Econ 522 – Lecture 20 (Nov 20 2009)
rooms assigned for final exam – Dec 19, 2:45 p.m., in Soc Sci 5208
Chao has moved his office hours for the rest of the semester to Soc Sci 7231
I’ll have office hours 1:30-3:30 on Monday next week, none on Wednesday
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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 were making two big assumptions:
o the legal system works flawlessly
o the legal system is costless
The first assumption we made explicitly – by assuming we could set damages
precisely in relationship to actual harm
And, in tort law, we even examined the effect on incentives when it is violated
The second assumption we made implicitly – by ignoring the costs of the legal
system in figuring efficiency, and also by ignoring the private costs of litigation
when considering the parties’ incentives.
The next two lectures, we will relax these assumptions, and explicitly consider the
details of the legal system and the incentives it creates.
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We begin 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.
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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.
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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.
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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.
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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
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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 even wider, and
makes settling more likely.
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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%
Your expected gain from trial is still $5,000
But now my expected cost, given my beliefs, is 10% x $10,000 + $3,000 = $4,000
So now we’re very unlikely to settle.
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Finally, even if our beliefs are compatible, that is, even if 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.
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This leads us to a few quick observations:
 With litigation costs, if we agree on the likely outcome of a trial, there will always
be 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 bargaining
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Recall that under a strict liability rule, or under a strict liability with contributory
negligence rule, the injurer bore the cost of accidents, and therefore 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
Suppose we believe 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 an accident might really be $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 for now.
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.
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Cooter and Ulen point out that the legal process has a large number of steps: Once an
injury has occurred….
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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 trial
o This consists of exchanging information relevant to the case – more on
this shortly
Once information has been exchanged, the two sides can bargain again 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 losing side at the original trial can choose to appeal or not
We’ll look more closely at each of these.
But first, it will help to have in mind what the theoretical goal of the legal process should
be.
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Recall that the economic essence of tort law was to minimize the total social cost
of accidents.
Similarly, in economic terms, the goal of the legal process is to minimize its total
social costs.
These costs come in two varieties: direct (administrative) costs, and error costs.
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Administrative costs are obvious.
If a legal process is going to require judges, you have to hire judges.
If it’s going to require courtrooms, you have to build a courthouse.
If it’s going to require jurors, you’ll have to pay the jurors.
The more complex the process is, the more it is likely to cost.
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Error costs are less obvious.
Any legal process will be imperfect – some defendants will not be found liable
when they should be, damages will sometimes be set incorrectly, and so on.
We can think of an error as any judgment that differs from the theoretically
perfect judgment, that is, the judgment that the court would impose if it were
infinitely wise and had perfect information.
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An error in, say, computing damages after the fact affects distribution but not
efficiency
However, anticipated errors also affect the costs that each side perceives as
stemming from their actions, and therefore changes incentives and may lead to
actions which are not efficient.
Error costs are the costs of any distortions in actions (precaution, activity levels,
etc.) due to imperfect incentives caused by flaws in the legal system.
Theoretically, then, we can see the goal of a legal process as minimizing the sum of these
two costs
 the direct costs of administering a legal process
 plus the economic effects of errors due to that process.
The next several sections of Cooter and Ulen consider in depth each of the different
stages we already mentioned:
 the decision to pursue a legal claim or not
 the decision to settle immediately or exchange information
 the decision to settle then or go to trial
 the trial itself
 the appeals process
We begin with the question of whether or not to sue. In a rational world, this comes
down to calculating the amount you expect to gain from suing, and comparing it to the
cost.
Looking at the problem from the victim’s point of view, we can turn all the questions
above into a decision tree, assign values and probabilities to the different outcomes, and
calculate the overall expected value of a legal claim.
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SUE?
Don’t File
File
SETTLE IMMEDIATELY OR EXCHANGE INFO?
Settle
“Discovery”
SETTLE OR GO TO TRIAL?
Settle
Trial
WIN OR LOSE AT TRIAL?
