive at a present value of $8.28, less than one percent lower than the estimate based solely on historical data. Obviously, the estimate of inflation implicit in an economist's forecast of future nominal wage growth is not always identical to that of an insurance company. However, as both can only rely on historical data, their estimates of future inflation are likely to be consistent. Conclusion The choice of a future earnings growth rate, though not as highly contested as the choice of a future interest rate, plays a very important role in determining the present value of a future stream of payments. Economists must therefore understand that while, in the short-run, wage growth is very industry-specific, in the long-run, it is generally accepted that it converges to an economy-wide rate. Additionally, while an economist's estimate of future nominal wage growth may be inaccurate due to changes in inflation, it is relatively unimportant if the interest rate used in calculating the present value incorporates a similar estimate of future inflation. 31 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 4 WORKLIFE EXPECTANCY VERSUS PROBABILITY OF EMPLOYMENT When calculating the future loss of an earnings stream an economist is invariably forced to make assumptions as to the length of time an individual would have remained in the labor force. When making these assumptions an economist generally has two choices: the use of probability of employment statistics or a worklife expectancy figure. This chapter discusses each of these methods of determining labor activity and their salient differences. Probability o f Employment The Bureau of Labor Statistics regularly tracks, and irregularly publishes, information on the structure of the labor force based upon four variables: sex, age, race and educational attainment. This information, together with a breakdown of the total stationary population, can be used to derive the probability of employment for any individual given their sex, age, race and educational attainment. Figure 7 illustrates the probability of employment of a white, female, college graduate, ages 18 and up. 32 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Figure 7: Probability of Employment (White Female College Graduate) Probability of Employment (White Female College Graduate) 80% 70% 60% H 50% JO | 40% 1 30% & 20% 10% 0% 18-25 25-35 35-45 45-55 55-65 65+ Age Cohort Source: United States Department of Labor, Bureau of Labor Statistics, Worklife Estimates: Effects o f Race and Education (1986). These probabilities of employment allow economists to attempt to forecast future earnings streams taking into consideration probable labor market inactivity due to factors such as seasonal, frictional or transitional unemployment. 33 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Worklife Expectancy An alternative method of forecasting the future labor market activity of an individual involves the use of worklife expectancy. Worklife expectancy is based upon the probability of employment with the assumption that an individual enters and leaves the labor force only once, i.e., there are never temporary periods of unemployment and once an individual leaves the labor force it is for retirement. In essence, worklife expectancy is the summation of the probabilities of employment for each of an individual's remaining years of life expectancy. For example, if person A has a 70 percent chance of being employed for each of the remaining 10 years of his life expectancy, he would have a seven year worklife expectancy. This may leave one with the false impression that worklife expectancy and probability of employment are actuarial equivalents. They are not. Two separate examples illustrate this point. First, imagine that individual A's future earnings are forecast to follow a traditional profile, as seen in Table 4. Table 4: Age Earnings Profile Age Cohort 18-25 25-35 35-45 45-55 55-65 65+ Eamings Profile $ 20,000 35.000 40.000 45.000 30.000 20.000 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 5: Present Value of Lost Earnings Assuming Zero Growth and Interest Rates. (Probability of Employment Approach). Prob. Years Start End Earnings of of Future Age Age Basis Employ. Earnings Value 1 2 3 4 5 6 18.00 25.00 $ 20,000 0.8000 7 $112,000 25.00 35.00 $ 35,000 0.8000 10 $280,000 35.00 45.00 $ 40,000 0.8000 10 $320,000 45.00 55.00 $ 45,000 0.8000 10 $360,000 55.00 65.00 $ 30,000 0.8000 10 $240,000 65.00 68.00 $ 20,000 0.8000 3 $48,000 $1,360.000 Table 6: Present Value of Lost Earnings Assuming Zero Growth and Interest Rates. (Worklife Expectancy Approach). Prob. Years Start End Earnings of of Future Age Age Basis Employ. Earnings Value 1 2 3 4 5 6 18.00 25.00 $ 20,000 1.0000 7 $140,000 25.00 35.00 $ 35,000 1.0000 10 $350,000 35.00 45.00 $ 40,000 1.0000 10 $400,000 45.00 55.00 $ 45,000 1.0000 10 $450,000 55.00 65.00 $ 30,000 1.0000 3 $90,000 65.00 68.00 $ 20,000 1.0000 0 $0 $1,430,000 Additionally, imagine individual A has an 80 percent probability of employment for each of his 50 remaining years of life expectancy. Under the probability of employment approach, the future value of individual A's losses, assuming no growth, are $1,360,000 as calculated in Table 5. Under the worklife expectancy 35 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. approach, holding all assumptions constant, the future value of individual A's losses are $1,430,000 as calculated in Table 6. In this example, these methods yield losses differing by $70,000, or 5.2 percent. This difference occurs because under the worklife expectancy approach an individual is given a probability of employment of 1.0 during the years of highest earnings, i.e. ages 35 to 55, in lieu of evaluating losses at an age when earnings are significantly lower, i.e. ages 55 and up. An alternative example illustrates that the worklife expectancy method also varies from the probability of employment method due to the time value of money. Assume individual A now has a constant earning capacity of $30,000 per annum thus eliminating any difference due to decreasing earnings. Additionally, assume no growth and a real interest rate of three percent per annum. Under the probability of employment approach, individual A would have a present value loss of $731,161, as seen in Table 7. Alternatively, the worklife expectancy approach would lead to a present value of $821,062, as seen in Table 8. The worklife expectancy approach leads to a 12 percent greater estimate of present value than the probability of employment approach because it does not consider the time value of money. While an individual typically suffers periods of labor market inactivity dispersed throughout his career, the worklife expectancy approach assumes that an individual's earnings 36 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. occur in one continuous stream and, thus, pull future payment streams closer to the present. Table 7: Present Value of Lost Earnings Assuming No Growth and 3% Interest (Probability of Employment Approach). Prob. Years Present Start End Earnings of of Value Present Age Age Basis Employ. Earnings Factor Value 1 2 3 4 5 6 7 18.00 25.00 $ 35,000 0.8000 7 6.3230 $177,044 25.00 35.00 $ 35,000 0.8000 10 7.0391 $197,095 35.00 45.00 $ 35,000 0.8000 