Optimism and pessimism in bargaining and contests

Abstract

This paper uses the rank-dependent expected utility (RDEU) model to capture the effects of optimism and pessimism on the choice between a pre-trial settlement and a trial (or more generally, between a private settlement and a litigation). These two legal procedures are described as a bargaining game and a contest game, respectively. My models predict that a contest occurs if the aggregate optimism premium in a contest (AOPC) is sufficiently high. I also find that the AOPC tends to be higher for close cases. Such predictions are consistent with the Priest-Klein empirical observation that a plaintiff's winning probability is often near 50% in many areas of civil litigation. I also show that the highest levels of effort in both a bargaining game and a contest game are exerted when one is moderately optimistic. However, excessive optimism will reduce one's effort level, and hence, one's winning rate. As a result, when faced with an excessively optimistic party, a risk-neutral party may prefer a contest over bargaining.