Win
Lose
APPEAL?
Win
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Lose
(In the U.S., before going to trial, the two sides in a lawsuit go through “pre-trial
discovery” – basically, the two sides exchange information they have that is
relevant to the case.
This could be doctor’s reports about the extent of injury, police reports about the
accident, lists of witnesses each side intends to call, and so on
In many European countries, there is no pre-trial discovery, and instead, the first
part of the trial itself involves a “giving of proofs,” in which the two sides offer
evidence to support the basic facts of their claim.)
To keep the arithmetic simple, Cooter and Ulen make the numbers unrealistically
small – you can think of these as hundreds of dollars.
They assume that the damage done was $100.
Starting at the bottom of the tree, suppose that if you lose at trial, an appeal will
cost $20, and will be successful 10% of the time.
That is, 10% of the time you’ll win the appeal and get a judgment of $100; the
rest of the time, you’ll get nothing. But either way, you pay the costs of $20
So an appeal has an expected value of
10% X $100 + 90% X 0 – $20 = –$10
so the victim expects not to appeal if he loses at trial.
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Now go back a step.
Suppose going to trial costs $20, and you’ll win with probability ½.
So with probability ½, you’ll win a judgment of $100, and with probability ½,
you’ll win nothing.
So the expected value of going to trial, knowing that you don’t plan appeal if you
lose, is
½ (100) + ½ (0) – 20 = $30
Now go back another stage, and consider bargaining for a settlement.
Suppose that it’s out of your hands whether bargaining will be successful or not;
70% of the time, you’ll reach a settlement, for an average of $50, and incur costs
of $1. The other 30% of the time, talks will break down, and you’ll go to trial.
So now the expected value of reaching this stage is
70% * ($50 - $1) + 30% * ($30) = $43.30
So this is the expected benefit of reaching the stage where you’ve already initiated
a suit, failed to settle initially, and already gone through discovery.
Now go back another stage, to the initial decision to settle immediately or go
through discovery.
Again, Cooter and Ulen assume this is not a decision but a random chance – with
70% probability, you’ll reach a settlement (averaging $50, and costing $1 in legal
costs), and with 30% probability, negotiations will fail.
They assume the discovery process costs $3.30
So the expected value of getting to this stage is
70% X ($50 – 1) + 30% * ($43.30 – 3.30) = $46.30
Finally, they assume it costs $10 to file a lawsuit; in this case, the expected gain,
$46.30 (with all the later costs built in), outweighs the filing cost, $10, so you
would expect the victim to file.
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Obviously, the exact numbers are arbitrary, but the general idea seems reasonable.
For each injury that occurs – that is, each accident, or breached contract, or invasion of
property, or nuisance – we expect a claim to be filed if the expected value of the claim
exceeds the filing cost.
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This means that there are three things that seem to directly influence the number
of claims:
o the number of injuries
o the cost of filing a complaint
o the expected value of a claim
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Obviously, more injuries should lead to more claims
And per accident, lower filing costs, or higher expected value of claims, should
lead to more claims as well.
They give a cool of example of how things can get more complicated, however.
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Think about the number of legal complaints filed, as a function of the level of
damages typically awarded by the court.
Obviously, when damages are very low, defendants have no reason to agree to
generous settlements, and so the expected value of a claim will be low – since all
the “upside” of a claim comes from either court-imposed damages or a settlement.
As damages rise, the expected value of a claim rises, and so the number of
lawsuits should rise.
However, as damages continue to rise, the cost of accidents to injurers rises as
well, and this will lead to greater precaution (or to less breach of contracts, or
fewer nuisance activities)
When damages get very high, injurers will go to great length to either prevent
accidents or avoid liability; so the number of accidents will be low, and so the
number of claims will be low
Therefore, as a function of damages, the number of claims filed might have an
inverted-U shape.
