Settlement Bargaining and the Design of Damage Awards

Abstract

An injurer undertakes precautions to reduce both the probability and the severity of an accident. The damages that the victim suffers are privately observed, and will be verified at a cost if the case is litigated. While finely tuned damage awards induce the injurer to take appropriate precautions ex ante, they increase the probability that the litigants will disagree about the case, and thereby aggravate the settlement process. Flat damage awards reduce the level of costly litigation, but lead to underinvestment in precautions. We show that when the litigation costs are small the optimal award is finely tuned to the actual damages, and when litigation costs are large the optimal award is a flat penalty. Applications to scheduled damages and workers' compensation are discussed.

JEL Classification: C78, D82, K13, K41