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Finance And Law: How Economists Measure Damages Before And After An Event

Please welcome our newest columnist, Professor Michael McDonald, who will be writing about the intersection of law and finance.

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scales of justice money law legal business financeEd. note: Please welcome our newest columnist, Professor Michael McDonald, who will be writing about the intersection of law and finance.

This is the inaugural edition of a new column here at Above the Law titled Finance and Law. Thank you for taking the time to read this first article. My name is Mike McDonald. I have a PhD in finance and am a university professor in the subject. I approached Above the Law about writing this column based on my experience in providing litigation support to attorneys and as an expert witness in cases related to financial matters.

The focus for this column is on business matters and how they relate to the law. This will include exploring different approaches to finance and economics that lawyers can use when arguing cases as well as current events like changes in the Fed interest rates and how these can impact ongoing cases. I welcome any feedback or questions on this column or any future column. Column suggestions are also welcome. I can be reached by email at M.McDonald@MorningInvestmentsCT.com.

This week, I thought I’d start by tackling one of the biggest misconceptions in many legal cases – the issue of calculating economic damages or harm. Many people see economic damages as being a single number based on a single calculation. That view is incorrect based on the modern consensus among economists.

Instead there are actually four different measures of economic damages, each with a separate calculation. The correct measure of damages to be used depends on the specific situation at hand. In this week’s column I will talk about the two more common measures – Equivalent Variation (EV) and Compensating Variation (CV) and the distinction between them.

Let’s take a step back for a moment though and look at a situation. In the town where I live, there is a developer proposing to build a large retail complex on an existing wooded area. Neighbors around the proposed complex are extremely upset about the proposal and are considering suing to block the project. A court might be asked to help determine the damages that will be inflicted on these homeowners.

This leads to an interesting quandary. There are two possible measures of economic harm here. One is the total amount of money that the homeowners would have to be paid to accept the building of the new complex. The second measure is the total amount of money that homeowners would pay the developer not to have built the project after the project is completed and homeowners have seen the effects. The first measure is Equivalent Variation, while the second measure is Compensating Variation. Compensating Variation may seem harder to calculate in this case, but in point of fact either measure can effectively be estimated by a skilled economist.

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Both CV and EV are appropriate not only in property disputes like the one outlined above, but in business disputes, unfair trade practices, insurance claims, and a variety of other settings. Both metrics are generalizable to any situation involving damages. As a result, CV and EV are often comingled unknowingly or not used properly by those unfamiliar with the concepts. Each measure is distinct though and will usually yield different levels of damages. The essential difference between the two is that EV measures the damage done in current price terms while CV measures the damage done in price terms after the change has taken place.

EV tells us how big the wealth impact is on overall well-being from a change in the overall environment. EV is especially useful when the property rights belong to the aggrieved party rather than the party making the change. In this case, if the zoning is not on the developer’s side and the homeowners are seeking to prevent a change in zoning that would allow the development, then EV is the appropriate metric.

CV tells us how much impact a change has had on the well-being of aggrieved parties based on post-change income and price levels. In essence, it tells us after the fact how much worse off a party is than they were previously. Since it uses new prices and income levels, the metric is more useful when dealing with changes that have already occurred or cases where the property rights belong to the party making the change rather than the aggrieved party.

The point here is that the amount of damage done to a party depends on how we measure prices, income levels, and wealth levels. CV can be larger than EV or vice versa, depending on the type of change involved, and both measures have specific calculations behind them. An argument can be made for using either metric in many circumstances, so it behooves attorneys to understand the difference between the two. Remember the case for CV is strongest when a change has already occurred (e.g., a car accident), while the case for EV is strongest a priori (e.g., a development proposal like the one outlined above).

Thanks for the opportunity to explain this issue, and I hope you’ll keep an eye out next week for my next column.

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Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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