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Obviously, different injuries in different situations are different, so the expected
value of claims should vary widely
Whatever this distribution, filing costs basically divide this distribution into those
where the victim will find it worthwhile to sue, and those where he won’t
Higher filing costs mean fewer actions (at least on a per-injury basis).
In the U.S., courts do charge fees for filing a claim and for subsequent stages of
the process, but these fees are much less than the actual cost to the state; that is,
the state bears much of the cost of the legal process, but does charge some fees
In some civil law countries, the state charges no fees at all for using the civil
courts
Come back to our earlier point: economically, the ideal legal system is one that
minimizes the sum of administrative costs and error costs
Higher filing fees mean fewer actions, and therefore lower administrative costs
But higher filing fees also mean a greater number of injuries will go unpunished,
leading to a greater distortion in incentives and therefore greater error costs.
The filing fee is set optimally when these two exactly balance on the margin: that
is, when the administrative cost of an additional complaint is equal to the error
cost of providing no remedy in the marginal case, that is, the case which is right
on the border between justifying a lawsuit and not justifying a lawsuit.
The size of error costs depends on how strongly peoples’ behavior responds to the
incentives caused by liability
The textbook puts this another way:
the social value of reducing errors depends upon whether the errors affect
production or merely distribution.
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(Recall with contract law, we discussed the difference between “productive
information” and “redistributive information”. The distinction here in the same –
the question is whether errors just affect who has how much of the pie, not how
big the pie is, or whether the errors lead to a shrinking of the pie as well.)
In some situations, failing to provide a remedy for a harm will impact distribution,
but will not change anyone’s behavior
This might be the case with lawsuits involving hunting accidents: my reasons for
not wanting to shoot my friend probably have very little to do with how worried I
am about paying his widow if I kill him.
So failing to “punish” the marginal hunting accident might be bad for widows and
good for hunters, but it won’t have any impact on the number of accidents, so the
social cost of these errors is very small.
On the other hand, consider a contract setting where I paid up front for you to
provide a valuable service
Whether or not you want to live up to your end of the deal might depend very
much on whether you think I’ll bother to sue you if you walk away
So failing to “punish” the marginal breach might have a substantial impact on
production – whether you actually perform the service, or even whether I agree to
the contract in the first place.
So we conclude that when errors have large incentive effects, filing fees should be
kept low; when errors have small incentive effects, efficiency requires higher
filing fees.
The textbook goes on to make some obvious, and uninteresting, points about the
effect of the number of lawyers on the supply of legal services, and therefore on
price. Feel free to read about it if you like.
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As long as there are filing fees or other litigation costs, there will be some
situations where the harm done to each victim is below the threshold to justify a
complaint
One solution when the harm is small to each individual but large overall is one we
talked about Tuesday: a class action lawsuit
This is where one or more plaintiffs bring a lawsuit on behalf of a large group of
people harmed in a similar way
The book gives the example of a California man who sued his bank over a $6 fee
for bouncing a check
$6 obviously exceeds the costs of pursuing the claim, so he sued on behalf of all
the bank’s customers who were charged the same fee.
In order for a class-action suit to proceed, the court must decide to “certify” the
class
This has to be done thoughtfully, since participation in a class-action suit
extinguishes each victim’s right to sue later
(Some class action suits do allow individuals to choose whether to participate or
opt out, preserving their right to sue on their own.)
If a class-action suit succeeds – if it leads to either a settlement or a judgment at
trial – the court must then approve the plaintiff’s proposal for distributing the
award to the other members of the class.
Economics suggests class-action suits are appropriate where individual harms are
very small but aggregate harms are large, since these cases might otherwise go
unpunished – and especially appropriate especially if the avoidance of liability
will have strong effects on incentives.
However, there’s also a view that class-action suits come with a danger: that when
a class is large enough, losing at trial would be so catastrophic for the defendant
that even when the claim is very dubious, the defendant can’t take the risk at trial
and is basically forced to settle.
(These have been referred to as “blackmail settlements.”)
