Rooms Assigned for Final Exam Dec 19, 2:45 P.M., in Soc Sci 5208

Econ 522 – Lecture 20 (Nov 202009)

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

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:
the legal system works flawlessly
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.

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.

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.

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.

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.

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

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.

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.

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.

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

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.

Cooter and Ulen point out that the legal process has a large number of steps: Once an injury has occurred….

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
This consists of exchanging information relevant to the case – more on this shortly
Once information has been exchanged, the two sides can bargain againover 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.

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.

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.

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.

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.

(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.

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.

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.

This means that there are three things that seem to directly influence the number of claims:
the number of injuries
the cost of filing a complaint
the expected value of a claim

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.

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.

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.

(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.

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.)

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.
A lawyer being paid by the hour has an incentive to do too much work
A lawyer paid for each individual service has an incentive to do them quickly and sloppily
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 long-run 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.

Exchange of information.