Econ 522Economics of Law

Dan Quint

Spring 2013

Lecture 22

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MT2 is graded, will be returned today

HW2 graded, HW3 will be shortly

HW4 up, due next Thursday (May 2)

Plan Today: legal process Wednesday/next Monday: criminal law next Wednesday: behavioral law and econ May 6/8: wrap-up/review May 12: final exam

Logistics

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Discussion question – recapping tort law

Choice Bad Luck Outcome+

punish the choice

• criminal law

• regulations

punish the combination of choice and outcome

• negligence rule

punish the outcome

• strict liability rule

QUESTION: What are the pros and cons of each approach?

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Thinking aboutthe legal process

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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 three months, we have…

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Property law Goal was to allocate resources/entitlements efficiently… …or, to minimize inefficiencies due to misallocation

Contract law Goal was to further facilitate trade… …or, to decrease inefficiencies due to unrealized Kaldor-Hicks

improvements

Tort law Goal was explicitly to minimize social costs… …which consist of cost of accidents plus cost of precaution

We’ve been thinking of normative goal of minimizing social costs

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The legal system works flawlessly Whatever theoretical goal we set, we can implement correctly (In tort law, we’ve considered effect of errors)

The legal system costs nothing

Gave us nice theoretical results for achieving efficiency Example: injunctions when TC low, damages when TC high Example: strict liability when injurer activity matters a lot; negligence

when both sides’ precaution matters a lot

Next: what additional concerns are there when trying to put a legal structure in place to enforce these ideas?

Implicitly, we’ve generally been assuming two things so far

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Start with the best possible benchmark Theoretically perfect rules, implemented flawlessly and costlessly That’s obviously the best we can hope to do

How does reality differ? 1. Rules actually implemented won’t be the perfect ones Imperfect rules will lead to imperfect incentives, leading to

less-than-perfectly-efficient actions and outcomes Think of any loss of efficiency due to imperfections in legal system

as error costs 2. Actual system won’t be costless – administrative costs Goal of legal system: minimize sum of these two costs

What is the goal of the legal system itself?

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Administrative 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 and error costs

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So theoretically, the 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 process not being perfect

We’ve already seen the tradeoff between these two types of costs Tradeoff between “simpler” versus “more complex” rules We’ve seen this several times

The goal of the legal process

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Whaling law – “fast fish/loose fish” vs. “iron-holds-the-whale” FF/LF: lower administrative costs (fewer disputes) IHTW: lower error costs (better incentives for whaling)

Pierson v. Post (fox hunt case) Majority: first to catch, otherwise “fertile source of quarrels” Dissent: first to chase, hunting foxes is “meritorious”

Privatizing ownership of land Expanding property rights adds admin costs (boundary maintenance) But lowers error costs (better incentives for efficient use of resource) Demsetz: privatize when gains outweigh costs Same as: pick system with the lower sum of admin + error costs

We’ve already seen tradeoff between administrative and error costs

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The legalprocess

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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)

The legal process

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Worth it for victim to sue if

Sue or not sue?

Expected value of

legal claim

Cost toinitiatelawsuit

>

Probability of winning at trial, times expected judgment…

Or likelihood of a settlement, times expected amount…

Minus costs expected to be incurred

“Filing fees”

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Expected value of claims should vary widely

Filing fees

Probability

Expected value of claims

Filing Fee

SUE

DON’TSUE

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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

How high should filing fees be?

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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

How high should filing fees be?