10 5.2378 $146,658 45.00 55.00 $ 35,000 0.8000 10 3.8974 $109,127 55.00 65.00 S 35,000 0.8000 10 2.9000 $81,200 65.00 68.00 S 35,000 0.8000 3 0.7156 $20,037 $731,161 Table 8: Present Value of Lost Earnings Assuming No Growth and 3% Interest (Worklife Expectancy Approach). Prob. Years Present Start End Earnings of of Value Present Age Age Basis Employ. Earnings Factor Value 1 2 3 4 5 6 7 18.00 25.00 $ 35,000 1.0000 7 6.3230 $221,305 25.00 35.00 $ 35,000 1.0000 10 7.0391 $246,369 35.00 45.00 $ 35,000 1.0000 10 5.2378 $183,323 45.00 55.00 $ 35,000 1.0000 10 3.8974 $136,409 55.00 65.00 $ 35,000 1.0000 3 0.9616 $33,656 65.00 68.00 $ 35,000 1.0000 0 0 $0 $821,062 37 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Pros and Cons While the previous examples illustrate that the worklife expectancy approach potentially results in a different present value than the probability of employment approach, due to its assumption that an individual's earnings occur in one continuous stream, it is not without its benefits. Economists often use a net discount rate of zero, i.e. the interest rate and growth rate are equal, and an earnings base that does not drop off with age thus eliminating any difference between the two methods. Additionally, some economists say the simplicity of using worklife expectancy, and explaining it to a jury, outweigh the occasional discrepancies. Conclusion The choice between the use of probability of employment statistics and worklife expectancy figures can cause significant changes in the present value of an individual's losses. Economist's should use the probability of employment approach when either of the following conditions are present: (1) when the net discount rate is not zero; (2) when projected earnings change with age. In these cases the worklife expectancy approach's assumption that an individual's earnings occur in one continuous stream pulls future payment streams closer to the present and can create large differences in the projected present value. 38 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 5 ESTIMATING EARNINGS BASES The establishment of the lost earnings base is of fundamental importance in the calculation of lost earnings capacity. This chapter first discusses the most prevalent methods of incorporating an individual's historical earnings in future projections. Second, it covers the use of labor market statistics in forecasting future earnings bases. Third, it explains the benefits of using age earnings indices. Incorporating Past Earnings In 1995, Michael L. Brookshire conducted a study entitled Principles of Establishing, the Lost Earnings Base. In that study he concluded the following: "In determining an earnings base, forensic economists rely when possible upon the earnings history of the specific individual, versus government statistics or other sources." This is evident in the responses to the following question in Brookshire's study: John Doe, a journeyman electrician since 1990, died on December 26, 1993, at the age of 34. Following are Mr. Doe's regular and overtime earnings from 1990 to 1993 (in 1994 dollars). What fiill-year, dollar base would you choose for 1994? 39 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Year Age Straight-Time Wages (In 1994 Dollars) Wage Rate (In 1994 Dollars) Overtime Wages (In 1994 Dollars) Total Wages (In 1994 Dollars) 1990 (31) $23,920 $11.50 $3,450 $27,370 1991 (32) $24,752 $11.90 $1,785 $26,537 1992 (33) $25,480 $12.25 $2,481 $27,961 1993 (34) $26,520 $12.75 $2,200 $28,720 1994 Base = $ . The responses to this question were as follows: Mean = $28,571 Quartj]e Values Base lit Pollaps 100% (maximum) $30,443 75% $29,500 50% (median) $28,720 25% $27,647 0% (minimum) $25,168 These results support the conclusion that forensic economists, given the opportunity, consistently rely on an individual's earnings history when forecasting future losses. They can be further interpreted to show that half of economists choose to rely on the historical earnings trend, half disregard trends and estimate future earnings bases using historical averages. For instance, half of the economists polled chose a base of equal to or greater value than $28,720, leading to the conclusion that they believed that a trend in 40 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. historical earnings is more applicable than an average. Conversely, the other half of the economists polled chose a base which most likely represents an average of historical earnings. The following question in Brookshire's study indicates that the proportion of economists relying upon a trend in earnings rather than an average is consistent when the earnings trend is reversed: John James owned a small construction company at the time of his death on January 1, 1994. Following are the (Schedule C) profits of the business. What fiill-year, dollar base would you choose for 1994? Year Age Earned Income (In 1994 Dollars) 1987 (44) $65,000 1988 (45) $63,000 1989 (46) $55,000 1990 (47) $41,000 1991 (48) $32,000 1992 (49) $39,000 1993 (50) $34,000 1994 Base = $. The responses to this question were as follows: Mean = $37,367 Ouartile Values gase Jn Dollars 100% (maximum) $47,000 75% $40,200 50% (median) $36,500 25% $34,000 0% (minimum) $23,571 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. In this case the earnings trend has been reversed and economists are similarly split between relying on an earnings trend and a historical-average. For example, approximately 25 percent of economists polled chose an earnings base identical to, or less than, the last year of earnings. These economists appear to place greater emphasis on the downward trend in earnings experienced prior to the injury. Conversely, at least half of the economists polled chose an earnings base that reflects an average of historical earnings. These two cases support the conclusion that economists are relatively evenly split when it comes to relying on trends or averages in arriving at an earnings base. This lack of industry-wide agreement emphasizes the importance of evaluating which method best suits each individual case. For example, a downward trend in earnings for an older individual approaching retirement merits a continuation of said trend. However, traditional business cycles should not be ignored, for example, a downward trend in earnings for a 30 year-old construction worker in the early 1990's should not be projected into the future because there was a recession in the housing market over that time period. Government Statistics Although forensic economists may prefer to use an earnings base supported by historical earnings, they are frequently forced to evaluate losses without the benefit 42 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. of a demonstrated earnings capacity. When this occurs an economist must rely upon labor market statistics to provide them with an estimate of an earnings base. The most common statistics used in lieu of a demonstrated earnings capacity are those published by the Bureau of the Census on the mean annual earnings of individuals by age, sex and education. Mean annual earnings statistics are published annually in Money Incomes o f Households, Families, and Persons in the United States. Table 9 lists the mean annual earnings of a female