Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 20.

Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 20

The legal process

Over the last 2 ½ 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 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 thought about how these rules can be chosen to achieve efficient, or close to efficient, results

Over the last 2 ½ 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 In general, in order to achieve efficiency, we’ve tried to set one party’s liability for damages equal to the harm he caused to the other party damages in nuisance law expectation damages in contract law compensatory damages in tort law That way, he would internalize the externality he was causing, and therefore make efficient decisions Implicitly, we were making two big assumptions: the legal system works flawlessly the legal system costs nothing The first assumption we made explicitly – by assuming we could set damages precisely in relationship to actual harm 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. Over the next two lectures, we will relax these two assumptions, and explicitly consider the details of the legal system and the incentives it creates.

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 = 11,000 We begin with an example from a book by Mitch Polinsky, “An Introduction to Law and Economics” 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.

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… 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

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 = $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 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.

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 = $4,000 Now an out-of-court settlement is impossible There are no settlements that you and I would both agree to On the other hand, suppose I’m more 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.

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 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.

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 This leads us to a few quick observations: When there are 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

So what? Under strict liability… But also…
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! Recall that under a strict liability rule, the injurer bore the cost of accidents, and therefore internalized these costs and took efficient precaution But this 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.

The legal process

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) 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 decide not to The victim and injurer can immediately settle out of court, or else begin the process of preparing for trial In the U.S., one of the first steps in preparing for a trial involves exchanging information relevant to the case – more on this shortly Once information has been exchanged, the two sides still have an opportunity to bargain again over an out-of-court settlement, and can either settle or go to trial At trial, the victim (now the plaintiff) might win or lose The losing side at the original trial can choose to appeal or not Over the next lecture and a half, we’ll look more closely at each of these steps.

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 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 counting both the cost of the accidents themselves, and the costly actions that were taken to prevent them 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 and error 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 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, any result that is different the judgment a court would impose if it were infinitely wise and had perfect information An error in computing damages after the fact will affect distribution but not efficiency That is, after the fact, me paying you very high damages, or not being found liable when I should be, will matter to us But since the damage is already done, it won’t affect efficiency But anticipated errors also affect the costs that each side perceives as stemming from their actions And therefore change 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 An example we already saw: if courts make errors in sometimes not finding injurers liable, this may lead to lower precaution, which is inefficient This inefficiency – however much the results differ from what would happen if damages were always set correctly – is an error cost

The goal of the legal process
So theoretically, for 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

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 Next, we look more closely at 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

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? 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

Why sue? Sue? Settle immediately or exchange info?
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 (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.) If we know how likely different outcomes are at each stage of the tree, we can assign values to the different points in the tree And work our way back up to the top to calculate the overall expected value of a legal claim. There’s an example of this in the textbook To keep the arithmetic simple, the are numbers unrealistically small – you can think of these as hundreds of dollars. They assume that the damage done was $100. Appeal? 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 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% Like with backward induction, we start at the bottom of the tree Suppose that if the plaintiff (the victim) loses at trial, an appeal will cost $20 That is, if you win the appeal, you’ll get a judgment of $100, but have to pay the cost of $20 If you lose the appeal, you get nothing, and still pay the cost of $20 And suppose an appeal will only be successful 10% of the time So an appeal has an expected value of 10% X $ % 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 Appeal? $100 – $20 = $80 –$20 No Yes Win or Lose Appeal? $0 –$10 Win Lose 10% 90% $100 – $20 = $80 –$20

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% * $ % * $30 = $43.30 Settle Trial 70% 30% Win or lose at trial? $50 – $1 = $49 $30 Win Lose 50% 50% To make this less messy, let’s wipe out everything at the lower levels At this point, we’ve calculated the value of going to trial to be $30, so everything that happens after that doesn’t matter 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 the expected benefit of reaching the stage where you’ve already initiated a suit, failed to settle initially, and already gone through discovery, is $43.30 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% * $ % * $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 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 So the expected gain from beginning the process (filing a lawsuit) is $46.30 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 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 So the expected gain from beginning the process (filing a lawsuit) is $46.30 If this is greater than the cost of filing, we expect the victim to file If the cost of filing is greater than $46.30, we expect the victim not to Obviously, the exact numbers are arbitrary, but the general idea seems reasonable For each injury that occurs each accident, each breached contract, each invasion of property, each nuisance We expect a claim to be filed if the expected value of the claim exceeds the filing cost. 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…