(And as I mentioned Tuesday, there’s also a view that some class-action suits are
motivated more by lawyers looking for a plaintiff rather than the other way
around.)
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This last point brings us to the next one: the agency problem between lawyer and
client
Ideally, the client wants the lawyer to work on the case until the marginal cost of
more work (the opportunity cost of the lawyer’s time) equals the marginal benefit
(in increased expected value of a settlement or judgment)
However, this is very hard to achieve via a contract.
o A lawyer being paid by the hour has an incentive to do too much work
o A lawyer paid for each individual service has an incentive to do them
quickly and sloppily
o A lawyer working on contingency – for example, a lawyer who receives
30% of the eventual judgment or settlement – internalizes some but not all
of the benefit of working, but all of the cost, and so has an incentive to
work too little.
One solution to this problem would be for lawyers to work on 100% commission
That is, they pay the client some up-front amount, and then get to keep whatever
settlement or judgment they get – functionally, the client sells their legal claim to
the lawyer
The lawyer would then internalize the full cost and full benefit of additional
effort, so they would work the optimal amount
Of course, this creates a different problem – the client, who is probably a key
witness, now has no incentive to testify or assist in the case
Also, as it happens, this kind of arrangement is illegal, pretty much everywhere
Since the lawyer tends to know more about the law than the client, the client can’t
always tell when he’s getting good advice, or whether more (or less) effort would
be optimal
In addition, there is some randomness to the legal process, so a lawyer’s effort
level can’t always be judged by the outcome of the case.
Given these problems, people often choose lawyers based on reputation and longrun relationships
Established firms have an incentive to maintain their reputation by hiring good
lawyers and getting them to do good work
Given that, clients are willing to pay a premium to hire a firm with an established
reputation.
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Exchange of information.
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We’ve already said: trials are costly for both parties
So if the two parties can anticipate the likely outcome of a trial, and come to a
settlement with similar terms, they both end up doing better
One of the obvious ways that this can fail to happen is if the two sides disagree
about the likely outcome of a trial.
The parties might disagree about the chance the defendant is held liable at all, or
about the likely size of damages
In our usual risk-neutral world, all that matters is the expected value of the
judgment each side expects
As we said before, when the plaintiff’s view of the expected judgment is higher
than the defendant’s view, the two sides are relatively optimistic – each one has
beliefs favoring their own interests
When the two sides are relatively optimistic, the range of settlements that both of
them would agree to is smaller than if they shared the same beliefs, and may not
exist – that is, there may be no settlement which both the defendant and the
plaintiff would agree to over a trial.
Once a suit has been filed but before it goes to trial, the parties have the
opportunity to negotiate a settlement, as well as to exchange information relevant
to the trial
In addition to voluntary sharing of information, there is some required sharing
In the U.S., this is the “discovery” process: each side must supply the other side
with the evidence they plan to use, and answer questions about the case.
(So named because each party has the right to “discover” facts the other party has
about the case.)
In Europe, there is no discovery pre-trial, but the first stage of the trial involves a
similar sharing of information in front of the judge.
Cooter and Ulen ask two distinct questions about the effect of information exchange:
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does voluntary pooling of information promote settlements out of court?
does involuntary pooling of information promote settlements out of court?
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First, we consider voluntary pooling – that is, information one of the parties willingly
shares without being required to.
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In general, parties tend to disclose information that corrects the other side’s
relative optimism
For example, suppose I hit you with my car, and we both know I’ll be held liable
I am relatively optimistic: I think you likely sustained only minor injuries, and
that damages might be $1,500
You know that you sustained more serious injuries, and have x-rays and doctors’
reports to prove it; given this information, damages will likely instead be set at
$15,000
Suppose going to trial would cost us each $3,000
As things stand, since I expect a trial to cost me $4,500, I have no reason to offer
a settlement larger than that
Since you expect to gain $12,000 from a trial, you have no reason to accept a
settlement smaller than that.
So settlement looks unlikely.