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As long as there are any filing fees or other costs to litigation, some harms will be too low to justify a lawsuit When harm is small to each individual but large overall, one solution is a class action lawsuit

Filing fees

Probability

Expected value of claims

Filing Fee

SUE

DON’TSUE

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One or more plaintiffs bring lawsuit on behalf of a large group of people harmed in a similar way Example: California lawsuit over $6 bounced-check fee

Court must “certify” (approve) the class Participating in a class-action suit eliminates victim’s right to sue on his

own later If suit succeeds, court must then approve plaintiff’s proposal for dividing

up the award among members of the class

Class-action suits are desirable when individual harms are small but aggregate harms are large… Especially when avoidance of liability has strong incentive effect But there’s also a danger

Class Action Lawsuits

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Number of lawsuits

Number of lawsuits

Typical level of damages

not worth suing for most victims

more precaution fewer accidents

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Costlylitigation

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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 + 3,000 = 11,000

An example from Polinsky, “An Introduction to Law and Economics”

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So… Going to trial gains you $5,000 (in expectation) Going to trial costs me $11,000 (in expectation)

If all this is common knowledge, maybe we can avoid trial If we settle out of court and I pay you any settlement between

$5,000 and $11,000, we’re both better off So maybe this happens

But…

An example from Polinsky, “An Introduction to Law and Economics”

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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 + 3,000 = $4,000 Now an out-of-court settlement is impossible

On the other hand, if I’m more pessimistic than you, settlement is even easier But even then, not guaranteed if threat points are private information!

An example from Polinsky, “An Introduction to Law and Economics”

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Defendant made faulty product, lots of people injured Some sustained minor injuries ($2,000) Some sustained major injuries ($10,000) Before trial, defendant can’t tell scope of plaintiff’s injuries Suppose legal costs are $500 for each side Suppose half of plaintiffs had major injuries, so average injury = $6,000

Suppose defendant makes settlement offer of $6,000 to all victims The ones with minor injuries will take … …and the ones with major injuries will go to trial and win $10,000

Defendant has two choices: Offer settlements large enough that everyone will accept But then even people with very minor injuries, or none, might sue Or offer only small settlements, and get stuck going to trial in many cases

Failures in negotiations due to private information – example

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Under strict liability… 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 social cost of an accident includes both 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

Why does costly litigation matter?

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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

In the U.S., before going to trial, the two parties must exchange information

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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.

Exchange of information might facilitateout-of-court settlement

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Involuntary disclosure leads to information being shared that 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 more likely

So overall effect is unclear

But some exchange of information would happen voluntarily anyway

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Nuisance suit – lawsuit with no legal merit, purely meant to extract an out-of-court settlement Suppose trial costs $10,000 for plaintiff but $50,000 for defendant If case goes to trial, plaintiff will get nothing Threat points are -10,000 and -50,000 Gains from cooperation if settlement reached are 60,000 If gains are split evenly, defendant pays settlement of $20,000,

even though case had no merit

With costly litigation comes possibility of “nuisance suit”

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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?

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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?

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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?

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In Europe… Judges in civil trials take active role in asking questions and

developing case “Inquisitorial system,” since judge asks questions

In U.S… Lawyers’ job to develop case Judge is more of a passive referee “Adversarial system,” since competing lawyers are adversaries

Trial

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Trial has to answer two questions: Is defendant liable? If so, how much are damages?

Unitary trial considers liability and damages at same time Economies of scope

Segmented trial considers liability first, then damages later (if necessary) Damages phase may not be necessary

In U.S., judges have discretion over which type of trial

Unitary versus Segmented Trials

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Rules for what evidence court can pay attention to

Textbook gives examples where rules seem inconsistent, if goal is simply to maximize probability of “right outcome”

When we focus on efficiency, we care only about outcomes, not about process

But in real-world legal system, process is important in its own right

Rules of evidence

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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

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Recall goal of legal system Minimize administrative costs + error costs

Clearly, appeals process increases administrative costs So only efficient if it reduces error costs

Reasons why appeals process may reduce error costs Appeals courts are more likely to reverse “wrong” decisions than

“right” decisions… …which leads to losing parties appealing more often when decision

was “wrong”

Appeals

3939

Scores significantly lower than the first one

Average 72, median 73

For this exam, I’d think of 70-80 being roughly the B range, high 50s/low 60s roughly the C range

Second Midterm

A-G P-ZH-O