and male college graduate by age. Table 9: Mean Annual Earnings. Male Female Age College College Cohort Graduate Graduate 22-25 $ 26,056 S' 21,493 25-35 40,345 30,256 35-45 51,794 33,615 45-55 58,584 36,026 55-65 54,555 41,744 65+ 54,315 21,589 Source: U.S. Department of Commerce, "Money Income of Households, Families, and Persons in the United States" (1995). These annual earnings figures can be projected over the relevant ages to forecast the probable lifetime earnings of a college graduate. These statistics can also be 43 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. used in the form of an age earnings index when an individual's earnings history is available. For example, assume individual A is a 24 year old college graduate earning $22,000 per annum as an account clerk at the time of his wrongful death. While there exists a demonstrated earnings capacity in this scenario, it is unlikely that the $22,000 earnings base accurately reflects the present value of individual A's probable earnings at the peak of his career. In this case an economist must take into consideration the impact of experience on earnings through the use of an age earnings index. Table 10 lists age earnings indices for male and female college graduates based upon the figures in Table 9. Table 10: Age Earnings Index. Male Female Age College College Cohort Graduate Graduate 22-25 1.00 1.00 25-35 1.55 1.41 35-45 1.99 1.56 45-55 2.25 1.68 55-65 2.09 1.94 65+ 2.08 1.00 Source: U.S. Department of Commerce, "Money Income of Households, Families, and Persons in the United States" (1995). 44 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. The age earnings index in Table 10 allows economists to take experience into consideration and calculate the present value of individual A's annual earnings from ages 45 to 55 at $49,500.3 Age earnings indices which are occupation-specific can also be calculated based upon statistics published by the U.S. Department of Commerce in Earnings by Occupation and Education. This allows the economist to account for industry- specific lifetime earnings trends. Conclusion The establishment of the lost earnings base is of fundamental importance in the calculation of lost earnings capacity. The fact that economists are split on the topic of whether or not to rely on trends or averages of historical earnings emphasizes the need to evaluate cases on an individual basis. Additionally, economists must account for the impact experience plays in an individual's earnings. This can be done through the use of age earnings indices. $22,000 x 2.25. 45 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 6 FRINGE BENEFITS The inclusion of fringe benefits in estimates of future economic losses is becoming increasingly important. Employees are opting to receive more and more of their gross earnings package in the form of non-wage benefits. Non-wage benefits have grown from 20 percent of total employee compensation in 1966 to a share of nearly 30% in 1988.4 This trend can be attributed to the preferential treatment given non-wage benefits under state and federal laws. As fringe benefits gain increasing importance in the determination of a gross earnings base so does the debate on how to forecast future loss of fringe benefits. This chapter first discusses whether benefits should be valued based upon employer cost or employee value. Second, it discusses which benefits should be counted as losses and which benefits are already counted in future wage projections. 4 U.S. Department of Labor, Bureau of Labor Statistics, "Bulletin 2319" (1988). 46 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Employer Cost vs. Employee Value In the debate over valuing fringe benefits, Robert Rosenman argues that the use of the employer cost method overstates the value of losses and that the value of the benefits to the employee is a more appropriate measure of economic loss. His position rests on the following argument: Because few workers are able to choose their optimal mix of fringe benefits, whether the employer cost method or the replacement cost method of accounting is used, the economic value is overstated.5 Proponents of the employer cost method, Thomas J. Romans and Frederick G. Floss, however maintain that there are two major flaws in Rosenman's argument.6 First, the argument implies that laborers play no significant role in determining the fringe benefits they receive. This is not always the case because many individuals are often able to negotiate for fringe benefits in the same manner they negotiate for wages. Also, many individuals have a choice over which job they take or which union they join. Second, even if one accepts the assumption that employees have no choice in determining the level or mix of their benefits package, there is no guarantee that the benefits an individual received satiated his demand. Many individuals use their 5 Robert Rosenman, "Economic Value of Restricted Fringe Benefits: A Reply, "Journal o f Forensic Economics (1992). 6 J. Thomas Romans and Frederick G. Floss, "Economic Value of Restricted Fringe Benefits: A Comment," Journal o f Forensic Economics (1992). 47 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. wages to purchase supplemental health or retirement benefits. In their cases, the employer cost of their benefits lost would surely not overstate the value of their losses. In addition to the two criticisms mentioned above, the practicality of the methods of valuing benefits should be mentioned. While it is relatively easy to measure the employer cost of lost benefits, it is extremely difficult and time consuming to estimate the amount an individual would have paid for the benefits he received. This is especially difficult in wrongful death cases when economists cannot question the deceased. The difficulty of estimating the value of the benefits to an injured party can be seen in the following example. Imagine individual A is indifferent to receiving a $10 pizza, $100 of caviar or an $80 per annum vision plan. Is the vision plan worth $10 or $100 to individual A? It is difficult to say. Additionally, imagine the difficulty of using the employee value method in a wrongful death case when it is impossible to even question the injured party regarding his preferences. 48 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Double Counting When calculating the loss of fringe benefits an economist must be careful to ensure that those benefits received in the form of wages are not again added to an individual's lost fringe benefits. This would result in double counting and an overestimation of an individual's losses. For example, sick pay and vacation pay are benefits that are already included in an individual's wages and should not be counted again as lost benefits. While an individual would prefer a job with 10 weeks vacation to a job with 2 weeks vacation, a forensic economist is charged with calculating the loss of probable earnings rather than the loss of enjoyment of vacation time. The subject of calculating loss of enjoyment is discussed more thoroughly in Chapter 7. Table 11 lists a breakdown of employee benefits, as defined by the U.S. Chamber of Commerce, as a percentage of payroll. Paid leave, holidays and sick leave are all included in an individual's wages. On the other hand, employee payments for insurance, pension and savings plans, and legally required benefits represent non wage benefits. 