Typical level of damages
Number of lawsuits Number of lawsuits Think about the number of legal complaints filed, as a function of the level of damages typically awarded by the court. 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 as well more people find it worthwhile to file lawsuits However, as damages rise, the cost of accidents to injurers rises as well 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. Typical level of damages

Expected value of claims
Filing costs Expected value of claims should vary widely Probability Filing Fee Obviously, different injuries in different situations are different, so the expected value of claims should vary widely So we can think of there being some big probability distribution of different values for different types of claims 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 SUE DON’T SUE 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: Administrative cost of an additional lawsuit = error cost of providing no remedy in the marginal case Coming 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 (the case which is right on the border between justifying a lawsuit and not justifying a lawsuit)

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 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 introduced by the legal system only affect who gets how much of the pie, 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 – it affects 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 And 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.

Expected value of claims
Filing costs Probability Filing Fee SUE DON’T SUE As long as there are any 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 mentioned earlier: a class action lawsuit 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 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. Efficiency suggests that class-action lawsuits are desirable when individual harms are small but aggregate harms are large, since these cases might otherwise go unpunished And especially desirable if the avoidance of liability will have a strong incentive effect However, there’s also a view that class-action suits come with a danger In some scenarios, a “class” might be so large that losing at trial would be so catastrophic for the defendant Then even if the claim is dubious, maybe the defendant can’t take the risk at trial, and would basically be forced to settle These have been referred to as “blackmail settlements” (We’ll come back to this idea shortly – “nuisance suits”

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 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 his 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 could 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.

decision to pursue a legal claim bargaining over out-of-court settlements pre-trial exchange of information trial itself appeals process

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? Exchange of information We’ve already said: trials are costly for both parties So if the two parties can anticipate the likely outcome of a trial, and come to a settlement with similar terms, they both end up doing better One of the obvious ways that this can fail to happen is if two sides disagree about the likely outcome of a trial. The parties might disagree about the chance the defendant is held liable at all, or about the likely size of damages In our usual risk-neutral world, all that matters is the expected value of the judgment each side expects As we said before, when the plaintiff’s view of the expected judgment is higher than the defendant’s view, the two sides are relatively optimistic That is, each one has beliefs favoring their own interests When the two sides are relatively optimistic, the range of settlements that both of them would agree to is smaller than if they shared the same beliefs It may not even exist – that is, there may be no settlement which both the defendant and the plaintiff would agree to over a trial. Once a suit has been filed but before it goes to trial, the parties have the opportunity to negotiate a settlement, as well as to exchange information relevant to the trial In addition to voluntary sharing of information, there is some required sharing In the U.S., this is the “discovery” process: each side must supply the other side with the evidence they plan to use, and answer questions about the case (So named because each party has the right to “discover” facts the other party has about the case.) In Europe, there is no discovery pre-trial, but the first stage of the trial involves a similar sharing of information in front of the judge. Cooter and Ulen ask two distinct questions about the effect of information exchange: does voluntary pooling of information promote settlements out of court? does involuntary pooling of information promote settlements out of court?

