The level of litigation: private versus social optimality of suit and of settlement

Abstract

The legal system is a very expensive social institution. Increasingly we read about the volume and the high costs of suit, and we observe the use of various measures to reduce litigation activity, for example, requirements that losing plaintiffs bear defendants’ legal fees, ceilings on damage awards, and judicial fostering of settlement. At the same time, we occasionally encounter the view that suit might need to be encouraged to overcome the private costs of litigation, and we notice some employment of policies promoting litigation, such as legal aid programs and requirements that losing defendants bear plaintiffs’ legal fees. Against this background, I ask the basic question: What is the socially optimal level of litigation given its expense, and how does it compare to the privately determined level of litigation? As will be explained, the former and the latter levels of legal activity generally differ, and the reasons involve two fundamental types of externality. The first is a negative externality: When a party spends on litigation, he does not take into account the litigation costs that he induces others to incur. The second is a positive externality: When a party engages in litigation, he does not take into account the effect that this has on incentives to reduce harm. In consequence, the privately determined level of litigation can depart from the socially optimal level—in either direction—and corrective social policy may help to remedy the divergence. To develop these points, I investigate the standard model of potentially harmful behavior and the liability system, 1 but I allow for the costliness of litigation. Let me now summarize the analysis that follows. 2