49 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 11: Employee Benefits Expressed as a Percentage of Payroll. Paid Leave 1. Vacations 5.1% 2. Holidays 3.1% 3. Sick Leave Holidays 1.2% 4. Other Paid Leave 0.3% Insurance 5. Life Insurance 0.4% 6. Health Benefits 10.4% 7. Sickness and Accident Insurance 0.5% 8. Long Term Disability 0.2% 9. Dental Insurance 0.5% Pension and Savings Plan 10. Pension and Retirement Plans 4.0% 11. Savings and Thrift Plans 1.5% 12. Profit Sharing 0.5% Legally Required Benefits 13. Old Age, Survivors, and Disability Ins.(FICA) 7.1% 14. Unemployment Compensation 0.6% 15. Worker’ s Compensation 1.1% 16. Other Legally Required Benefits__________________________0.1% Source: U.S. Chamber of Commerce, "Employee Benefits" (1995). Table 12 lists information on the appropriate treatment of benefits as determined by four leading forensic economists. An examination of the differences among the economists in this table will make the present disagreements among economists clear. 50 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 12: Treatment of Non-Wage Fringe Benefits as an Addition to Lost Gross Earnings in Wrongful Death. Brookshire King& Smith Lambrinos Speiser Insurance Benefits Health Y Y Y Y Life Y Y Y N Short-Term Disability Y N N N Long-Term Disability Y Y N Y Legally Required Benefits Social Security Y Y Y Y Unemployment Insurance Y Y N N Worker’ s Compensation Y Y N Y Pension and Savings Plan Pension Y Y Y Y Savings and Thrift Plans Y Y N/A N/A Source: Ralph R. Frasca, "The Inclusion of Fringe Benefits in Estimates of Earnings Loss: A Comparative Analysis," Journal of Forensic Economics (1992). While insurance benefits are generally accepted as employer-paid fringe benefits, not all economists agree on whether or not they should be included in a calculation of losses. Speiser argues that life insurance should not be included in estimates of future losses in wrongful death cases because the beneficiaries of the decedent would already have collected on the insurance. This argument is flawed in that it creates an inconsistency in the handling of expenses. 51 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. For example, imagine two identical employees have the option between a $50 per month dental plan and a $50 per month insurance policy. Also, imagine employee A chooses the life insurance through the company and spends an additional $50 per month on dental benefits independently while employee B chooses the dental insurance through the company and spends an additional $50 per month on life insurance independently. If both employees were to die at the same time, Speiser would argue that their losses differed. There is an opportunity cost that Speiser fails to consider. An individual receiving life insurance benefits has foregone higher wages to obtain life insurance. The loss of the life insurance premium should be considered an economic loss. The economists also differ in their handling of disability benefits. Three out of the four agree that short-term disability should not be included in future losses and half believe that long-term disability should not be included. The economists that agree short-term disability should not be included in future losses argue that periods of short-term disability are already included in the probability of employment and worklife tables. In the case of most sicknesses, or temporary disabilities, employers keep employees on the payroll. These employees are therefore considered employed when probabilities of employment and worklife expectancies are calculated. Adding short-term disability insurance to future losses would result in double counting. 52 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. On the other hand, those receiving long-term disability benefits are unlikely to be considered employed. Accordingly, the probability of employment and worklife expectancy tables do not incorporate periods of long-term disability. Long-term disability benefits should therefore be included in future losses. From the above discussion it follows that unemployment and worker's compensation insurance should be included in estimates of future losses. When an individual is receiving either unemployment benefits or worker's compensation insurance he is not considered employed. Therefore these benefits are not included in the probability of employment or worklife expectancy tables and should be accounted for in the loss of fringe benefits. There is unanimous agreement in the handling of pension and savings plans with a few remarks on whether or not to value the employer's contribution or the actual value of the retirement benefit. The most accurate method would be to use the actual value of the benefit to the employee. However, the employer's contribution is usually the actuarial equivalent of the value of the benefit to the employee. Conclusion As employees choose to receive more and more of their gross earnings packages in the form of non-wage benefits, accurate forecasts of the loss of fringe benefits is 53 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. becoming increasingly important. In the debate over the best method for estimating the value of fringe benefits, economists have raised the issue of whether to use the employer cost or the employee value method in arriving at a fringe benefits base. Rosenman defended the employee value method indicating that because employees are not able to choose their optimal mix of benefits, the employer cost method overestimates losses. Rosenman's conclusion is not altogether correct. As Thomas and Floss pointed out, frequently, individuals do have a say in the benefits they receive and the unions they join. Additionally, even when assuming that individuals have no choice in their benefits package there is the possibility that their demand for benefits is not satiated, in which case they would purchase additional benefits independently. Even ignoring these flaws in Rosenman's argument, the difficulty alone of using the employee value method merits some skepticism. Economists must also carefully evaluate which benefits to include in their fringe benefits base. While most insurance benefits should be included, there are benefits such as short-term disability which have already been included through other means. 54 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 7 HOUSEHOLD SERVICES "Household production consists of those goods and services produced by a household for its own use, which alternatively are available for purchase in the market place."7 This chapter first discusses the alternative approaches to the valuation of household services. Second, it presents statistics on the average number of hours devoted to household services. Direct Output or Labor Value Approach The most common method of valuing an individual's household services, as outlined in an article by J. Thomas Romans and Frederick G. Floss,* is to estimate the number of hours the individual spent in such activities as meal preparation, house cleaning, yard work, etc., and valuing that time at activity- specific market wages. This method is commonly referred to as the labor value approach. This is a popular approach due to the availability of data on the amount of time spent on household activities. 