An accident has occurred, causing $10,000 in harm to the victim. The amount of h

Question

An accident has occurred, causing $10,000 in harm to the victim. The amount of harm done is undisputed and easy to prove; punitive damages are not applicable, so any damage award would be for exactly $10,000. This type of accident is governed by strict liability, so the injurer is legally responsible, but it may be difficult to prove in court that he caused the harm. The victim can hire a lawyer for $3,000 and go to trial, in which case he would have a 40% chance of winning. He could also hire an expert witness to testify. This would ensure victory at trial, but would cost an additional $10,000, for a total of $13,000. Going to trial costs the defendant (injurer) $5,000, regardless of whether the plaintiff (victim) hires an expert witness. Assume that neither party pays any legal expenses if an out-of-court settlement is reached.

First, consider the usual American rule where each party pays its own legal fees.

(a) If the case goes to trial, will the plaintiff hire an expert witness or not?

(b) Given your answer to (a), calculate

i. each party’s threat point during pre-trial negotiations (which is its noncooperative payoff if the case goes to trial)

ii. the gains from cooperation if a pre-trial settlement is reached

iii. the settlement that would occur if the two parties agreed to divide the gains from cooperation evenly

(c) In this scenario, would the American rule lead to over-, under-, or efficient precaution on the part of the injurer?

Explanation / Answer

Consider the following decision tree and the respective payoffs of the plaintiff and the defendant under the different scenario. Here 'S' stands for the settlement amount.

A.

It is clear from the above illustration that defendant will choose 'S' equal to the expected net loss for no offer/ offer rejected case:

So, S = 50%*15 + 50%*35 = 25

So, the Defendant should be ready to pay a settlement of $25,000

B.

For low damage, the plaintiff has a payoff of 5 for the no offer/ offer rejected case. When the settlement offered is 25, she will accept.

For a high damage, the plaintiff has a payoff of 25 for the no offer/ offer rejected case. The settlement offered is 25. So, this is a point of indifference for the plaintiff.

C.

For high demand, for the defendant, the best option is to go for settlement i.e. loss of 25

For low demand, for the defendant, the best option is to go for trial i.e. loss of 15

So, expected value with perfect information = - (25+15)*50% = - 20

Expected value of perfect information = - 20 - (EMV) = - 20 - (-25) = 5

Sinc $4000 < $5000, it is worth to spend $4000.

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