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 First, we consider voluntary pooling – that is, information one of the parties would willingly share without being required to. In general, parties tend to disclose information that corrects the other side’s relative optimism For example, suppose I hit you with my car, and we both know I’ll be held liable I am relatively optimistic: I think you likely sustained only minor injuries, and that damages might be $1,500 You know that you sustained more serious injuries, and have x-rays and doctors’ reports to prove it; given this information, damages will likely instead be set at $15,000 Suppose going to trial would cost us each $3,000 As things stand, since I expect a trial to cost me $4,500, I have no reason to offer a settlement larger than that Since you expect to gain $12,000 from a trial, you have no reason to accept a settlement smaller than that. So settlement looks unlikely But you’re more than happy to show me the x-rays and doctors’ reports Once I see this evidence, I might agree that damages will be close to $15,000 Given that, I might be willing to offer a settlement close to that level, saving us both the cost of going to trial. So when the information you have corrects my relative optimism, you’re happy to share it with me; and this encourages settlement. On the other hand, suppose we started our relatively pessimistic I heard something go “crunch” when I hit you and am worried I broke your hip, and expect damages to be $15,000 You know the crunch was your iPod, and your actual injuries were minor. I might be willing to offer a fairly high settlement; you might be willing to accept a reasonably low one; a settlement seems likely You have no reason to voluntarily inform me your injuries were minor, as this would likely make me lower my settlement offer In general, parties tend to withhold information that would correct the other side’s relative pessimism Since relative pessimism makes settlement likely, this withholding of information likely encourages 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. The same intuition holds in reverse for information which corrects false pessimism – revealing the information is bad for the discloser, and discourages settlement. So voluntary disclosure will naturally lead to sharing of information that corrects false optimist, but not information that corrects false pessimism And in both cases, this promotes settlement

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 So that’s voluntary disclosure. What about involuntary (forced) disclosure? Involuntary disclosure will tend to reveal the information that the parties would otherwise choose to withhold We just said, this will tend to be information that corrects relative pessimism In this way, forced disclosure may make settlement less likely On the other hand, involuntary disclosure reduces uncertainty, and makes the two sides’ threat points more clear In this way, it may make reaching a settlement easier So the overall effect is unclear. (One other thing, of course, is that the existence of a disclosure rule may make some make parties less willing to settle before disclosure, since they know they won’t be forced to disclose any harmful information, and want to see what the other side is forced to reveal. So involuntary disclosure may 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 The disclosure rule in the U.S. is very extensive Well before trial, both parties reveal the basic arguments it will make, the evidence that supports them, the names of witness, and the nature of each witness’s testimony Witnesses or evidence that are not disclosed ahead of time may not be allowed at trial Each side can inspect the other side’s evidence and question its witnesses. Most European countries have little or no pre-trial discovery Part of this difference may stem from the constitutional right in the U.S. to request a trial by jury Jury trials are costly – the jurors are taken away from their jobs – so there is more value in having the trial proceed quickly and without interruption once it begins Pre-trial discovery makes this more likely. In Europe, juries are rarely used in civil cases So delays and interruptions are less costly, and much more common In addition, in European civil law, judges take a more active role in developing arguments and exploring evidence In the U.S., the judge plays a more passive role, serving as a referee between the two opposing sides.

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 We can also consider the effects of voluntary and involuntary disclosure on the two types of costs we considered earlier – administrative costs and error costs. Voluntary disclosure, we said, encourages settlements, and therefore decreases the number of trials In addition, having more information out in the open ahead of time should ideally simplify and quicken the trial itself So we expect voluntary disclosure to reduce administrative costs. In addition, as information is shared, the parties get closer to agreeing on the likely outcome of a trial, so the terms of a settlement likely get closer to the result of a trial If we believe that the judgment at trial would likely be correct, this reduces the size of errors in outcomes, and therefore reduces error costs. So voluntary disclosure should reduce both administrative and error costs, reducing the overall social costs of the legal process. Involuntary disclosure, we said, does not predictably encourage or discourage settlement – it’s ambiguous whether it will lead to more or fewer trials Pre-trial discovery is expected to lead to simpler, shorter trials However, discovery is also a costly process It’s unclear whether the overall effect on administrative costs is positive or negative. Even more than voluntary disclosure, though, involuntary disclosure pools much of the information that would come out at trial; so when settlements occur, we expect them to deviate less from the likely outcome at trial So we expect involuntary disclosure to reduce error costs