7 Ronald A. Dulaney, John H. Fitzgerald, Matthew S. Swenson and John H. Wicks, "Market Valuation of Household Production", Journal o f Forensic Economics (1992), 115. 8 J. Thomas Romans and Frederick G. Floss, "Evaluation of Homemaker Services: Replacement Cost, Opportunity Cost Or Something Else?" Journal o f Forensic Economics (1989). 55 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. An alternative method to the labor value approach is the measurement of the value of the household product of an individual. This method is called the direct output approach. The proponents of this method, led by Thomas R. Ireland and John O. Ward,9 are quick to point out several "problems" in the labor value approach. The first of these "problems" in the labor value approach is its failure to consider the value added by inputs other than labor. Production in the household involves inputs other than labor such as a vacuum cleaner or a tool box. The labor value approach ignores the value that these capital resources add to the household product, concentrating solely on an individual's contribution to household product. The direct output approach implicitly includes all inputs as it values the household product. The above argument rests on the assumption that the most accurate valuation of an individual's contributions to household services includes not only his or her labor contribution, but also the value added to household product by any capital that may have been used. Romans and Floss disagree with this assumption arguing that the only loss suffered is that of labor. Impaired individuals have not lost any of the capital that assisted them in household production. 9 Thomas R. Ireland and John O. Ward, "Replacement Cost Valuation of Production by Homemakers: Conceptual Questions and Measurement Problems," Journal o f Forensic Economics (1991). 56 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. For example, imagine individual A vacuums his house once a week with his own vacuum cleaner. Also, assume that the monthly value of the time it takes individual A to vacuum is $40 and that the monthly value of using the vacuum cleaner for that time is $10. According to the direct output method, the monthly value of the household product is therefore $50. Now, assume individual A is injured and can no longer vacuum his house. What is his loss of household services for the first month following his injury? Ireland and Ward would argue that the losses are $50 because the individual has lost the household product of a vacuumed house. They base their argument on the assumption that when an individual attempts to replace household product he is, more often than not, unable to simply replace the lost labor. For example, imagine individual A regularly changed his oil before he was impaired. He may still have the tools to change his oil, but now he has to take his care to a mechanic and pay for the total product of an oil change. Romans and Floss would argue that the losses are $40. The individual has lost the ability to vacuum but he has not lost his vacuum. In the future he will solely need to hire a helper, not a vacuum, to replace his household product. They claim the direct output approach overestimates the loss of household services by including the value added by capital assets such as a vacuum cleaner. 57 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Another criticism of the labor value approach involves the appropriate hourly wage. The labor value approach values the time spent in household production using rates which reflect the prevailing hourly rate for the type of work involved. Proponents of the direct output method argue that the prevailing rate may be inappropriate for an individual's work. For example, the hourly rate a painter charges may overestimate the hourly value of an inexperienced individual who paints his or her house every 10 years. However, this criticism can also be turned on the direct output method. Similar to the fact that economists are unable to objectively compare the value of each individual's time to that of a professional tradesman, economists are also unable to compare the value of a professional paint job to that by an inexperienced individual. How does an economist employing the direct output method account for the differences in the value of a paint job? A third "problem" with the labor value method is that it includes household services that also constitute a leisure activity. For example, the labor value approach overestimates the value of an individual's time who works in the garden for the sheer enjoyment of gardening. This again is both a valid criticism of the labor value method and one that can also be turned on the direct output method. How can economists account for differences in enjoyment of household services in either method? 58 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Hours Per Annum The labor value method relies on an economist's ability to estimate the number of hours an individual devoted to household services. Tables 13-15 present data on the average hours devoted to household services per annum based upon research by the Survey Research Center of the University of Michigan. These tables break families into three categories: working couples, single mothers and couples in which only the male works. The data support common intuition on the number of hours devoted to household services. First, there is a positive correlation between the number of hours dedicated to household services and the number of children in a family. Second, regardless of the number of children in a family, the presence of a child under the age of six increases the number of hours devoted to household services. Third, housewives devote more time to household services than employed wives when children are present in the household. 59 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 13: Average Number of Hours Devoted to Household Services by Working Couples. Family Status Male Female No Children Hours of Housework 372 838 Parents of One Child Youngest Child < 6 yrs Hours of Housework 432 989 Youngest Child 6-11 yrs Hours of Housework . 337 947 Youngest Child > 11 yrs Hours of Housework 336 936 Parents of Two Children Youngest Child < 6 yrs Hours of Housework 425 1086 Youngest Child 6-11 yrs Hours of Housework 364 1022 Youngest Child > 11 yrs Hours of Housework 416 1114 Parents of Three Children Youngest Child < 6 yrs Hours of Housework 444 1393 Youngest Child 6-11 yrs Hours of Housework 430 1215 Youngest Child > 1 1 yrs Hours of Housework 376 1072 Source: David H. Ciscel and David C. Sharp, "Household Labor in Hours by Family Type," Journal o f Forensic Economics (1995), 117-119. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 14: Average Number of Hours Devoted to Household Services in Female Headed Households. Family Status Female No Children Hours of Housework 618 Parents of One Child Youngest Child < 6 yrs Hours of Housework 853 Youngest Child 6-11 yrs Hours of Housework 632 Youngest Child > 11 yrs Hours of Housework 807 Parents of Two Children Youngest Child < 6 yrs Hours of Housework 963 Youngest Child 6-11 yrs Hours of Housework 816 Youngest Child > 11 yrs Hours of Housework 661 Parents of Three Children Youngest Child < 6 yrs Hours of Housework 1048 Youngest Child 6-11 yrs Hours of Housework 1060 Youngest Child > 11 yrs Hours of Housework _______ 485 Source: David R Ciscel and David C. Sharp, "Household Labor in Hours by Family Type," Journal o f Forensic Economics (1995), 117-119. