Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 20

Econ 522Economics of Law

Dan Quint

Fall 2010

Lecture 20

2

The legalprocess

3

Last week, we said that to achieve efficiency, the legal process should minimizes the sum of two types of costs

Direct (administrative) costs – the tangible costs of administering the system, and

Error costs – the economic effect of any distortions caused by imperfections in the process

Last week…

4

Stages of the legal process…decision to pursue a legal claimbargaining over out-of-court settlementspre-trial exchange of informationtrial itselfappeals process

5

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?

6

Why sue?

Sue?

Settle immediately or exchange info?

Settle then or go to trial?

Win or lose at trial?

Appeal?

Don’t File File

Settle “Discovery”

Settle Trial

Win Lose

No Yes

Win or Lose Appeal?

Win Lose

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

7

Why sue?

Sue?




Appeal?

Don’t File File


Settle Trial

Win Lose

No Yes

Win or Lose Appeal?

Win Lose

$100 – $20 = $80 –$20

10% 90%

–$10$0

50% 50%

$100 – $20 = $80 –$20

$30

Harm done: $100





Trial costs $20


Appeal costs $20


8

Why sue?

Sue?




Appeal?

Don’t File File


Settle Trial

Win Lose

No Yes

Win or Lose Appeal?

Win Lose

$100 – $20 = $80 –$20

10% 90%

–$10$0

50% 50%

$100 – $20 = $80 –$20

$30$50 – $1 = $49

70% 30%

70% * $49 + 30% * $30 = $43.30

Harm done: $100





Trial costs $20


Appeal costs $20


9

Why sue?

Sue?




Appeal?

Don’t File File


Settle Trial

Win Lose

No Yes

Win or Lose Appeal?

Win Lose

$43.30 – $3.30

70% 30%

$50 – $1 $43.30

70% * $49 + 30% * $40 = $46.30

Harm done: $100





Trial costs $20


Appeal costs $20


10

Why sue?

Sue?

Don’t File File

$46.30 $46.30 – filing costs$0

Harm done: $100





Trial costs $20


Appeal costs $20


11

Why sue?

Sue?

Don’t File File

$46.30 – filing costs$0

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

12

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

13

Number of lawsuits

Number of lawsuits

Typical level of damages

not worth suing for most victims

more precaution fewer accidents

14

Expected value of claims should vary widely

Filing costs

Probability

Expected value of claims

Filing Fee

SUE

DON’TSUE

15

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

16

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

17

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

Filing costs

Probability

Expected value of claims

Filing Fee

SUE

DON’TSUE

18

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

Class Action Lawsuits

19

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

Lawyers and clients

20


21

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?

Exchange of Information

22

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

23

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.

Voluntary exchange of information

24

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?

25

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

What about involuntary exchange of information?

26

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

Effect of information disclosure on administrative and error costs

27


28

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

Pre-Trial Bargaining

degree of relative optimism

combined legal costs

29

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


30

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


31

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

32

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

Nuisance Suits

33

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

Failures in negotiations

34


35

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

Trial

36

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.”

Incentives

37

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?

38

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


39

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


40

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


41

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

Unitary versus Segmented Trials

42

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

Burden of proof

43

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

Standard of proof

44

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

Rules of evidence

45


46

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

47

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”

Appeals

48


49

Up next: criminal law If you want to read ahead: Friedman chapter 15, or Becker paper

Happy Thanksgiving!

Up next

Documents

Econ 522 Economics of Law Dan Quint Fall 2010 Lecture 20