Econ 522
Economics of Law
Dan Quint
Spring 2012
Lecture 20
Discussion question – recapping tort law
punish the choice
punish the outcome
• criminal law
• strict liability rule
• regulations
Choice
+
Bad Luck

Outcome
punish the combination of choice and outcome
• negligence rule
QUESTION: What are the pros and cons of each approach?
1
Thinking about
the legal process
2
Over the last three months, we have…
 Developed theories of property/nuisance law, contract law,
and tort law
 Looked at how rules of legal liability create incentives
 Thought about how these rules can be chosen to try to
achieve efficient outcomes
3
Over the last three months, we have…
 To achieve efficiency, we’ve generally tried to set a party’s
liability equal to the harm he caused someone else




Damages in nuisance law
Expectation damages in contract law
Compensatory damages in tort law
That way, he internalizes the externality he imposes, leading to
efficient decisions
 In doing this, we’ve been making two big assumptions:


The legal system works flawlessly
The legal system costs nothing
4
An example from Polinsky, “An Introduction
to Law and Economics”
 I hit you with my car and did $10,000 worth of damage





We both know I was negligent
But courts aren’t perfect
If we go to trial, 80% chance I’ll be found liable, 20% I won’t
If I’m held liable, damages are correctly set at $10,000
So on average, if we go to trial, you expect to recover $8,000
 But if we go to trial, we both have to hire lawyers



Suppose this costs us each $3,000
Now your expected gain from going to trial is $8,000 – 3,000 = 5,000
And my expected cost is $8,000 + 3,000 = 11,000
5
An example from Polinsky, “An Introduction
to Law and Economics”
 So…


Going to trial gains you $5,000 (in expectation)
Going to trial costs me $11,000 (in expectation)
 Maybe we can settle out of court


If we avoid going to court and I pay you any settlement between
$5,000 and $11,000, we’re both better off
So maybe this happens
 But…
6
An example from Polinsky, “An Introduction
to Law and Economics”
 Suppose I’m more pessimistic about my chances than you


You think I’m 80% likely to be found liable
I think I’m 90% likely to be found liable
 You think your expected gain is $8,000 – 3,000 = $5,000
 I think my expected cost is $9,000 + 3,000 = $12,000
 Now the range of possible settlements is even wider


Any settlement between $5,000 and $12,000 is a Paretoimprovement over going to trial
So settling is more likely
7
An example from Polinsky, “An Introduction
to Law and Economics”
 Now instead, suppose I’m more optimistic about my
chances than you


You think I’m 80% likely to be found liable
I think I’m only 10% likely to be found liable
 You think your expected gain is $8,000 – 3,000 = $5,000
 I think my expected cost is $1,000 + 3,000 = $4,000
 Now an out-of-court settlement is impossible

There are no settlements that you and I would both agree to
8
An example from Polinsky, “An Introduction
to Law and Economics”
 And, even if our beliefs are compatible and there are
settlements that we would both prefer to trial…
 …private information might lead to failure to reach a
settlement

Remember from before: if our threat points are private
information, we might fail to reach an agreement because each of
us is holding out for too big a share
 So even if we had the same beliefs about what will happen
at trial, private information could prevent settlement
9
An example from Polinsky, “An Introduction
to Law and Economics”
 So when litigation is costly…




If the two parties agree on the likely outcome of a trial, there are
gains from settling out of court, and a range of settlements they
would both prefer to going to trial
If the two parties are relatively pessimistic, settlement is even
more likely
If the two parties are relatively optimistic, settlement may be
impossible
Even if the two have the same beliefs or are relatively pessimistic,
private information may lead to failures in bargaining
10
So what?
 Under strict liability…




We said injurers internalize cost of accidents  efficient precaution
But this assumes cost of being sued = damage done
If courts are unpredictable and litigation is costly, private cost of
being sued for damages could be > or < cost of accident
Which could lead to too much or too little precaution
 But also…