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 15: Average Number of Hours Devoted to Household Services for Couples with the Male Only in Labor Force. Family Status Male Female No Children Hours of Housework 383 560 Parents of One Child Youngest Child < 6 yrs Hours of Housework 346 1411 Youngest Child 6-11 yrs Hours of Housework 379 1278 Youngest Child > 11 yrs Hours of Housework 272 1245 Parents of Two Children Youngest Child < 6 yrs Hours of Housework 395 1841 Youngest Child 6-11 yrs Hours of Housework 318 1613 Youngest Child > 11 yrs Hours of Housework 276 1391 Parents of Three Children Youngest Child < 6 yrs Hours of Housework 424 1862 Youngest Child 6-11 yrs Hours of Housework 341 1661 Youngest Child > 11 yrs Hours of Housework 107 2014 Source: David H. Ciscel and David C. Sharp, "Household Labor in Hours by Family Type," Journal o f Forensic Economics (1995), 117-119. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. This data also supports the conclusion that there exists a wide variance, based upon family size and structure, in the number of hours devoted to household services. Economists must therefore take these factors into consideration when calculating the value of household services. Conclusion Forensic economists need to remember two things when calculating the loss of household services. First, economists must be aware that while the labor value approach to the measurement of the value of household services is the most generally accepted method to use, it is not without flaws— the flaws being its inability to account for differences both in the quality of work performed and in enjoyment received from said work. Second, economists should understand the relationship between family structure and size and the average contribution to household services. 63 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 8 HEDONIC DAMAGES The value of human life can be divided into two distinct categories: the value derived from the goods produced by that life, i.e. earning capacity and non-labor market services; and, the value of the enjoyment of that life, i.e. the hedonic value of life. Economists have long relied on willingness-to-pay (WTP) studies to determine the hedonic value of life. A WTP study estimates the value of a change in well-being that would result from changing the risk o f death. The three most common types of WTP studies are as follows: Wage-risk studies, behavioral studies and contingent valuation surveys. Wage Risk Studies Wage risk studies calculate the wage premium associated with a greater risk of death on the job. For example, imagine jobs A and B are identical with the exception that workers in job A are faced with a higher risk of death than workers in job B. Assume this difference to be that one additional worker in 10,000 dies each year in job A than in job B. Additionally, assume that job A pays $200 more each year than job B. This implies that individuals are willing to pay $2 million to save a single life. Table 16 lists the results of a number of wage risk surveys. 64 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Table 16: Estimates of the Value of Life in Wage-Risk Studies. (Thousands o f 1988 Dollars). Study Wage Data Year Value Range Amould & Nichols (1983) 1970 784 Brown (1980) 1966-71 1516 Butler (1983) 1940-69 901-914 Cousineau et al. (1988) 1979 3162-3260 Leigh & Folsom (1984) 1974 6921-8387 Leigh (1987) 1977 9031-9500 Viscusi & Moore (1989) 1981 7200-15650 Source: Ted R. Miller, "The Plausible Range for the Value of Life - Red Herrings Among the Mackerel," Journal o f Forensic Economics (1990), 26. This approach relies on two assumptions. First, it assumes that workers are aware of differing risks across jobs. If workers do not perceive risk accurately, this will reduce the significance of the study. For example, workers who are unaware of the risk involved in working on job A may accept a lower wage than would be indicative of their willingness to pay for a decrease in risk. Second, it assumes that individuals have the capability to move freely between jobs. If individuals are unable to move freely between jobs they may find themselves forced to take risks they would otherwise refuse to accept. This approach has three potential limitations. First, it fails to account for non wage compensation in its analysis. This effectively leads to a continual 65 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. underestimation of the value of life. Second, it overlooks the effects of taxation on wages. This would tend to lead to an upward bias to the value of life. Third, the range of $784,000 to $15,650,000 provides an inconclusive estimate of the value of a life. Behavioral Studies Behavioral studies examine the observable tradeoffs people make between risks and benefits in their consumption decisions. These studies analyze actual behavior and are therefore similar to wage-risk studies. For example, a popular behavioral study examines the willingness of an individual to purchase and install a smoke Table 17: Values of Life from Studies of Consumer Behavior. (Thousands of 1988 Dollars) Study Subject Value Range Bloomquist (1979) Seat Belt Use 663 Bloomquist & Miller (1990) Seat Belt Use 1908 Ghosh, Lees & Seal (1975) Speeding 609 Landefeld & Seskin (1982) Life Insurance 960 Miller (1990) Smoke Detectors 643 Melinek (1974) Pedestrian Walk Use 1524 Ippolito & Ippolito (1984) Smoking 258-1364 Smith & Gilbert (1984) Jobs in Unpolluted MSA’ s 2191-4060 Source: Ted R. Miller, "The Plausible Range for the Value of Life - Red Herrings Among the Mackerel," Journal o f Forensic Economics (1990), 27. 66 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. detector in an attempt to reduce the risk of death. Table 17 lists the results of a number of behavioral studies. This approach again relies upon the assumption that individuals are aware of the change in risk a product represents. For example, if individuals believe that smoke detectors reduce risk more than is truly the case, the value of life implied by the cost of the smoke detector would overestimate the true value of life. Additionally, this method also produces a wide variance, $609,000 to $4,060,000, in the estimated value of a human life. Contingent Valuation Surveys The contingent valuation approach poses a hypothetical market situation to survey respondents who are then asked about their willingness to pay for alternate levels of safety. For example, a survey may ask individuals how much they would pay for an immunization that would reduce their chances of death from two in a million to one in a million. Therefore for every one million individuals immunized at, say, five dollars a shot, one life is saved. This allows an economist to value a life by multiplying one million shots by five dollars per shot. In this case the value of a life is estimated at $5,000,000. 