Econ 522 Economics of Law

Econ 522Economics of Law Dan Quint Fall 2010 Lecture 20

The legalprocess

Last week… • 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

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.”

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”

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

Econ 522 Economics of Law