decision to pursue a legal claim bargaining over out-of-court settlements pre-trial exchange of information trial itself appeals process We said that we expect people to sue for harms where the expected gain from suing is bigger than the cost Filing fees – initial costs of beginning a legal complaint – determine how many people choose to file suits When failures to provide a remedy have only distributional effects, the social cost of these errors is close to 0, so filing fees should be high, to minimize administrative costs When failures to provide a remedy have strong incentive effects, the social cost of these errors is large, so filing fees should be low We talked about the decision to settle or go to trial Trials are costly to both parties So the expected cost of a trial to the defendant (including litigation costs) is greater than the expected benefit to the plaintiff (net of litigation costs) Out-of-court settlements can be Pareto-improving, and seem likely to occur when the two sides agree on the expected judgment that a trial would lead to When the parties are relatively pessimistic about their chances in court, settlements should be more likely. When the parties are relatively optimistic about their own chances, settlements are less likely, and may be impossible We talked about the process of pre-trial discovery Before trial, the two parties share information about the case – some of it voluntarily, some of it because they are required to The parties will happily share information that corrects the other side’s relative optimism So voluntary information exchange should make settlements more likely Voluntary information exchange reduces both administrative costs and error costs During the discovery process, parties are also forced to share information they would otherwise have kept secret This could be information that would correct the other side’s relative pessimism, and therefore could make settlement less likely Involuntary information exchange reduces error costs, but the impact on administrative costs is unclear

degree of relative optimism
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 Suppose there are no legal costs to settling out of court … The left-hand side can be thought of as the amount of relative optimism When the two sides agree on the expected judgment, this is 0 Relative pessimism makes this negative, relative optimism makes it positive And the right-hand side is the two sides’ combined legal costs. 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 Suppose the two sides are bargaining over a settlement And suppose that the two sides agree on the expected outcome of a trial, EJ The defendant knows that if bargaining breaks down, they’ll go to trial, and his expected payoff will be – EJ – LCD, so this is his threat point. The plaintiff knows that if bargaining breaks down, they’ll go to trial, and his expected payoff will be EJ – LCP, so this is his threat point. Combined payoffs if they go to trial are – LCD – LCP if they go to trial If they reach a settlement, their combined payoffs will be 0 – the plaintiff will receive exactly what the defendant pays So the gains to cooperation are the litigation costs that are avoided, LCD + LCP. Recall earlier in the class, we said that when two parties bargain, one reasonable outcome is when the gains from cooperation get split evenly That is, each side’s payoff is his threat value plus half the gains from cooperation We can apply the same idea in the context of an out-of-court settlement If bargaining is successful and the gains are split evenly, then the plaintiff gets his threat value plus half the gains from cooperation: this would be EJ – LCP + ½ (LCD + LCP) = EJ – ½ LCP + ½ LCD And so the settlement reached is for the plaintiff to pay EJ – ½ LCP + ½ LCD

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 As we mentioned before, though, even when the parties are not relatively optimistic, settlements may sometimes fail to be reached due to private information For example, suppose the defendant made a faulty product, which injured lots of people Some people sustained minor injuries, say, $2,000 worth of harm Some sustained major injuries, say, $10,000 worth of harm But the defendant can’t tell, before going to trial, whether a given plaintiff received major or minor injuries. Suppose legal costs are $500 for each side If major and minor injuries were equally common and everyone sued, the average judgment might be around $6,000 With equal litigation costs, this might be a reasonable settlement offer But if the defendant offered to settle each case for $6,000, the plaintiffs with minor injuries would all accept, and the plaintiffs with major injuries would go to trial and be awarded larger damages. So the defendant has two choices He can offer settlements large enough that everyone will accept them But if he does this, he creates a large incentive for even people with very minor injuries, or none at all, to initiate meritless lawsuits, hoping to settle Or he can offer only very small settlements, or no settlements at all, and accept that he’ll go to trial much of the time. (The book points out that we can see nuisance suits as bluffs – people with no valid claim start a lawsuit hoping to settle, knowing that they can’t win at trial. They point out that another strategy is to settle with some plaintiffs and go to trial with others, at random – basically, making bluffing more costly.)