If settlement talks break down and cases go to trial…
…then total social cost of an accident includes the harm done,
and the resources expended during the trial!
If trial costs $6,000, then social cost of the accident isn’t $10,000,
but $16,000 – which increases the efficient level of precaution!
11
What is the goal of the legal process?
 Tort law: efficiency meant minimizing the total social cost
of accidents


Actual cost of accidents
Plus cost of actions taken to prevent them (precaution)
 Goal of the legal process: minimize its social costs


Direct (administrative) costs
Error costs
12
Administrative costs and error costs
 Administrative costs


Hiring judges, building courthouse, paying jurors…
More complex process  higher cost
 Error costs





Any legal process is imperfect
Errors are any judgments that differ from theoretically perfect ones
An error in computing damages after the fact only affects
distribution, not efficiency
But anticipated errors affect incentives, which may lead to
actions which aren’t efficient
Error costs are costs of distortions in actions people take
(precaution, activity levels, etc.) due to flaws in legal system
13
The goal of the legal process
 So theoretically, the efficient legal process is the one that
minimizes the sum of…

The direct costs of administering the system, and

The economic effects of errors due to that process not being
perfect
14
The legal
process
15
The legal process
 Once an accident has happened…

Victim could sue or not sue

The victim and injurer might quickly settle out of court

If the case proceeds to trial, the first step (in the U.S.) is a pre-trial
exchange of information

After that, victim and injurer might still settle out of court

If the case goes to trial, victim (now plaintiff) might win or lose

Losing side at trial can choose to appeal (or not)
16
Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
17
Why sue?
 In a rational world, victim compares cost of filing a
lawsuit to expected gain from suing
 How to calculate expected value of a legal claim?
18
Why sue?
Harm done: $100
70% chance you
settle immediately
Sue?
Don’t File
File
Average settlement is
$50, legal costs of $1
Settle immediately or exchange info?
“Discovery”
Settle
Discovery process
costs $3.30
70% chance you
settle after discovery,
average settlement is
$50, legal costs of $1
Settle then or go to trial?
Settle
Trial
Win or lose at trial?
Win
Lose
Trial costs $20
Plaintiff wins with
probability 50%,
damages = harm
Appeal costs $20
Appeal?
No
Yes
Win or Lose Appeal?
Win
Lose
Appeal succeeds with
probability 10%,
damages = harm
19
Why sue?
Harm done: $100
70% chance you
settle immediately
Sue?
Don’t File
File
Average settlement is
$50, legal costs of $1
Settle immediately or exchange info?
“Discovery”
Settle
Discovery process
costs $3.30
70% chance you
settle after discovery,
average settlement is
$50, legal costs of $1
Trial costs $20
Plaintiff wins with
probability 50%,
damages = harm
Appeal costs $20
Appeal succeeds with
probability 10%,
damages = harm
Settle then or go to trial?
Settle
Trial
Win
$30
50%
Win or lose at trial?
Lose
50%
Appeal?
–$20
$100 – $20 = $80
No
$0
Yes
–$10
Win
10%
$100 – $20 = $80
Win or Lose Appeal?
Lose
90%
–$20
20
Why sue?
Harm done: $100
Sue?
70% chance you
settle immediately
Don’t File
File
Average settlement is
$50, legal costs of $1
Settle immediately or exchange info?
“Discovery”
Settle
Discovery process
costs $3.30
70% * $49 + 30% * $30 = $43.30
70% chance you
settle after discovery,
average settlement is
$50, legal costs of $1
Trial costs $20
Plaintiff wins with
probability 50%,
damages = harm
Appeal costs $20
Appeal succeeds with
probability 10%,
damages = harm
Settle then or go to trial?
Settle
Trial
70%
$50 – $1 = $49
Win
30%
Win or lose at trial?
$30
Lose
50%
50%
Appeal?
–$20
$100 – $20 = $80
No
$0
Yes
–$10
Win
10%
$100 – $20 = $80
Win or Lose Appeal?
Lose
90%
–$20
21
Why sue?
Harm done: $100
70% chance you
settle immediately
Sue?
Don’t File
File
Average settlement is
$50, legal costs of $1
70% * $49 + 30% * $40 = $46.30
Settle immediately or exchange info?
“Discovery”
Settle
Discovery process
costs $3.30
70% chance you
settle after discovery,
average settlement is
$50, legal costs of $1
70%
$50 – $1 $43.30 –$43.30
$3.30
30%
Settle then or go to trial?
Settle
Trial
Win or lose at trial?
Win
Lose
Trial costs $20
Plaintiff wins with
probability 50%,
damages = harm
Appeal costs $20
Appeal?
No
Yes
Win or Lose Appeal?
Win
Lose
Appeal succeeds with
probability 10%,
damages = harm
22
Why sue?
Harm done: $100
70% chance you
settle immediately
Average settlement is
$50, legal costs of $1
Sue?
Don’t File
$0
File
$46.30 $46.30 – filing costs
Discovery process
costs $3.30
70% chance you
settle after discovery,
average settlement is
$50, legal costs of $1
Trial costs $20
Plaintiff wins with
probability 50%,
damages = harm
Appeal costs $20
Appeal succeeds with
probability 10%,
damages = harm
23
Why sue?
Sue?
Don’t File
$0
File
$46.30 – filing costs
 Decision to sue


