A Price Theory of Legal Bargaining: An Inquiry into the Selection of Settlement and Litigation Under Uncertainty

Conventional wisdom says that economic surplus is created when the cost of litigation is foregone in favor of settlement, a theory flowing from the Coase Theorem. The cost-benefit analysis weighs settlement against the expected value of litigation net of transaction cost. This calculus yields the normative proposition that settlement is a superior form of dispute resolution and so most trials are considered errors. While simple in concept, the prevailing economic model is flawed. This article is a theoretical inquiry into the selection criteria of settlement and trial. It applies principles of financial economics to construct a pricing theory of legal disputes. In addition to probability and transaction cost, dispute risk must capture the concepts of weight of evidence, volatility of case disposition and confidence in assessment. In much the way cost of capital, a measure of financial risk, affects the valuation of firms, the risks associated with litigation and settlement imply a cost of resolution of which transaction cost is but one. By focusing on transaction cost, the standard model underestimates true economic cost. Valuation under uncertainty implies a risk premium or discount. Because the expenditure of transaction cost reduces uncertainty, transaction cost and risk adjusted valuation are in dynamic tension. Under this approach, settlement and litigation are different pricing mechanisms in the absence of market pricing, and are imperfect substitutes operating under uncertainty. Accordingly, this article rejects the normative axiom that litigation is inferior to settlement, a conclusion that has broad policy implications in the administration of justice.