Econ 522 – Lecture 21 (Nov 27 2007)Hope you all had a nice Thanksgiving.Reminder: last homework due next Tuesday.Thursday: class evaluations – please bring a pencil!Over the last two months or so, we’ve developed theories of property and nuisance law, contract law, and tort law. We’ve looked at how rules of legal liability create incentives, and how these rules can be chosen to achieve efficient, or close to efficient, results.With damages in nuisance law, with expectation damages in contract law, and with compensatory damages in tort law, we assumed it was possible to make one party’s liability for damages exactly match the harm he caused to the other party, so that he would internalize this harm and therefore make efficient decisions. Implicitly, we made two big assumptions:- the legal system works flawlessly- the legal system is costlessThe first assumption we made explicitly – by assuming we could set damages precisely inrelationship to actual harm – and, during tort law, we considered the effect on incentives when it is violated. The second assumption we made implicitly – by ignoring the costs ofthe legal system in figuring efficiency, and also by ignoring the private costs of litigation when considering the parties’ incentives.The next three lectures, we will relax these two assumptions, and explicitly consider the details of the legal system and the incentives it creates.We’ll start with an example from the Polinsky book. I hit you with my car and did $10,000 worth of damage. (Sorry.)You and I both know that I was negligent, but we also both know that courts aren’t perfect – if we go to trial, there’s an 80% chance I’ll be held liable, and a 20% chance I won’t. If I am held liable, damages will be correctly set at $10,000; so if we go to trial, you expect to recover (on average) 80% X $10,000 = $8,000.However, if we go to trial, we’ll both have to hire lawyers, and lawyers are expensive. Suppose going to trial will cost each of us $3,000.So now your expected net gain from going to trial is $8,000 – $3,000 = $5,000.Similarly, my expected cost if we go to trial is $8,000 + $3,000 = $11,000.Of course, since a trial will (in expectation) cost me $11,000 and earn you $5,000, it’s possible we can agree to settle without going to court. Any settlement between $5,000 and $11,000 makes both of us better off. So perhaps this will happen.However, it’s also possible we disagree about the likely outcome of a trial. You probably have some private information about the degree of your injuries. I probably have some private information about how recklessly I was driving.First, suppose I’m more pessimistic about my chances at trial than you. That is, you think I’m 80% likely to be found liable, but I think it’s more like 90%. So you perceive your expected gain from trial to be $5,000; but I perceive my expected cost to be 90% X $10,000 + $3,000 = $12,000. This makes the range of possible settlements we’d both agree to wider, and makes settling more likely.On the other hand, suppose I’m optimistic about my chances. You still think I’m 80% likely to be held liable, but I think it’s more like 10%. You expected gain from trial is still $5,000; my expected cost (given my beliefs) is $4,000. So now we’re very unlikely to settle.Finally, even if our beliefs are compatible, that is, there is a range of settlements which would make us both better off than going to trial, the private information we both have might lead to a failure to settle. Recall from before, that if each of our threat points are private information, we might fail to reach an agreement because one of us tries to hold out for too big a share. So even if we both had the same beliefs about the likely outcome of a trial, private information could lead us to fail to settle.This leads us to a few quick observations:- With litigation costs, if we agree on the likely outcome of a trial, there will alwaysbe gains from settling out of court, and a range of settlements we would both prefer to trial- If the two sides are relatively pessimistic – the injurer perceives his expected liability to be higher than the victim – settlement is even more likely- If the two sides are relatively optimistic – the injurer perceives his expected liability to be lower than the victim – settlement may be impossible- Even if the two sides have the same beliefs or are relatively pessimistic, private information may lead to failures in bargainingBut then there’s another thing as well. Recall that under a strict liability rule, or under a strict liability with contributory negligence rule, the injurer bore the cost of accidents, andtherefore internalized them and took efficient precaution. But that assumed the cost of being sued was equal to the damage done. With unpredictable courts and litigation costs, the private cost of being sued for damages can be either greater or less than the actual cost of the accident; so this could lead to either too much or too little precaution.But it’s trickier than that as well. If we assume that settlement talks are likely to break down, and most cases will end up going to trial, then the total social cost of an accident includes the resources expended during a trial. That is, rather than $10,000, the cost of anaccident is really $16,000 – the harm done, plus the cost of a trial. If accidents do more harm, this means more precaution is cost-justified – the optimal level of precaution is higher than before.We’ve already spent a lot of time looking at how incentives respond to the private cost of accidents, so we’ll put that question aside. However, in the next couple of lectures, we’ll go into greater detail about the legal process itself – how these costs are incurred, and the effects this has.Cooter and Ulen point out that the legal process has a large number of steps: Once an injury has occurred….- The victim can decide to sue or let it go- The victim and injurer can immediately settle out of court, or else begin the process of preparing for trialo This consists of exchanging information relevant to the case – more on this shortly- Once information has been exchanged, the two sides can again bargain over an out-of-court settlement, and can either settle or go to trial- At trial, the victim (now the plaintiff) can win or lose- The loser at trial can choose to appeal or notWe’ll look more closely at each of
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