Settlement, Deterrence and the Economics of Punitive Damages Reform
Posted: 18 May 1997
Date Written: March 1997
Abstract
Recent proposals to reform the frequency and amount of punitive damages involve absolute and proportional limits on awards, higher evidentiary standards and/or bifurcated trials, and the sharing of punitive damages awards with the state. In this paper we present a formal model, in the product safety context, that examines the effect of such reforms on equilibrium pricing and safety claims made by firms and on equilibrium settlements and awards made to consumers who have suffered losses due to product safety failures. A firm with private information may be tempted to intentionally misrepresent its product's quality, enabling it to charge more than an informed consumer would be willing to pay. Recognizing this temptation, consumers can provide market incentives for the firm to reveal its true quality through their purchasing behavior, but in some circumstances this is insufficient to ensure the existence of a revealing equilibrium. However, intentional misrepresentation is a tort which is subject to punitive damages, and we determine the minimum punitive damages necessary, in conjunction with consumer behavior, to deter it. We also argue that this corresponds to the maximum level of punitive damages which is legally justified. Raising evidentiary standards requires an increase in punitive damages in order to maintain deterrence, but has no effect on the equilibrium probability of trial and hence no effect on the expected trial costs. Raising the share of the punitive damage award taken by the state results in an increase in the equilibrium probability of settlement, and necessitates an increase in punitive damages awarded at trial in order to maintain deterrence.
JEL Classification: K13, K41
Suggested Citation: Suggested Citation