Econ 522 – Lecture 21 (April 21, 2009)Last Thursday, we began to examine the legal process itself.- We said that the goal of the legal process should be to minimize the sum of two types of costs:o the administrative costs of implementing the processo error costs – inefficiencies coming from distorted incentives caused by animperfect system- We then broke the entire legal process up into a series of steps, or decision pointso The decision to sue or not sueo The option to settle out of court immediatelyo The exchange of information before a trialo The subsequent decision to settle or to proceed with the trialo The trial itselfo And the appeals process- We said that we expect people to sue for harms where the expected gain from suing is bigger than the costo Filing fees – the initial costs of beginning a legal complaint – help determine how many people choose to file suitso 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 costso When failures to provide a remedy have strong incentive effects, the social cost of these errors is large, so filing fees should be low- We talked about the decision to settle or go to trialo Trials are costly to both partieso 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)o Out-of-court settlements can be Pareto-improving, and seem likely to occur when the two sides agree on the expected judgment that a trial would lead too When the parties are each relatively pessimistic about their own chances in court, settlements should be even more likely.o When the parties are relatively optimistic about their own chances, settlements are less likely, and may be impossible- 1 -- We talked about the process of pre-trial discoveryo Before trial, the two parties share information about the case – some of it voluntarily, some of it because they are required too The parties will happily share information that corrects the other side’s relative optimismo So voluntary information exchange should make settlements more likelyo Voluntary information exchange reduces both administrative costs and error costso During the discovery process, parties are also forced to share information they would otherwise have kept secreto This could be information that would correct the other side’s relative pessimism, and therefore could make settlement less likelyo Involuntary information exchange reduces error costs, but the impact on administrative costs is unclear- 2 -Next topic: Pre-Trial Bargaining- Suppose 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, one reasonable outcome is when the gains from cooperation get split evenlyo That is, each side’s payoff is his threat value plus half the gains from cooperation- We can apply the 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- 3 -- Suppose the two sides are bargaining 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.- Combined payoffs if they go to trial are – LCD – LCP if they go to trial- If they 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 and the gains are split evenly, then the plaintiff gets his threat value plus half the gains from cooperation: this would beEJ – LCP + ½ (LCD + LCP) = EJ – ½ LCP + ½ LCD- When 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 is exactly 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 woulddefinitely 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 LCP = LCD and both sides agree that EJ = 0, 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- In this case, the cost of going to trial would be high for the defendant, since it would include construction 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- 4 -- 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 point plus half the gains from cooperation – here, -1000 + 3000 = 2000-
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