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.” We can think about the incentives of the parties in a trial Lawyers have a strong incentive to win at trial Plaintiff’s lawyers may be working on contingency, so they make more money when their client wins Even when this isn’t the case, successful lawyers earn a reputation, and can charge more for their services in the future So lawyers are motivated to work hard, but only in the interest of their own client On the other hand, judges, by design, have no stake in the outcome of the trial. (Different countries have different systems for ensuring this.) Thus, we expect judges to generally do what is right, rather than what favors one side or the other Judges, however, also have less motivation to work hard. The book sums up by saying that “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 Another important question is who pays the costs of the trial. We already mentioned that some courts (but not all) charge fees for filing a complaint and for various other stages of the legal process. In the U.K., the loser in a lawsuit generally has to pay the legal expenses of the winner That is, if someone brings a baseless suit against me and loses, they have to pay my legal expenses This discourages “nuisance suits” of the type we described earlier However, it also discourages suits where there was actual harm that will be hard to prove. In the U.S., each side usually pays their own legal costs. However, some states have rules that change this under certain circumstances.

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

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 The rule does two things to encourage settlements: it gives me an added incentive to make a serious settlement offer and it gives you an added incentive to accept my offer. Your incentive is because if you don’t accept my offer, you may be stuck paying some of my legal costs My incentive is the same: if I make you an offer and you refuse, I may end up getting some of my legal costs covered This should lead to fewer cases going to trial. Rule 68 is not actually as generous as it sounds For one thing, attorney’s fees are not always counted as part of the legal fees that are covered Also, note that it is one-sided: plaintiffs are penalized for rejecting defendants’ settlement offers, but defendants are not penalized for rejecting plaintiffs’ offers.

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 The paper by Kathryn Spier on the syllabus, “Pretrial Bargaining and the Design of Fee-Shifting Rules,” gives a game-theory analysis of Rule 68 and similar rules. The paper is quite technical, but the conclusions she reaches are nice. She shows that when both parties have private information about the likely outcome of a trial, a fee-shifting rule like Rule 68 increases the probability of a settlement She then goes on to consider what would happen if the court could design the “perfect” rule to maximize the number of cases that are settled out of court She shows that this ideal rule would look similar to a a two-sided version of Rule 68, where if the case goes to trial, either side could be penalized for “exaggerating” how strong their case was pre-trial In approximate terms, the ideal rule would take each side’s most generous settlement offer, and based on these, compute some cutoff level of damages If the case went to trial and the eventual judgment was below this cutoff, the plaintiff would pay both sides’ legal fees; if the eventual ruling was above this cutoff, the defendant would pay both sides’ legal fees If the cutoff rule is chosen correctly, this gives each side strong enough incentives to be honest about the strength of their case ahead of time, which maximizes the chance of a settlement (The paper uses a theoretical framework known as “mechanism design” – basically, where someone designs a game ahead of time to get people to reveal private information they have. Mechanism design is also used as a tool in analyzing auctions, voting rules, and some other situations. Like I said, the paper itself is pretty technical, but the results are nice.)

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 Recall that a typical trial has to answer two questions: is the defendant liable, and if so, how much are damages? Another variable in the design of a trial system is whether these questions are considered at the same time, or separately Trials where liability and damages are considered at the same time are referred to as unitary trials Trials where liability is judged first, and then damages are evaluated in a separate trial segment, are called segmented trials There are arguments in favor of either one The argument for unitary trials is economies of scope – the reduction in costs from doing more than one thing at once The court will have to consider much of the same evidence to judge liability and damages In some cases, the two are tightly linked – figuring out negligence under the Hand rule requires knowing how much damage the accident caused So when the two are closely related, it is likely cheaper (in terms of time) to evaluate both at once. The argument for segmented trials is that the second segment will not always be necessary First of all, of course, if the defendant is not held to be liable, damages don’t have to be calculated Second, we considered earlier the case where the defense cannot distinguish between legitimate suits and baseless nuisance suits This makes it very hard to settle cases ahead of time – the defense can either offer a large settlement that everyone would accept, and live with richly rewarding the nuisance suits; or he has to go to trial with all the legitimate suits. In a segmented trial, however, once liability has been established, the parties then have another opportunity to settle. So the second phase of the trial could be unnecessary, either because liability was not found, or because the liability phase was enough to filter out the baseless lawsuits and lead to settlement of the legitimate ones. In the U.S., judges have discretion over whether a trial will be unitary or segmented.