67 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. There are three major benefits to this approach. First, it allows for situations to be created to answer specific questions for which actual market data does not exist. Second, it can be applied to the general population. Third, it can address specific magnitudes of risk. The principal disadvantages of the contingent valuation approach are that it is based upon what people say, rather than what they do, and that its estimates of the value of human life vary from $1.4 million to $3.6 million. Table 18 lists the results of a number of contingent valuation surveys. Table 18: Value of Life in Surveys. (Thousands of 1988 Dollars) Study Context Value Gerking et al. (1988) Labor Market 2217 Jones-Lee et al. (1985) Highway Safety 2813 Landefeld (1979) Cancer 2632 Viscusi, Magat (1989) Highway Safety 2379 Persson (1989) Highway Safety 1458 Maclean (1979) Fire Safety 3597 Source: Ted R. Miller, "The Plausible Range for the Value of Life - Red Herrings Among the Mackerel," Journal o f Forensic Economics (1990), 31. 68 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Conclusion The role of the forensic economist is to assist the jury by providing a statistically probable value of an individual's losses. When an economist is merely able to reduce the probable losses to between $784,000 and $15.5 million, as has been done in Table 16, he or she is no longer of any use to the jury. The forensic economist should limit his or her testimony to that which can assist the jury in arriving at a figure of loss. It appears that economists should refrain from attempting to quantify this aspect of an individual's losses and admit they lack the tools to assess the value of "enjoyment". 69 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. CHAPTER 9 CONCLUSION In an attempt to set forth a comprehensive guide to calculating economic damages, this thesis compiled, compared and built upon historical research on each of the major issues in forensic economics. The methodologies of leading forensic economists were covered in a discussion of current debates in the field of forensic economics. Chapter 1 discussed the law relative to interest rates and the wide range of rates of return offered in financial markets, concluding that insurance company annuities offer a prime choice of interest rates when calculating the present value of economic losses. Additionally, the importance of intra-year discounting was demonstrated in a discussion of the time value of money and in exposing the common error of assuming individuals get paid once a year when calculating present values. The debate between Peter C. Eisemann and William F. Landsea on the necessity of intra-year discounting was covered, concluding that with today's technology, economists can very easily incorporate individuals' payment periods rather than use an adjustment table for differences caused by annual discounting. Chapter 2 examined the differences between industry-specific and economy-wide nominal earnings growth rates when forecasting future earnings streams, concluding that in the short-run, industry-specific growth rates are optimal, while 70 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. in the long-run, economy-wide growth rates are more applicable. This chapter also discussed the generally accepted methods of using a weighted or straight average when forecasting future nominal earnings growth rates. Additionally, this chapter covered the topic of inflation and its role in nominal earnings growth, concluding that as long as both the nominal growth rate and interest rate contain similar estimates of inflation, the accuracy of the estimated present value is not significantly affected. Both the use of worldife expectancy and probability of employment statistics in calculating economic losses are acceptable under certain circumstances; however, Chapter 3 concluded that the use of worldife expectancy in calculating an individual's economic losses, at times, provides a different present value than the use of the probability of employment for two reasons. First, the worklife expectancy approach assumes that an individual's earnings occur in one continuous stream and thus, pull future payment streams closer to the present. This fails to take into account that, typically, individuals experience periods of labor market inactivity dispersed throughout their careers. Second, in cases where individuals experienced decreasing earnings, by pulling future payment streams closer to the present, the worklife expectancy approach evaluates lost earnings at a point higher on the age earnings cycle. 71 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Chapter 4 examined different methods of estimating earnings bases concluding that it is best to use an earnings base as specific to the individual as possible. Additionally, this chapter covered the importance of using age earnings indices when projecting earnings bases into the future. When calculating the value of lost fringe benefits, forensic economists debate whether to use the employer cost or the employee utility method. Chapter 5 covered the debate between Robert Rosenman, a proponent of the employee utility method, and Thomas J. Romans and Frederick G. Floss, proponents of the employer cost method, concluding that using employer cost is the most practical method. Chapter 6 examined the direct output method, supported by J. Thomas Romans and Frederick G. Floss, and labor value method, maintained by Thomas R. Ireland and John O. Ward, of calculating the value of lost household services. It concluded that the labor value approach, while not without flaws, is the most appropriate method. This chapter also evaluated the relationship between family structure and size and the average number of hours contributed to household services. 72 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. There are several prevalent methods of calculating hedonic damages. Chapter 7 described each of these methods, concluding that currently no method exists that can provide an estimate of the value of life on more than a speculative basis. 73 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. BIBLIOGRAPHY Abraham, Fred J. "Pitfalls to Using the Real-Rates or Age-Eamings Profile Models in Calculating Economic Loss," Journal o f Forensic Economics, 1988. Albrecht, Gary R. "The Application of the Hedonic Damages Concept to Wrongful Death and Personal Injury Litigation," Journal o f Forensic Economics, 1994. Albrecht, Gary R. "Compensatory Damages and the Appropriate Discount Rate: A Comment," Journal o f Forensic Economics, 1993. Albrecht, Gary R. and Moorhouse, John C. " On the Derivation and Consistent Use of Growth and Discount Rates for Future Earnings," Journal o f Forensic Economics, 1989. Altman, James L. "A Note on the Feasibility of Using Long-Term Real Interest Rates in Present Value Calculations," Journal o f Forensic Economics, 1994. Battaglia, Samuel T. "The Effects of Intra-Period Payments on Award Calculations," Journal o f Forensic Economics, 1994. Bell, Edward B. and Taub, Allan J. "More on Alternative Measures of Earnings Growth," Journal o f Forensic Economics, 1991. Benich, Joseph. "Intra-Year Discounting Assumptions and Bias in Lost Earnings Analysis: A Comment," Journal o f Forensic Economics, 1993. Benich, Joseph. "Comment: On the Relative Stability of the Interest Rate and Earnings Growth Rate," Journal o f Forensic Economics, 1992. Brooking, Carl G. and Taylor, Patrick A. "On the Necessity of Estimating Expected Inflation in Determining the Value of Lost Earnings," Journal o f Forensic Economics, 1990. Brookshire, Michael L. and Caruthers, Shelly E. "Principles of Establishing the Lost Earnings Base," Journal o f Forensic Economics, 1995. 