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«JOURNAL OF LAW, ECONOMICS & POLICY VOLUME 10 SPRING 2014 NUMBER 2 EDITORIAL BOARD 2013-2014 Steve Dunn Editor-in-Chief Crystal Yi Meagan Dziura Sarah ...»

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In the model with imperfect information, the injurer’s expected liability differs from that in the perfect information model because at least some piggyback plaintiffs succeed in obtaining settlements under either of the two equilibria of the settlement–trial subgame. Under the Type 1 (pure strategy) equilibrium, the defendant settles with all plaintiffs, and accordingly, the amount the defendant pays per suit is the same as in the perfect information model. However, because all piggyback plaintiffs file suit, the defendant faces more suits (or, what amounts to the same thing, a higher probability of a suit). It turns out, though, that the injurer’s optimal care choice in this case is the same as in the perfect information model. The reason is that the injurer perceives the number of piggyback lawsuits to be fixed relative to its level of care, and so increasing that level would not reduce the number of such suits. In other words, the injurer only chooses care up to the point where the marginal reduction in liability costs from genuine suits equals the marginal cost of care. And since this is the same in the perfect and imperfect information models, the injurer chooses the same care level in the two cases.

The situation is different under the Type 2 equilibrium of the settlement–trial subgame. In this case, the injurer will choose a higher level of care as compared to the perfect information model. This is true because the injurer’s expected liability now includes the possibility of trial costs when it defends claims brought by genuine plaintiffs. As a result, in an effort to avoid some costly trials, the injurer will exercise more care than it would under perfect information. Specifically, by exercising additional care, the injurer reduces the frequency of cases that end up at trial with genuine plaintiffs. Accordingly, the existence of piggyback lawsuits has the following impact on the care choice of injurers when compared to a world characterized by perfect information—injurers exercise the same amount of care under a Type 1 equilibrium, but they exercise more care under a Type 2 equilibrium. This demonstrates that the existence of piggyback lawsuits is capable of enhancing the care component of deterrence.

Let us now consider the impact of piggyback suits on the injurer’s activity level. Under both type of equilibria, the number of piggyback plaintiffs is positively correlated with the injurer’s activity. This is true, recall, because under both equilibria, at least some piggyback suits succeed in receiving settlements. Thus, as an injurer’s activity level increases, the number of piggyback plaintiffs also increases. Furthermore, in the Type 2 equilibrium, the average liability per suit is higher because, as noted, some cases go to trial. For both of these reasons, the cost per unit of activity is higher in the imperfect information model. As a result, the injurer chooses a lower activity level compared to the perfect information model. This illustrates that piggyback lawsuits are always capable of enhancing the activitylevel component of deterrence.

In conclusion, when compared to the equilibrium under perfect information, an injurer sometimes exercises more care and always decreases its 2014] THE IMPACT OF FRIVOLOUS LAWSUITS ON DETERRENCE 319 activity level given the threat of piggyback lawsuits under imperfect information. It remains to be seen, however, whether this enhanced deterrence is socially desirable. We address this question in the next section.

E. Welfare Analysis To evaluate the social desirability of piggyback lawsuits, we first need to determine the care and activity levels that a perfectly informed benevolent social planner would choose. A benevolent planner’s objective is to maximize the net value of the injurer’s activity, taking into account all liability-related costs, including the filing costs of victims. We therefore take as given the need for accident victims to file suit in order to receive compensation for their losses. Given the need for suits, however, it is socially desirable for all of them to settle in order to avoid trial costs.

Based on this objective, we first note that injurers underinvest in care and overengage in the risky activity in the perfect information case compared to the social optimum; that is, even when injurers can distinguish between genuine and piggyback plaintiffs, there is underdeterrence. This occurs through two channels. First, the injurer does not internalize a genuine victim’s filing costs, and second, the injurer is able to settle for less than the full amount of the victim’s damages. (Recall that genuine plaintiffs will settle for an amount equal to their damages less their costs of trial.) Consistent with past literature on the topic, we see that when litigation is costly, strict liability results in underdeterrence, even when information is perfect.76 The injurer’s optimal care and activity choices will also generally diverge from the social optimum in the imperfect information case, but the direction of the divergence is ambiguous. Under a Type 1 equilibrium, the injurer will underinvest in care relative to the social optimum because, as in the perfect information case, it does not fully internalize the filing cost and damages suffered by a genuine victim. The filing cost is paid solely by the genuine victim, and as noted above, the injurer is able to exploit the plaintiff’s litigation costs in making its settlement offer. With respect to its activity level, however, the injurer may overengage or underengage in the activity from a social perspective under a Type 1 equilibrium. The injurer may overengage in the activity because it does not internalize a genuine victim’s filing cost, but it may underengage due to the costs of paying off piggyback plaintiffs. Given these two competing forces, the direction of the deviation from the social optimum with respect to the injurer’s activity level in a Type 1 equilibrium is ambiguous.

With respect to a Type 2 equilibrium, the injurer may overinvest or underinvest in care, and overengage or underengage in activity, for roughly the same reasons. The injurer does not internalize a genuine victim’s filing 76 See, e.g., Hylton, supra note 15, at 161.

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costs, nor does the injurer fully internalize a genuine victim’s damages when settling a fraction of cases. This factor alone suggests that the injurer underinvests in care and overengages in activity. Working in the opposite direction, however, is the fact that the injurer incurs litigation costs for those cases filed by genuine plaintiffs that end up going to trial. Taken together, these factors show that, from a social perspective, it is unclear whether piggyback lawsuits induce, or fail to induce, beneficial deterrence under a Type 2 equilibrium.

