Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2009 Lecture 21

Logistics • Midterm is graded – pick it up at end of class • HW3 due next Tuesday (December 8)

The legalprocess

Tuesday, we… • Formulated the goal of the legal process • Minimize social costs, which consist of: • Administrative costs, and • Error costs • Broke the legal process into a series of steps, and discussed a couple of them • Today: • More on the legal process • A bit on crime and criminal law (more Thursday)

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

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.”

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

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

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

Who pays the costs of a trial? • Kathryn Spier, “Pretrial Bargaining and the Design of Fee-Shifting 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

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

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

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

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

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

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”

CriminalLaw

Criminal law differs from civil law in several ways • Criminal intended to do wrong • Case brought by government, not individual plaintiff • Harm done tends to be public as well as private • Standard of proof is higher • If found guilty, defendant will be punished

Crime in the U.S. • As of 2005, over 2,000,000 prisoners, nearly 5,000,000 more on probation or parole • Up from ~500,000 in 1980 • 93% male • In federal prisons, 60% are drug-related • Incarceration rate of 0.7% is 7 times that of Western Europe • Cooter and Ulen estimate social cost of crime • $100 billion spend annually on prevention and punishment • 1/3 on police, 1/3 on prisons, 1/3 on courts, prosecutors, public defenders, probation officers, etc. • Estimate another $100 billion on private crime prevention • Estimate total social cost to be $500 billion, or 4% of GDP

Crime in the U.S. • Crime rates (relative to population) in the U.S… • Decreased steadily from mid-1930s to early 1960s • Increased sharply in 1960s and 1970s • In 1980s, • Nonviolent crimes committed by adults dropped sharply • Violent crimes committed by adults dropped slightly • Violent crimes by young people went up • Violent and nonviolent crime rates dropped sharply in 1990s, continued to drop more slowly since 2000 • Nonviolent crime rate in U.S. now similar to Europe

Crime in the U.S. • Criminals in the U.S… • Disproportionally young males • Crime rates generally follow trend in fraction of population age 14-25 • Both violent criminals and victims disproportionally African-American • Relatively small number of people commit large fraction of violent crimes • Tend to come from dysfunctional families… • …have relatives who are criminals… • …do poorly in school… • …be drug- and alcohol-abusers… • …live in poor/chaotic neighborhoods… • …and being misbehavior at young age

Do harsher punishments deter crime? • Hard to answer empirically, because two effects • Deterrence • When punishment gets more severe, crime rates may drop because criminals are afraid of being caught • Incapacitation • When punishment gets more severe, crime rates may drop because more criminals are already in jail • Kessler and Levitt: natural experiment • Voters in California in 1982 passed ballot initiative adding 5 years per prior conviction to sentence for certain crimes • Found immediate drop of 4% in crimes eligible for enhanced sentences

Imprisonment • Imprisonment has several effects: • Deterrence • Punishment • Opportunity for rehabilitation • Incapacitation • When is incapacitation effective? • When supply of criminals is inelastic • (When there isn’t someone else waiting to take criminal’s place) • And when it changes number of crimes a person will commit, rather than just delaying them

Imprisonment • Direct costs of holding someone in maximum-security prison estimated at $40,000/year • In some states, prisoners do useful work • Attica State Prison (NY) had metal shop • Minnesota firm employs inmates as computer programmers • Medium-security prisons in Illinois make marching band uniforms • But legal limitations • 1980-1990: most state and federal courts moved away from judicial discretion toward mandatory sentencing • Recent move in opposite direction

Why did U.S. crime rate fall in 1990s? • Sharp drop in crime rate in U.S. in 1990s • Several explanations: • deterrence and incapacitation • decline of crack cocaine, which had driven much of crime in 1980s • economic boom • more precaution by victims • change in policing strategies • Donohue and Levitt give a different explanation: abortion

Why did U.S. crime rate fall in 1990s? • Donohue and Levitt • U.S. Supreme Court legalized abortion in early 1973 • Number of legal abortions ~ 1,000,000/year (compared to birth rate of 3,000,000) • Violent crimes largely committed by males of certain ages • Donohue and Levitt argue legalized abortion led to smaller “cohort” of people in high-crime age group starting in early 1990s • Evidence: • Most of drop was reduction in crimes committed by young people • Five states legalized abortion three years before Roe v Wade, saw drop in crime rates begin earlier • States with higher abortion rates in late 1970s and early 1980s had more dramatic drops in crime from 1985 to 1997, no difference before • Argue this explains 50% of drop in crime in 1990s • Half of that from cohort size, half from composition

Thursday… • Model of criminal law, what does efficient criminal system look like?

Second midterm • Mean 73, median 74.5, std dev 12 • Again, in very approximate terms… > 80 roughly AB or A 70-80 roughly B 60-70 roughly BC below 60 roughly C or worse last names A-Llast names M-Z

Econ 522 Economics of Law