74 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Ciecka, James E. "Intra-Year Discounting Assumptions and Bias in Lost Earnings Analysis: A Comment," Journal o f Forensic Economics, 1993. Ciscel, David H. and Sharp, David C. "Household Labor in Hours by Family Type," Journal o f Forensic Economics, 1995. Dillman, Everett G. "The Age-Eamings Cycle-Eamings by Education,” Journal o f Forensic Economics, 1988. Douglass, John B., Kenney, Genevieve M. and Ted R. Miller, "Which Estimates of Household Production are Best," Journal o f Forensic Economics, 1990. Dulaney, Ronald A., Fitzgerald, John H., Swenson, Matthew S., and Wicks, John H. "Market Valuation of Household Production," Journal o f Forensic Economics, 1992. Eisemann, Peter C. "Intra-Year Discounting Assumptions and Bias in Lost Earnings Analysis," Journal o f Forensic Economics, 1992. Feldman, Allan M. "Discounting in Forensic Economics," Journal o f Forensic Economics, 1990. Foster, Robert D. and Ruth, Richard L. "Calculating Present Value of Intra-Year Receipts: A Comment," Journal o f Forensic Economics, 1995. Fresca, Ralph R. "The Inclusion of Fringe Benefits in Estimates of Earnings Loss: A Comparative Analysis," Journal o f Forensic Economics, 1992. Fresca, Ralph R. and Winger, Bernard J. "An Investigation Into the Nelson Median and the Mean Age of Final Separation from the Work Force," Journal o f Forensic Economics, 1989. Gamboa, Anthony M., Tierney, John P., and Holland, Gwendolyn H. "Worklife Expectancy and Disability," Journal o f Forensic Economics, 1989. Gilbert, Roy F. "In Defense Of The Application Of Hedonic Models To Wrongful Death And Personal Injury Litigation," Journal o f Forensic Economics, 1995. Gilbert, Roy F. "A Review of the Monte Carlo Evidence Concerning Hedonic Value of Life Estimates," Journal o f Forensic Economics, 1995. 75 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Havrilesky, Thomas. "The Persistent Misapplication of the Hedonic Damages' Concept to Wrongful Death and Personal Injury Litigation," Journal o f Forensic Economics, 1995. Havrilesky, Thomas. "The Misapplication of the Hedonic Damages Concept to Wrongful Death and Personal Injury Litigation," Journal o f Forensic Economics, 1993. Houldsworth, Mark A. and McKinnon, Tom D. "Dedicated Portfolios and the Present Value of Lost Earnings: A Comment," Journal o f Forensic Economics, 1994. Ireland, Thomas R. "The Application of the Hedonic Damages Concept to Wrongful and Personal Injury Litigation: A Comment," Journal o f Forensic Economics, 1995. Ireland, Thomas R. and Ward, John O. "Replacement Cost Valuation of Production by Homemakers: Conceptual Questions and Measurement Problems," Journal o f Forensic Economics, 1991. Landsea, William F. "Get Real! A Comment on the Need for 'Adjustments'" in Discounting Future Periodic Damage Amounts," Journal o f Forensic Economics, 1995. Launey, George V. "On Valuing Lost Fringe Benefits in Death Cases," Journal o f Forensic Economics, 1990. Lewis, W. Cris. "On the Relative Stability and Predictability of the Interest Rate and Earnings Growth Rate," Journal o f Forensic Economics, 1991. Lewis, W. Cris. "On the Relationship Between Age, Earnings and the Net Discount Rate," Journal o f Forensic Economics, 1989. Miller, Ted R. "The Plausible Range for the Value of Life-Red Herrings Among the Mackerel," Journal o f Forensic Economics, 1990. Mullett, Matthew J., Nelson, David M., and Patton, Robert T. "Alternative Measures of Earnings Growth," Journal o f Forensic Economics, 1989. Nowak, Laura S. "Empirical Evidence on the Relationship Between Earnings Growth and Interest Rates," Journal o f Forensic Economics, 1991. 76 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Orlowski, David. "Employer vs. Market Rate Theory in Valuing Benefits," Presented, 1995. Pelaez, Rolando F. "The Below-Market Discount Rate Method: Junk Science in the Courtroom?" Journal o f Forensic Economics, 1995. Pelaez, Rolando F. "Expected Long-Term Real Interest Rates: A Reprise," Journal o f Forensic Economics, 1993. Pelaez, Rolando F. "Valuation of Earnings Using Historical Growth-Discount Rates," Journal o f Forensic Economics, 1991. PonArul, Richard. "Inflation in the Computation of the Present Value of Lost Earnings," Journal o f Forensic Economics, 1991. Raymond, Richard. "Which Estimates of Household Production are Best?: A Comment," Journal o f Forensic Economics, 1993. Romans, J. Thomas and Floss, Frederick G. "Four Guidelines for Selecting a Discount Rate," Journal o f Forensic Economics, 1992. Romans, J. Thomas and Floss, Frederick G. "Economic Value of Restricted Fringe Benefits: A Comment," Journal o f Forensic Economics, 1992. Romans, J. Thomas and Floss, Frederick G. "Three Concepts of the Value of Fringe Benefits," Journal o f Forensic Economics, 1989. Romans, J. Thomas and Floss, Frederick G. "Evaluation of Homemaker Services: Replacement Cost, Opportunity Cost Or Something Else?" Journal o f Forensic Economics, 1989. Rosenman, Robert. "Economic Value of Restricted Fringe Benefits: A Reply," Journal o f Forensic Economics, 1992. Roseman, Robert. "The Restricted Role of Fringe Benefits and Their Economic Value in Personal Injury and Wrongful Death Settlements," Journal o f Forensic Economics, 1991. Rowe, John W. "The Net Discount Rate in a Model of Long-Run Growth Equilibrium," Journal o f Forensic Economics, 1991. Samuels, George E. "Calculating Damages: Real or Nominal Rates," Journal o f Forensic Economics, 1990. 77 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Saurman, David S. and Means, T.S. "Estimating Earning Capacity With Constant Earnings Growth Rates," Journal o f Forensic Economics, 1989. Staller, Jerome M., Sullivan, Brian P., and Friedman, Edward A. "Value of Life Estimates-Too Imprecise for Courtroom Use: A Note," Journal o f Forensic Economics, 1994. Thornton, Robert J. "Pitfalls in Estimating the Loss of Employer-Paid Fringe Benefits," Journal o f Forensic Economics, 1989. Trout, Robert R. "Intra-Year Discounting Made Easy: A Comment," Journal o f Forensic Economics, 1994. Walker, Kathryn E. and Woods, Margaret E. Time Use: A Measure o f Household Production o f Family Goods and Services. Center for the Family of the American Home Economics Association, 1976. 78 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

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Creator Gilbreth, Mark Mckinley (author)

Core Title Calculating economic damages in litigation matters

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Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

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Advisor Kamrany, Nake (committee chair), Deprano, Michael E. (committee member), Elliott, John (committee member)

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