Against Compromise: A Mechanism Design Approach

Abstract

We solve for the settlement mechanism and fee-shifting rule that minimize the likelihood of litigation yet maintain optimal deterrence under the assumption that the main dispute between the parties is about the defendant's liability. The solution turns out to be surprisingly simple: let the defendant plead liable or not, and then, if the plaintiff decides to proceed to trial although the defendant pleads not liable, discourage any further settlement between the parties, and shift all litigation costs to the loser in trial (following the English fee-shifting rule). Using a mechanism design approach we demonstrate that no other mechanism can implement a lower rate of litigation without undermining deterrence. We discuss our result in the context of recent legal reforms in the U.S. and U.K.

Keywords: Litigation, settlement, fee-shifting, pleadings, deterrence

JEL Classification: D82, K41