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But you’re more than happy to show me the x-rays and doctors’ reports
Once I see this evidence, I might agree that damages will be close to $15,000
Given that, I might be willing to offer a settlement close to that level, saving us
both the cost of going to trial.
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So when the information you have corrects my relative optimism, you’re happy to
share it with me; and this encourages settlement.
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On the other hand, suppose we started our relatively pessimistic
I heard something go “crunch” when I hit you and am worried I broke your hip,
and expect damages to be $15,000
You know the crunch was your iPod, and your actual injuries were minor.
Given this, I might be willing to offer a fairly high settlement; you might be
willing to accept a reasonably low one; a settlement seems likely
You have no reason to voluntarily inform me your injuries were minor, as this
would likely make me lower my settlement offer
In general, parties tend to withhold information that would correct the other
side’s relative pessimism
And since relative pessimism makes settlement likely, this withholding of
information likely encourages settlement.
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Cooter and Ulen explain these results in the following way:
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.
The same intuition holds in reverse for information which corrects false pessimism –
revealing the information is bad for the discloser, and discourages settlement.
So voluntary disclosure will tend to share information that corrects false optimist but not
false pessimism, promoting settlement.
So that’s voluntary disclosure. What about involuntary (forced) disclosure?
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Involuntary disclosure will tend to reveal the information that the parties initially
chose to withhold – that is, information that corrects relative pessimism
In this way, it may make settlement less likely.
On the other hand, involuntary disclosure reduces uncertainty, and makes the two
sides’ threat points more clear
In this way, it may make reaching a settlement easier
So the overall effect is unclear.
(One other thing, of course, is that the existence of a disclosure rule may some
make parties less willing to settle before disclosure, since they know they won’t
be forced to disclose any harmful information, and want to see what the other side
is forced to reveal. So involuntary disclosure may delay settlement until after
disclosure occurs.)
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The disclosure rule in the U.S. is very extensive
well before trial, both parties reveal the basic arguments it will make, the
evidence that supports them, the names of witness, and the nature of each
witness’s testimony
Witnesses or evidence that are not disclosed ahead of time may not be allowed at
trial
Each side can inspect the other side’s evidence and question its witnesses.
Most European countries have little or no pre-trial discovery
Part of this difference may stem from the constitutional right in the U.S. to request
a trial by jury
Jury trials are costly – the jurors are taken away from their jobs – so there is more
value in having the trial itself proceed quickly and without interruption.
Pre-trial discovery makes this more likely.
In Europe, juries are rarely used in civil cases
So delays and interruptions are less costly, and much more common
In addition, in European civil law, judges take a more active role in developing
arguments and exploring evidence
In the U.S., the judge plays a more passive role, serving as a referee between the
two opposing sides.
Finally, we can look at the effects of voluntary and involuntary disclosure on the two
types of costs we considered earlier – administrative costs and error costs.
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Voluntary disclosure, we said, encourages settlements, and therefore decreases the
number of trials
In addition, having more information out in the open ahead of time should ideally
simplify and quicken the trial itself
So we expect voluntary disclosure to reduce administrative costs.
In addition, as information is shared, the parties get closer to agreeing on the
likely outcome of a trial, so the terms of a settlement likely get closer to the result
of a trial
If we believe that the judgment at trial would likely be correct, this reduces the
size of errors in outcomes, and therefore reduces error costs.
So voluntary disclosure should reduce both administrative and error costs,
reducing the overall social costs of the legal process.
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Involuntary disclosure, we said, does not predictably encourage or discourage
settlement – it’s ambiguous whether it will lead to more or fewer trials
Pre-trial discovery is expected to lead to simpler, shorter trials
However, discovery is also a costly process
It’s unclear whether the overall effect on administrative costs is positive or
negative.
Even more than voluntary disclosure, though, involuntary disclosure pools much
of the information that would come out at trial; so when settlements occur, we
expect them to deviate less from the likely outcome at trial
So we expect involuntary disclosure to reduce error costs
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