In sum, the foregoing results suggest that piggyback lawsuits are not always undesirable from a social perspective. While the direction of the deviation relative to the social optimum is ambiguous in most cases, the existence of piggyback lawsuits generally results in more care and less activity relative to a world characterized by perfect information. Moreover, under certain conditions, they may actually serve to enhance deterrence in a socially valuable way. Now that we have described the theoretical model,77 we present a numerical example to illustrate the preceding conclusions.

F. Numerical Example

For the purposes of this numerical example, we continue with our hypothetical situation of a supermarket owner who causes injuries to a subset of customers who slip and fall on the owner’s premises. Suppose the supermarket owner is faced with the decision of whether to operate one, two, or three identical stores in a narrow geographic area. The owner’s choice of how many stores to operate reflects a decision concerning his activity level.

For the sake of argument, let the gross value per year of operating one, two, or three stores be $150,000, $200,000, and $235,000, respectively. Notice that the supermarket owner’s gross value is increasing in the number of stores, but at a decreasing rate, reflecting a diminishing marginal value.

This might reflect the idea that the supermarket owner is attracting fewer new shoppers per store as he operates more stores in a narrow geographic area.

The supermarket owner knows that he will be held strictly liable to a subset of customers who suffer injuries from slip-and-fall accidents on his premises.78 Recognizing this, suppose that the supermarket owner can choose one of three monetary expenditures on care per year to reduce the 77 Under a well-functioning negligence rule, as opposed to strict liability, the presence of piggyback lawsuits will have no effect on deterrence. Changing the liability rule to one of negligence results in neither genuine nor piggyback plaintiffs filing suit. All injurers will comply with the negligence standard of due care under the circumstances. Miceli & Stone, supra note 55, at 18–20 (noting that all injuries will comply with the negligence standard of due care under the circumstances).

78 For cases imposing strict liability for slip-and-fall accidents, see Steven D. Winegar, Comment, Reapportioning the Burden of Uncertainty: Storekeeper Liability in the Self-Service Slip-and-Fall Case, 41 UCLA L. REV. 861, 888–91 (1994).

2014] THE IMPACT OF FRIVOLOUS LAWSUITS ON DETERRENCE 321 probability of an accident. If he spends $50,000—i.e., a high level of care—per store, he can hire a full-time employee to monitor the condition of the floors and to subsequently cure any defects. With a full-time employee, the probability that a customer will suffer injuries arising from a slip-and-fall accident at a particular store is 5% per year. Or, the supermarket owner can spend $25,000—i.e., a medium level of care—per store to hire a part-time employee devoted to monitoring safety. In this case, the probability that someone will slip and fall at a particular store is 15% per year. Finally, the owner can spend $10,000—i.e., a low level of care—per store to finance overtime pay for his current employees. In this case, the owner’s employees work extra hours to share the burden of monitoring the floors, but because they are working longer hours, they are somewhat ineffective and the probability of an accident per year is 30%.79 The supermarket owner’s choice of his monetary expenditure on care will govern his decisions in each store which he operates, meaning, for instance, if he chooses a high level of care and operates three stores, then his total expenditures on care per year will be $150,000—three full-time employees at $50,000 each.

Finally, assume that when a customer suffers a slip-and-fall injury on the supermarket owner’s premises, the victim’s damages always amount to $100,000. To file suit, the victim incurs a reasonable filing fee of $500.

And, when cases are brought to trial, both the plaintiff and the defendant incur identical litigation costs of $20,000 each. The following tables summarize the relationship between the theoretical model’s variables and the numerical values adopted for this example.

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79 These conjectured values reflect the reasonable assumption that as care expenditures increase, they decrease the probability of an accident at a decreasing rate. See supra text accompanying note 68.

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Consistent with the theory provided above, a benevolent social planner would induce the supermarket owner to choose a monetary expenditure on care and an activity level consistent with no piggyback victims filing suit, and all genuine victims filing suit but settling for their entire level of damages and filing costs prior to trial. A three-by-three matrix can be constructed to represent the net social value of operating the supermarket for each activity level–care combination. The combination that a social planner would choose corresponds to the highest net value resulting from these nine combinations. Table 3 presents all of the possible combinations.

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In the table, the activity level–care combination that maximizes the net value of activity for the supermarket is highlighted. It is evident that the supermarket owner’s net value of activity is maximized from a social perspective when he chooses to operate two stores and exercises a middle level of care. All other combinations result in lower net values of operating the supermarket (that is, all other combinations exhibit a net value of less than $119,850).80 Put another way, the supermarket owner should hire two parttime employees at a cost of $25,000 each, and he should place one parttime employee in each of his two stores. However, he should not operate a third store. This is the benchmark against which we will judge the social desirability of frivolous lawsuits.

We next ask, What are the supermarket owner’s equilibrium choices of care and activity when he has perfect information regarding the plaintiff’s type? Recall that when there is perfect information, the supermarket owner can distinguish piggyback plaintiffs from genuine plaintiffs and can settle with the latter but offer nothing to the former. Our theory above predicted that injurers overengage in activity and underinvest in care in this case relaNotice, for example, that a social planner would not require the supermarket owner to exercise a high level of care. This reflects the idea that the social planner’s objective is not to minimize the probability of an accident.

2014] THE IMPACT OF FRIVOLOUS LAWSUITS ON DETERRENCE 323 tive to the social optimum. To verify this result for our numerical example, Table 4 depicts the net value of activity to the supermarket owner for each activity–care combination when there is perfect information.

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Notice in particular that the supermarket owner’s net value of activity is maximized when he operates three stores and exercises a low level of care. (The maximized net value is again highlighted.) The supermarket owner is underdeterred in this example because, as we saw above, it is socially optimal for him to operate only two stores and invest in two part-time employees—i.e., a middle level of care. But with perfect information, he instead chooses to operate three stores and exercises a low level of care in each store.

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