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 The standard of proof is the degree of certainty to which something must be proven in court In criminal cases, this is “beyond a reasonable doubt” – a very high standard In civil cases, the standard of proof is much lower: under the common law, the plaintiff must prove his case by a preponderance of the evidence This is usually interpreted as anything beyond 50% certainty. For punitive damages to be assessed, the standard of proof is often higher than this: clear and convincing evidence, which is higher than preponderance but lower than reasonable doubt The efficient level of the standard of proof depends on the relative costs of the two types of errors – in a criminal case, convicting someone innocent versus freeing someone guilty Convicting an innocent person of a crime is seem as very costly, so the standard of proof in criminal cases is very high Ruling against someone in a lawsuit when they should not have been liable is less costly They may get stuck paying damages they shouldn’t owe, but that doesn’t matter for efficiency So the standard of proof is lower in civil cases

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 The book gives a couple of examples of ways in which the rules of evidence – rules for what evidence a court should pay attention to – seem inconsistent, if the goal is simply to maximize the probability of getting the right answer They give an example of a concert being held in a 1000-seat auditorium 400 ticket holders have taken their seats when a mob breaks in and fills up the remaining seats without tickets The concert organizer photographs the crowd, and can identify some people who are in the audience, but doesn’t know who had a ticket and who didn’t. Since there were 400 legitimate customers and 600 crashers, each person has a 60% likelihood of having broken the law; but the court tends not to allow this type of statistical argument. On the other hand, an eyewitness who thought he could identify one of the gate crashers, but was shown to only identify people correctly 60% of the time, would probably be allowed The upshot: by focusing on efficiency in this class, we care only about outcomes, not on how they are reached But in a real-world legal system, the process by which an outcome is reached is seen as important in its own right, not just because it hopefully leads to the right outcome We’ll talk more about this in a couple of lectures

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 Finally, a little bit on the appeals process In the U.S., there are three levels of federal courts: district courts, circuit courts of appeals, and the Supreme Court Litigants in district courts have a right of appeal – the circuit court is required to consider their appeal Litigants in circuit courts do not have a right of appeal – the Supreme Court has discretionary review – it can choose whether to consider a particular case or not. In some countries, appeals courts hear the entire case again. In common law countries, appeals courts tend to only consider certain issues. Common law appeals are generally limited to matters of law – whether a legal error was made at trial, such as a statute being applied incorrectly. Matters of fact – whether a particular witness was credible enough to convince a jury of a particular claim – are generally not considered on appeal

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” Clearly, an appeals process adds to the administrative costs of a legal system So it is only beneficial if it reduces error costs Cooter and Ulen offer two reasons why this might be the case, and so the appeals process might decrease total social costs: Appeals courts are more likely to reverse “wrong” decisions than “right” ones This leads losing parties to appeal “wrong” decisions with higher probability than “right” ones The first condition is required for the appeals process to reduce error costs at all. The second condition – that bad decisions are more likely to be appealed than good decisions – suggests that the reduction in error costs may outweigh the increase in administrative costs. (If all cases were equally likely to be appealed, then the appeals process could simply be considered a part of the original trial.) We’ll come back to the legal process once more next week, when we revisit some of the big-picture questions about efficiency. But for now, …

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Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 20.

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Econ 522 Economics of Law Dan Quint Spring 2010 Lecture 20.

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