Academic journal article Journal of Forensic Economics

The Valuation of Earning Capacity Definition, Measurement and Evidence

Academic journal article Journal of Forensic Economics

The Valuation of Earning Capacity Definition, Measurement and Evidence

Article excerpt

In most courts of law, economic damages due to loss of wages or salary caused by injury or death is measured by an earning capacity standard rather than a standard of actual or expected earnings. Nevertheless, neither the courts, vocational experts, nor forensic economists have developed an explicit definition of earning capacity. As a result, there is considerable confusion as to how earning capacity should be measured. Our review of the forensic economics literature indicates that there has been relatively little written on this subject by economists.(1) The goal of this paper is to move the forensic economics profession, the vocational experts, and the courts closer to a practical and generally accepted approach to the measurement of earning capacity.

Economics is an analytic discipline. As such, its methods attempt to identify fundamental concepts, divide them into their constituent parts, and then to ascertain the rules that governs their interaction. One of the most fundamental concepts that economics can contribute to the discussion of earning capacity is the idea that earnings are determined in labor markets as a product of both supply and demand. The supply side encompasses consideration of what the person is able to do and willing to do for a given wage rate. What the person is able to do is a function of the person's capacities. What they are willing to do for a given wage rate is a function of their preferences, which are difficult to measure directly. The exercise of individual preference is at the root of many of the difficulties of measuring earning capacity through observation of past earnings. The demand side concerns the probabilities of a person actually finding a position at given wage rates, and is directly relevant to the question of whether an economic projection of future earnings has a reliable foundation, or is based merely on possibilities and speculation.

I. Definitions: Actual Earnings, Expected Earnings and Earning Capacity

While our focus is upon earning capacity, three related concepts must be separated: actual earnings, expected earnings, and earning capacity. Actual earnings are what a person actually earns, expected earnings are what a person is expected to earn, while earning capacity is what that person is able to earn. Each of these earnings concepts is a stream or series of values over an entire worklife and not just a single value. At various times, each of these concepts has been used as a standard of loss in personal injury cases. Thus, in the following sections, we consider their relationship in greater depth.

A. Actual Earnings

Loss of actual earnings is a standard that has been applied when such loss could be measured with reasonable, although not absolute, certainty. While loss of actual earnings seems the simplest standard to apply in personal injury cases, it is not necessarily simple to predict. The stream of actual earnings, which we shall call "actual earnings," is a series of outcomes of a complex stochastic process involving the interaction of a person's abilities and preferences with the needs of employers. In other words, actual earnings in various years are the observations of a random variable. Of course, actual earnings can only be observed in the past. Without a crystal ball, future actual earnings, which are determined by chance and choice, as well as skill and ability, cannot be observed. Just as it may be impossible to predict the outcome of a single trial of a random process, we cannot predict future actual earnings of an individual with certainty. Some courts have held that loss of actual earnings is the standard that applies to past losses, while earning capacity is the standard that applies to future earnings. However, even where loss of actual earnings is the standard applied to past earnings, the court will hear arguments as to whether the injured person could have earned more since the injury, and merely chose not to do so, perhaps to enhance the value of the lawsuit. …

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