If expected value of legal claim > filing costs, we expect victim to
file a claim
If expected value of legal claim < filing costs, we expect victim
not to
24
Number of lawsuits
 So there are three things that directly influence the number
of lawsuits



The number of injuries
The cost of filing a complaint
The expected value of a claim
 Holding everything else constant…



More injuries should mean more claims
Holding fixed the number of accidents, lower filing costs, or
higher expected value of claims, mean more claims
But things can sometimes get more complicated…
25
Number of lawsuits
Number of
lawsuits
not worth suing
for most victims
more precaution 
fewer accidents
Typical level of damages
26
Filing costs
 Expected value of claims should vary widely
Probability
Filing Fee
SUE
DON’T
SUE
Expected value of claims
27
Filing costs
 Recall the efficient legal system minimizes the sum of
administrative costs and error costs

Higher filing fees  fewer lawsuits  lower administrative costs

But, higher filing fees  more injuries go “unpunished”
 greater distortion in incentives  higher error costs

Filing fee is set optimally when these balance on the margin:


Marginal cost of reducing fee = marginal benefit
Administrative cost of an additional lawsuit = error cost of providing no
remedy in the marginal case
28
Filing costs
 Error costs



If we’re only concerned with efficiency, we don’t care about
distributional effects
That is, we don’t care if a particular victim is or isn’t compensated
So the size of error costs depends on how much peoples’ behavior
responds to the incentives caused by liability
 “The social value of reducing errors depends on whether
the errors affect production or merely distribution”


When errors have large incentive effects, filing fees should be low
When errors have small incentive effects, efficiency requires higher
filing fees
29
Filing costs
Probability
Filing Fee
SUE
DON’T
SUE
Expected value of claims
 As long as there are any filing fees or other costs to
litigation, some harms will be too low to justify a lawsuit

When harm is small to each individual but large overall, one
solution is a class action lawsuit
30
Class Action Lawsuits
 One or more plaintiffs bring lawsuit on behalf of a large
group of people harmed in a similar way

Example: California lawsuit over $6 bounced-check fee
 Court must “certify” (approve) the class


Participating in a class-action suit eliminates victim’s right to sue on
his own later
If suit succeeds, court must then approve plaintiff’s proposal for
dividing up the award among members of the class
 Class-action suits are desirable when individual harms
are small but aggregate harms are large…


Especially when avoidance of liability has strong incentive effect
But there’s also a danger
31
Lawyers and clients
 Agency problem





Client wants lawyer to work on case until marginal cost of more
work equals marginal benefit
This is hard to achieve through a contract, because lawyers face
their own incentives
One solution: 100% commission (client “sells lawsuit to lawyer”)
But this is illegal
Common solution: reputation
32
Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
33
Exchange of Information
 Trials are costly to both parties




