Abstract
We construct a model of optimal deterrence to address the issue concerning the form and efficiency of punitive damages. Because the same amount of damages means less to wealthy injurers than to poor ones, without punitive damages, it might happen that poor injurers abide by the law while wealthy injurers do not. Thus the court can increase social welfare by choosing its tolerance level and imposing punitive damages on injurers for any precautionary effort below this tolerance level. The use of tolerance together with punitive damages accords well with the empirical observation that punitive damages are normally awarded only for "outrageous" misconduct. We show that the optimal negligence standard, the tolerance level and the punitive damages crucially depend on the wealth distribution in the society. This explains that when juries are instructed to relate the awarded damages to an outrageous injurer's wealth, it may be an efficient design rather than a pure prejudice against people's wealth. Some comparative statics results are also provided. © 2004 Elsevier Inc. All rights reserved.