Exploiting Plaintiffs through Settlement: Divide and Conquer

Abstract

Che and Spier [2007] consider a model of a single defendant and N plaintiffs where the total cost of litigation is fixed on the plaintiff side. As litigation cost is shared among the suing plaintiffs a plaintiff’s settlement decision creates a negative externality on the others. Failure to internalize this externality can be exploited by the defendant by making discriminatory settlement offers (divide and conquer strategy, see Segal [2003]). Compared to the benchmark case without externalities, this leads to a redistribution in favour of the defendant and dilutes the defendant’s incentives to take precaution. Although redistribution has no welfare effect per se, it nevertheless creates incentives for plaintiffs to organize (at a cost) in order to internalize the externalities. The welfare effect of diluted incentives depends on whether the defendant was overor underdeterred to begin with. Assuming that incentives were right in the benchmark, policies which promote the internalization of externalities (e.g. by facilitating the organization of plaintiffs) or prevent defendants from exploiting them (e.g. by prohibiting discriminatory offers) are potentially welfare increasing. Yet, even then there is a trade-off as these policies lead to lower settlement rates in a setting of asymmetric information which pushes up society’s cost of litigation. Che and Spier [2007] find these results robust in several variations of their leading case. In the following, I shall briefly sketch their analysis but then focus on an extension not considered in their paperunder which results are reversed.