If both parties agree on expected outcome of a trial, both are better
off agreeing to out-of-court settlement on similar terms
If two sides are relatively optimistic about their chances in court,
this may be impossible
After lawsuit filed but before trial, parties have opportunity to
negotiate a settlement, and to exchange information relevant to trial
Some information exchange is mandatory


“Discovery” process in U.S. – each side must supply opponent with
evidence they plan to use, answer questions about case
In Europe, no pre-trial discovery; instead, first stage of trial involves
similar sharing of information in front of judge
 Does voluntary pooling of information promote settlement?
 Does involuntary pooling of information promote settlement?
34
Voluntary exchange of information
 Parties tend to disclose information that corrects the other
side’s relative optimism







I hit you with my car
I think your injuries were minor, damages might be $1,500
You know they were serious, have x-rays and doctor’s reports to prove it,
know damages will be $15,000
Going to trial costs us each $3,000
As things stand: I expect trial to cost me $4,500; you expect to gain
$12,000; settlement seems unlikely
But you’re happy to show me your evidence
Once I see it, I might offer a bigger settlement, we both avoid cost of trial
 Parties tend to withhold information that would correct
other side’s relative pessimism
 Either way, voluntary exchange of information tends to
35
encourage settlement
Voluntary exchange of information
 Cooter and Ulen:
Trials occur when the parties are relatively optimistic about their
outcome, so that each side prefers a trial rather than settlement on
terms acceptable to the other side.
When the parties are relatively optimistic, at least one of them is
uninformed.
Pooling of information before trial that reduces relative optimism
promotes settlement.
Furthermore, by revealing private information to correct the other
side’s false optimism, the party making the disclosure increases the
probability of settling on more favorable terms.
36
What about involuntary exchange of
information?
 Involuntary disclosure will tend to reveal information the
parties would otherwise choose to withhold


This is usually information that corrects relative pessimism
So forced disclosure may make settlement less likely
 On the other hand, involuntary disclosure reduces
uncertainty, makes two sides’ threat points more clear

May make reaching a settlement easier
 So overall effect is unclear

Involuntary disclosure may also delay settlement until after
disclosure occurs
37
What about involuntary exchange of
information?
 Disclosure (“discovery”) rule in the U.S. very extensive



Parties reveal basic arguments they’ll make, evidence that supports
them, names of witnesses, nature of each witness’s testimony
Each side can inspect other’s evidence, question its witnesses
Witnesses or evidence not disclosed during discovery may not be
allowed at trial
 Most European countries have little or no pre-trial discovery



Europe: juries rarely used in civil cases
Delays and interruptions less costly, more common
Under civil law, judges take more active role in developing arguments
and exploring evidence
38
Effect of information disclosure on
administrative and error costs
 Voluntary disclosure encourages settlements


Fewer trials, simpler/quicker trials  lower administrative costs
Settlement terms get closer to likely trial outcome; if this judgment
would likely be correct, this reduces error costs
 Involuntary disclosure






Might lead to more or fewer trials
Should lead to simpler, shorter trials
Discovery is also a costly process
Overall effect on administrative costs could be positive or negative
Pools much of the information that would come out at trial, so
settlements should deviate less from trial outcomes
So involuntary disclosure should reduce error costs
39
Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
40
Pre-Trial Bargaining
 Plaintiff might accept settlements S when
S > Expected JudgmentPlaintiff – Legal CostsPlaintiff
 Defendant might offer settlements S when
S < Expected JudgmentDefendant + Legal CostsDefendant
 So settlement is possible when
EJP – LCP < EJD + LCD
which is when
EJP – EJD < LCP + LCD
degree of relative
optimism
combined legal
costs
41
Pre-Trial Bargaining
 Suppose parties agree on expected judgment EJ
 If bargaining fails and case goes to trial,




