ECO320H1 Chapter 10 Notes

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23 Nov 2014
ECO 320
Textbook Notes
Chapter 10: An Economic Theory of the Legal Process
The procedural aspects of civil disputes concern the process from the filing of a
complaint to the resolution of the dispute through dismissal, settlement, or
A full blown legal dispute can be depicted by the following (values will vary):
Victims will consult a lawyer in order to tell them whether they have a legal
remedy that is economically viable.
In order to bring suit, a plaintiff must have a cause of action, which usually
consists of harm caused by the defendant for which the law provides a remedy.
Pretrial discovery: the process where the parties exchange extensive information
before trial.
Procedural law can be analyzed by looking at the effect of various laws on social
oAdministrative costs: the sum of the costs to everyone involved in passing
through the legal stages of a legal dispute (the costs of applying
substantive law).
oCosts of errors: costs that arise from the legal process making errors in
applying substantive law.
The errors distort incentives and impose a variety of costs on
Assuming that the economic objective of procedural law is to minimize the sum
of administrative costs and error costs, minimize the following:
min SC=ca+c
Settlements that replicate the results of trials reduce the social costs of resolving
disputes (save on administration costs).
oSince they replicate the results of trials, any error costs from settlement
will be the same as the error costs from trial.
In order to compute
, a standard of perfection is needed to compare
against the actual judgement.
oThe standard of perfection arises from a perfectly informed court who
gives all the right decisions relative to existing law and the actual facts.
oThe right decision by the perfectly informed court is called the perfect-
information judgement and is denoted
is the actual judgement, the extent of the court’s error
concerning damages is
oThe extent of the error does not necessarily need to be equal to its social
I.e. if damages are $500 too low so a manufacturer takes less
precaution (saves $1,000), which in turn causes an additional
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$10,000 of harm to consumers,
The circles in a decision tree represent probabilities, and the squares represent
Use decision trees to make decisions (i.e. calculate p whereby the defendant is
indifferent between settlement and trial or where a lawyer is indifferent
between taking a case or not).
A plaintiff normally has to hire a lawyer and pay filing fees to the court in order to
file a complaint.
oWhen deciding on whether to file a claim or not, the plaintiff must
compare the cost of filing the claim against the expected value of the
EV depends on what the plaintiff thinks will occur after filing the
Probabilities and payoffs need to be attached to each event above (done by the
plaintiff with the help of a lawyer).
American rule in legal disputes is that each party pay their own costs; the English
rule is that the loser pays all.
When computing EV’s in a sequence of events, begin with the last possible event
and work toward the first event
oSince it is < 0, the rational plaintiff will not appeal if they lose at trial.
oThis tree is assuming each party pays its own costs
if rule were
changed to loser pays all, the EVA would drop further so the decision is
the same.
oSince the rational plaintiff does not appeal in the event they lose at trial, if
they lose at trial, their EV = 0.
oThe value of settling is $50 but $1 has to be paid as settlement costs and
the EV of not reaching settlement is 30.
is > 0, the plaintiff who reaches this stage will bargain.
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oIf they filed the claim and settled immediately, the plaintiff would get $50
and have to pay $1; if not, they would have an EV of bargaining of $43.30
and have to pay $3.30 in discovering costs.
The net payoff from filing is
, since the cost of filing (i.e.
costs of getting a lawyer, drafting the complaint and paying the filing fee to the
court) is $10 and the EV of the complaint itself is $46.30.
A rational plaintiff does the following:
EVC ≥ FC → file legal complaint
EVC <FC → do not file legal complaint
The defendant will solve a similar tree but instead their goal is to minimize the
costs to them.
oThe probabilities and payoffs may not be the same at each stage in the
legal process.
Game theory explains why rational bargainers sometimes fail to settle their
disputes and end up in trial.
The plaintiff will want trial if they expect liability and a large judgement, and the
defendant expects no liability or a small judgement.
oThe parties are relatively optimistic.
If the plaintiff’s EV of the judgement at trial exceeds the defendants EV of the
judgement at trial, the parties are said to be relatively optimistic.
oThe plaintiff usually rejects an offer by the defendant that falls short of the
EV of the legal claim.
oThe defendant usually rejects a demand by the plaintiff that exceeds the
EV of the legal liability.
Relative optimism makes settlement out of court difficult.
In many cases, the defendant knows less than the plaintiff about the extent of the
injury, and the plaintiff knows less than the defendant about the extent of the
defendant’s precautions against the accident.
oIf the defendant overestimates the plaintiffs injury, and the plaintiff
overestimates the defendants precaution, both parties are said to be
relatively pessimistic
settlement is easy.
oIf the defendant underestimates the plaintiffs injury, and the plaintiff
underestimates the defendants precaution, both parties are said to be
relatively optimistic
settlement is hard.
The EV of a legal claim diverges for the parties because of private information
valuable information possessed by one party and not possessed by the
Relative optimism can be corrected through exchanging of information prior to
oOne party will tell the other party information that is beneficial for them
and thus the recipient of the information is getting ‘bad news.
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