Theory of Externalities and workmen?s compensation

Theory of Externalities and workmen’s compensation

What are the proper roles of labour, the private sector and government in the provision and operation of workmen’s compensation? The economic theory of externalities provides an excellent framework to answer these and other questions relating to workmen’s compensation

First, what is the economic theory of externalities? The basic theory is simple and sound; the problem arises in the detail and in its application. A person (A) faces an externality when the actions of another person (B) impose a cost on him or her. Pollution is the most common example.

Assume B is an upstream factory and discharges polluted water into the river. Factory A is downstream. Before factory A can use the water, it has to clean it. It can then be said that B is imposing an externality on A.

A’s solution is to internalise the externality, which would mean that B would bear the cost of cleaning the pollution it has caused. This forms the basis of the polluter-pays principle.

Occupational accidents and diseases impose externalities. What would happen if a person is injured at work, or contracts an occupational disease? They would not be able to work and support themselves, which would mean someone else, or the state, would have to support them. The same would apply to medical expenses.

So, it can rightly be said that the injury or disease imposes an externality on other persons. The injury or disease is a consequence of working, regardless of whether or not someone else can be blamed. The cost of the injury or disease should be internalised as a cost of production.

What happens if legitimate costs of production are not internalised? If the person responsible for the externality does not internalise the cost as a cost of production, that person then has an unfair competitive advantage, and the person who bears the cost is at a competitive disadvantage. It makes sense, therefore, for the costs to be correctly internalised.

In the case of pollution, it should be noted that there is no cost transfer from B to A, as B bears the cost of cleaning the pollution and does not pay A to clean up the pollution.

The same applies to occupational injuries and diseases. The first obligation is to prevent the injury and disease, and the question of paying compensation to the injured employee arises only as a second obligation.

If workmen’s compensation is introduced, the uncertainty regarding the costs of accidents is replaced by the annually fixed premium and the injured employee receives compensation. The externality is removed, as it has been internalised via the premium or levy.

Therefore, the existence of accident-prevention programmes, such as workmen’s compensation, can be explained in terms of the economic theory of externalities.

Complication in the detail

As most economic theories show, the problems arise when details are considered during implementation. So, what are the problems?

Free marketers argue that costs are captured via the price in the free market. Marxists argue the costs are not captured, and thus government intervention is required.

The Marxists agree that the market can do what free marketers say it does, but that it may fail to capture all the costs.

The free marketers are probably correct. It can be recalled that workmen’s compensation was first introduced in South Africa by Rand Mutual before legislation on workmen’s compensation was introduced. Today workmen’s compensation exists because of legislation, therefore the free market argument need not be considered.

It is thus accepted that the purpose of workmen’s compensation is to internalise the costs associated with occupational injuries and accidents. With or without government legislation, the costs would be internalised. The private market solution is the spontaneous evolution of the appropriate forms of insurance. Private sector workmen’s compensation insurance is well known.

Consequences of government intervention

A reason why free market advocates would be unhappy with government intervention would revolve around the decision on what costs should be internalised. Interventionists take the opportunity to add costs which fall outside of the scope of mere internalisation of costs. This problem can be dealt with by examining the different types of costs, or utilising a principle basis.

We also suggest that, since government intervention exists, and has done for over a century, it has to be accepted that employers cannot now (at this late stage) be exposed to unknown costs. The responsibility to internalise the costs correctly should be settled by a process of negotiation between government, the private sector and labour organisations.

We therefore argue that section 56 of the Compensation for Occupational Injuries and Diseases Act 1993 (COIDA), which deals with increased compensation where fault is proved, is correct and is a significant, conceptually sound provision.

In the United Kingdom (UK) two forms of claims evolved: common law claims and workmen’s compensation claims. The common law claims ceased to exist in 1880 when the UK passed the Employer’s Liability Act.

The UK thus has two forms of statutory actions; employer’s liability and workmen’s compensation (via the welfare provisions). We believe there should be only one internalisation mechanism.

In South Africa, because of section 35 and 56, there is only one course of action. We argue that this is correct; the uncertainty of workmen’s compensation facing the employer is replaced by the levy paid to internalise the costs of workmen’s compensation.

Occupational diseases

The argument in favour of the concept of internalisation via a single levy payment (which produces certainty), has practical relevance when it comes to occupational diseases.

Occupational diseases take a long time to manifest, sometimes decades. In the historical sense it is impossible to prove the existence of the common law elements: act, cause, fault, wrongfulness and harm.

Employees who contract an occupational disease should be entitled to compensation; the mere existence of harm caused by the disease should result in the appropriate compensation.

This compensation should be paid by a single central fund so there is no dispute as to which fund, what time and when, and so on.

Since its introduction, workmen’s compensation has treated accidents and disease equally (except in the mining industry). What is required is a single fund governed by the same piece of legislation.

Jurists head in the same direction – risk liability

Oddly, as indicated earlier, the theory of externalities is an economic theory. The jurists of yesteryear are, however, heading in the same direction – towards what can be called risk liability.

The problem with this adventure is that internalising cost requires legislation. It could not be introduced via case law, which can only state general laws. Workmen’s compensation requires specific laws and courts (via case law) are just not suited for this task. Any attempts at internalising costs via the courts would just create problems. Nevertheless, the judicial adventure is an interesting story.

In the late 1800s, UK judges recognised and articulated what economists now call the problem of externalities. American jurists, such as Jeremiah, and the more famous Dean of the Harvard Law School, Roscoe Pound, plotted out in great detail how he saw the common law changing to accommodate what can now be called risk liability.

In South Africa, the judges took a great short-lived leap in the case of Rabie versus the Minister of Police, when the Appellate Division (the previous equivalent of today’s Supreme Court) introduced risk liability – the jurists’ equivalent of the economists’ externalities.

The court could not articulate this doctrine in a satisfactory manner, and this opened the door too wide. In a subsequent case the Rabie decision was reversed. This was decried by one academic.

The courts are just not the institution to introduce new legal doctrines; that can only be done by parliament, but to do that parliament needs the correct theory. We suggest that in the context of occupational injuries and diseases, the economic theory of externalisation is that theory.


Legally Speaking is a regular column by Albert Mushai from the school of Economics and Business Sciences, University of the Witwatersrand. Mushai holds a master’s degree from the City University, London, and was the head of the insurance department at the National University of Science and Technology in Zimbabwe before joining the University of the Witwatersrand as a lecturer in insurance.                                 

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