Plaintiff gets expected payoff EJ – LCplaintiff
Defendant gets expected payoff – EJ – LCdefendant
So these are threat points during bargaining
Combined payoffs are – LCplaintiff – LCdefendant
 If settlement is reached, combined payoffs are 0

So gains from cooperation are LCplaintiff + LCdefendant
 If gains from cooperation are split evenly…

Plaintiff’s payoff is (threat point) + ½ (gains)
= (EJ – LCplaintiff) + ½ (LCplaintiff + LCdefendant)
= EJ – ½ LCplaintiff + ½ LCdefendant
42
Pre-Trial Bargaining
 We just concluded…




If the two parties agree on expected outcome of trial…
…and successfully negotiate a settlement…
…and divide gains from cooperation equally…
then settlement = EJ – ½ LCP + ½ LCD
 If going to trial is equally costly to both parties, this is just
EJ – the expected judgment at trial
 But if trial is more costly to defendant, this would be more
43
Nuisance Suits
 A nuisance suit is a lawsuit with no legal merit




If it goes to trial, defendant will definitely win (EJ = 0)
Sole purpose of a nuisance suit is to force a settlement
Just found: “reasonable settlement” = EJ – ½ LCP + ½ LCD
So if LCP = LCD, nuisance suit is pointless – reasonable settlement
would be 0
 But suppose going to trial is very costly for defendant





Publicity would be bad for defendant’s reputation
Or, developer has to settle lawsuit to avoid delaying construction
LCP is just legal fees
But LCD includes legal fees plus other costs
So even if lawsuit has no merit, defendant might feel forced to pay
44
a settlement
Nuisance Suits
 Example







Cost of going to trial is $5,000 for defendant, $1,000 for plaintiff
Expected judgment = 0
Threat points are -5,000 and -1,000
Gains from cooperation are 6,000
If gains are split evenly, plaintiff’s payoff is
(threat point) + ½ (gains)
= -1,000 + ½ (6,000)
= 2,000
So nuisance suit might lead to a settlement of $2,000, even though
expected judgment at trial is 0
45
Failures in negotiations
 Even without relative optimism, settlement negotiations
may fail due to private information









Ex: defendant made a faulty product, which injured lots of people
Some sustained minor injuries, say $2,000
Some sustained major injuries, say $10,000
Before trial, defendant can’t tell scope of plaintiff’s injuries
Suppose legal costs are $500 for each side
If ½ of plaintiffs had major injuries, average injury = $6,000
So reasonably settlement offer might be $6,000
But if all defendants are offered a settlement of $6,000, the ones with minor
injuries will take it, and the ones with major injuries will go to trial
Defendant has two choices:



Offer settlements large enough that everyone will accept
But then even people with very minor injuries, or none, might sue
Or offer only small settlements, and get stuck going to trial in many cases
46
Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
47
Trial
 In Europe…


Judges in civil trials take active role in asking questions and
developing case
“Inquisitorial system,” since judge asks questions
 In U.S…



Lawyers’ job to develop case
Judge is more of a passive referee
“Adversarial system,” since competing lawyers are adversaries
48
Incentives
 Lawyers have a strong incentive to win at trial


May be working on contingency
Value reputation for winning
 Judges have no stake in outcome of the trial


Judges will (we hope) generally do what is right…
…but have less motivation to work hard
 “Judges have incentives to do what is right and easy;
lawyers have incentives to do what is profitable and
hard.”
49
Who pays the costs of a trial?
 In U.K., loser in a lawsuit often pays legal expenses of
winner


Discourages “nuisance suits”
But also discourages suits where there was actual harm that may
be hard to prove
 In U.S., each side generally pays own legal costs

But some states have rules that change this under certain
circumstances
50
Who pays the costs of a trial?
 Rule 68 of Federal Rules of Civil Procedure
“At any time more than 10 days before the trial begins, a party
defending against a claim may serve upon the adverse party an
offer [for a settlement]…
If the judgment finally obtained by the offeree is not more
favorable than the offer, the offeree must pay the costs
incurred after the making of the offer.”
 “Fee shifting rule”
 Example




