Settlement and Litigation Under Alternative Legal Systems

We consider a situation in which one party (the plaintiff) has a legally admissible claim for damages from another party (the defendant). The level of damage is known to the plaintiff; the defendant knows only its distribution, which is assumed to be continuous on some range. Before a trial takes place, the plaintiff makes a settlement demand. If the defendant rejects the demand, the court settles the dispute. We characterize the plaintiff's settlement demand policy and the defendant's probability of rejection policy for both separating and pooling equilibria. In the separating equilibrium, the defendant correctly infers the level of true damage from the settlement demand made by the plaintiff. In this case we show that, under risk neutrality, the equilibrium probability of a trial (as a function of true damages) is independent of the allocation of litigation costs. We also analyze the comparative statics of the equilibrium policies and compare them for specific litigation cost allocation systems.