Equilibrium formation of class action suits

Abstract

In large class litigation, courts often award judgments or make important decisions on the basis of the aggregate merit of the entire class and not upon the individual merit of each member. This so-called damage averaging practice provides different incentives to victims with different stakes to join a class action. When the defendant has complete information about each plaintiff's case, adverse selection, much like Akerlof's ‘lemons’ problem, arises in that low-stakes plaintiffs join the class action and high-stakes plaintiffs opt out. However, when the defendant does not have complete information the signaling effect associated with a plaintiff's membership decision matters; in particular, a low-stakes plaintiff may opt out for fear that joining the class may be interpreted by the defendant as evidence of a weak case. Thus, pure adverse selection never occurs in equilibrium. In equilibrium, a large fraction of high-stakes plaintiffs may join a class action, and low-stakes paintiffs may opt out.