Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Spring 2012 Lecture 20

Discussion question – recapping tort law • punish the choice • criminal law • regulations • punish the outcome • strict liability rule Choice + Bad Luck  Outcome • punish the combination of choice and outcome • negligence rule QUESTION: What are the pros and cons of each approach?

Thinking aboutthe legal process

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

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

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

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…

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 Pareto-improvement over going to trial • So settling is more likely

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

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

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

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!

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

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

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

The legalprocess

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)

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

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?

Why sue? Harm done: $100 70% chance you settle immediately Average settlement is $50, legal costs of $1 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 Sue? Don’t File File Settle immediately or exchange info? Settle “Discovery” Settle then or go to trial? Settle Trial Win or lose at trial? Win Lose Appeal? No Yes Win or Lose Appeal? Win Lose

Why sue? Harm done: $100 70% chance you settle immediately Average settlement is $50, legal costs of $1 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 Sue? Don’t File File Settle immediately or exchange info? Settle “Discovery” Settle then or go to trial? Settle Trial Win or lose at trial? $30 Win Lose 50% 50% Appeal? $100 – $20 = $80 –$20 No Yes Win or Lose Appeal? $0 –$10 Win Lose 10% 90% $100 – $20 = $80 –$20

Why sue? Harm done: $100 70% chance you settle immediately Average settlement is $50, legal costs of $1 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 Sue? Don’t File File Settle immediately or exchange info? Settle “Discovery” Settle then or go to trial? 70% * $49 + 30% * $30 = $43.30 Settle Trial 70% 30% Win or lose at trial? $50 – $1 = $49 $30 Win Lose 50% 50% Appeal? $100 – $20 = $80 –$20 No Yes Win or Lose Appeal? $0 –$10 Win Lose 10% 90% $100 – $20 = $80 –$20

Why sue? Harm done: $100 70% chance you settle immediately Average settlement is $50, legal costs of $1 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 Sue? Don’t File File 70% * $49 + 30% * $40 = $46.30 Settle immediately or exchange info? Settle “Discovery” 70% 30% Settle then or go to trial? $50 – $1 $43.30 $43.30 – $3.30 Settle Trial Win or lose at trial? Win Lose Appeal? No Yes Win or Lose Appeal? Win Lose

Why sue? Harm done: $100 70% chance you settle immediately Average settlement is $50, legal costs of $1 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 Sue? Don’t File File $46.30 $0 $46.30 – filing costs

Why sue? Sue? Don’t File File $0 $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

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…

Number of lawsuits Number of lawsuits not worth suing for most victims more precaution  fewer accidents Typical level of damages

Filing costs • Expected value of claims should vary widely Probability Filing Fee SUE DON’TSUE Expected value of claims

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

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

Filing costs Probability Filing Fee SUE DON’TSUE 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

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

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

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?

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 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.

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

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

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

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

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

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

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 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

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

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

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.”

Econ 522 Economics of Law