Some thoughts concerning the economics of the “Loser Pays” rule

It is widely believed that the U.S. tort system needs to be reformed in order to ensure that the U. S. remains globally competitive.  Of course, this begs the obvious policy question: what kinds of reforms are likely to be most effective without significantly compromising beneficial aspects of the tort system?  One reform proposal which has been debated for quite some time involves requiring that the loser reimburse the winner’s legal fees. The rationale for “Loser Pays” is that it would likely have the effect of reducing the number of cases brought to court (along with the associated legal expenditures).  Other legal systems (such as exist in the U. K. and throughout most of Europe) typically require losers to compensate winners for a portion of their legal costs, and the evidence appears to suggest that such rules do in fact reduce the frequency of litigation and related expenses.

The economics of “Loser Pays” compared with “Loser Doesn’t Pay” would appear to be fairly straightforward.  Under the “Loser Doesn’t Pay” that is actually practiced in the U.S., the payoff from litigation resembles a call option.  From the plaintiff’s perspective, downside risk is limited to the option premium, which comprises the legal costs (if any) that are directly borne by the plaintiff.  Although the plaintiff will typically share upside risk (in the form of contingency fees), her payoff is not bounded from above.  Since the plaintiff does not fully internalize the cost of litigation, this creates an apparent moral hazard.  By linearizing the payoffs from litigation so that the plaintiff bears downside as well as upside risk, one would expect that such a rule would likely reduce the frequency and expense of litigation, a result that is corroborated by Baye, Kovenock, and de Vries (2004) in an auction-theoretic framework.

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