Econ 522 – Lecture 22 (Nov 29 2007)Homework due on Tuesday.So, Tuesday, we began consideration of the legal process itself.We said that the goal of the legal process should be to minimize the sum of two types of costs:- the administrative costs of implementing the process- “error costs” – inefficiencies coming from distorted incentives caused by an imperfect systemWe said that, not shockingly, we expect people to sue for harms where the expected gain from suing is bigger than the cost. Filing fees – the initial costs of beginning a legal complaint – help determine how many people choose to file suits.When failures to provide a remedy have only distributional effects, the social cost of these errors is close to 0, so filing fees should be high, to minimize administrative costs.When failures to provide a remedy have strong incentive effects, the social cost of these errors is large, so filing fees should be low.Trials are costly to both parties – so the expected cost of a trial to the defendant (including litigation costs) is greater than the expected benefit to the plaintiff (net of litigation costs). Out-of-court settlements can be Pareto-improving, and seem likely to occur when the twosides agree on the expected judgment that a trial would lead to.When the parties are each relatively pessimistic about their own chances in court, settlements should be even more likely.When the parties are relatively optimistic about their own chances, settlements are less likely, and may be impossible.Before trial, the two parties share information about the case – some of it voluntarily, some of it because they are required to.The parties will happily share information that corrects the other side’s relative optimism – so voluntary information exchange should make settlements more likely. Voluntary information exchange reduces both administrative costs and error costs.During the discovery process, parties are forced to share information that could correct the other side’s relative pessimism, and therefore could make settlement less likely. Involuntary information exchange reduces error costs, but the impact on administrative costs is unclear.Pre-Trial BargainingSuppose that there are no legal costs to settlement. After information exchange but before the trial starts, the plaintiff might be willing to accept settlements S such thatS > EJP – LCPwhere EJP is the plaintiff’s view of expected judgment and LCP is the plaintiff’s litigation costs.Similarly, the defendant might be willing to offer settlements S withS < EJD + LCDwhere EJD is the defendant’s view of expected judgment, and LCD is the defendant’s litigation costs.So settlement is at least a possibility whenEJP – LCP < EJD + LCDwhich is when EJP – EJD < LCP + LCD(This doesn’t mean settlement will always happen, just that it’s possible.)The left-hand side can be thought of as the amount of relative optimism. When the two sides agree on the expected judgment, this is 0. Relative pessimism makes this negative, relative optimism makes it positive. And the right-hand side is the two sides’ combined legal costs.Recall earlier in the class, we said that when two parties bargain, a reasonable outcome is when each one gets his threat value – the payoff he could get by not cooperating – plus one-half of the gains from cooperation. Let’s consider this same idea in the context of an out-of-court settlement. And let’s suppose that the two sides agree on the expected outcome of a trial, EJ.The two sides bargain over a settlement. The defendant knows that if bargaining breaks down, they’ll go to trial, and his expected payoff will be – EJ – LCD, so this is his threat point. The plaintiff knows that if bargaining breaks down, they’ll go to trial, and his expected payoff will be EJ – LCP, so this is his threat point.If they do reach a settlement, their combined payoffs will be 0 – the plaintiff will receive exactly what the defendant pays – so the gains to cooperation are the litigation costs that are avoided, LCD + LCP.If bargaining is successful, a reasonable settlement would be for the plaintiff to receive his threat value plus half the gains to cooperation: this would beEJ – LCP + ½ (LCD + LCP) = EJ – ½ LCP + ½ LCDWhen a trial is equally costly to both parties, this is just EJ. So when the parties agree on the likely outcome of a trial, and have the same litigation costs, a reasonable settlement isexactly the expected level of damages that would have been awarded at trial.The book talks about a different type of legal complaint: a nuisance suit. This is a lawsuit which has no legal value – if it went to trial, the defendant would win. The sole purpose of a nuisance suit is to force a settlement.Under the principles we just saw, this shouldn’t work if trials are equally costly to both sides. If both sides agree that EJ = 0, and LCP = LCD, then we just saw that a “reasonablesettlement” would be 0.However, suppose the cost of going to trial is different for the two sides. The book gives the example of a developer, who has to settle a lawsuit to avoid delaying construction. Inthis case, the cost of going to trial would be high for the defendant, since it would includeconstruction delays on top of lawyers’ fees; the plaintiff’s cost of going to trial might be much lower.For a concrete example, suppose the cost of going to trial would be $5,000 for the defendant, and $1,000 for the plaintiff. Assume the suit has no merit – there is no chance of a judgment. The two sides’ threat points – the value each could get if they are unable to bargain to a settlement – would be -5000 and -1000. The gains from cooperation are 6000. The “reasonable” settlement we described earlier gives the plaintiff his threat pointplus half the gains from cooperation – here, -1000 + 3000 = 2000. So the plaintiff might be stuck paying a settlement to avoid a worthless lawsuit, just to avoid the cost of going to trial.As we mentioned before, though, even when the parties are not relatively optimistic, settlements may sometimes fail to be reached due to private information. For example, suppose the defendant made a faulty product, which injured lots of people. Some people sustained minor injuries, say, $2,000 worth of harm. Some sustained major injuries, say, $10,000 worth of harm. But the defendant can’t tell, before going to trial, whether a given plaintiff
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