I hit you with my car, you sue
Before trial, I offer to settle for $6,000, you refuse
If you win at trial, but judgment is less than $6,000…
…then under Rule 68, you would have to pay me for all my legal
expenses after I made the offer
51
Who pays the costs of a trial?
 Rule 68 does two things to encourage settlements:


Gives me added incentive to make a serious settlement offer
Gives you added incentive to accept my offer
 But not actually as generous as it sounds

Attorney’s fees not always included in fees that are covered
 Asymmetric


Plaintiff is penalized for rejecting defendant’s offer
Defendant is not penalized for rejecting offer from plaintiff
52
Who pays the costs of a trial?
 Kathryn Spier, “Pretrial Bargaining and the Design of FeeShifting Rules”




Game-theory analysis of Rule 68 and similar rules
Shows that when parties have private information, fee-shifting rules
like this increase probability of settlement
Then considers designing “perfect” rule to maximize number of
cases that would settle out of court
Ideal rule is similar to two-sided version of Rule 68



Take each side’s most generous settlement offer
Compute a cutoff
If eventual judgment is below this cutoff, plaintiff pays both sides’ legal
fees; if above cutoff, defendant pays both sides’ fees
53
Unitary versus Segmented Trials
 Trial has to answer two questions:


Is defendant liable?
If so, how much are damages?
 Unitary trial considers liability and damages at same time

Economies of scope
 Segmented trial considers liability first, then damages
later (if necessary)

Damages phase may not be necessary
 In U.S., judges have discretion over which type of trial
54
Burden of proof
 Burden of proof: who is responsible for showing what at
trial




In criminal case, prosecutor’s burden to show defendant is guilty,
not defendant’s burden to show he’s innocent
Similarly, in civil case, plaintiff’s burden to make case
Under negligence rule, plaintiff has to prove defendant was
negligent (rather than defendant having to show he was not)
Under contributory negligence, once defendant is shown to be
negligent, it’s defendant’s burden to show plaintiff was also
negligent
55
Standard of proof
 Standard of proof: degree of certainty to which something
must be shown in court


In criminal cases, “beyond a reasonable doubt” – very high
standard
In civil cases, plaintiff usually has to prove case by “a
preponderance of the evidence”


Much lower standard – interpreted as anything over 50% certainty
For punitive damages to be awarded, high standard of proof is often
required: “clear and convincing evidence”
 Efficient level depends on relative costs of two types of
errors


Finding someone liable when they should not be
Finding someone not liable when they should be
56
Rules of evidence
 Rules for what evidence court can pay attention to
 Textbook gives examples where rules seem inconsistent, if
goal is simply to maximize probability of “right outcome”
 When we focus on efficiency, we care only about
outcomes, not about process
 But in real-world legal system, process is important in its
own right
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Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
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Appeals
 In U.S., three levels of federal courts



District courts, circuit courts of appeals, Supreme Court
(Many state court systems also have three levels, but this varies by
state)
Parties in district court cases have right of appeal


Circuit court is required to consider their appeal
Parties in circuit court cases do not

Supreme Court has discretionary review – chooses which cases to
hear
 In common law countries, appeals courts tend to only
consider certain issues


Appeals generally limited to matters of law
Matters of fact generally not considered
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Appeals
 Recall goal of legal system

Minimize administrative costs + error costs
 Clearly, appeals process increases administrative costs

So only efficient if it reduces error costs
 Reasons why appeals process may reduce error costs


Appeals courts are more likely to reverse “wrong” decisions than
“right” decisions…
…which leads to losing parties appealing more often when decision
was “wrong”
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Stages of the legal process…
decision to pursue a legal claim
bargaining over out-of-court settlements
pre-trial exchange of information
trial itself
appeals process
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Up next
 Up next: criminal law

If you want to read ahead: Friedman chapter 15, or Becker paper
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