Spier and Prescott, ‘Contracting on Litigation’

Two risk-averse parties with different subjective beliefs negotiate in the shadow of a pending trial. Through contingent contracts, the parties can mitigate risk and/or speculate on the outcome. These contracts mimic the services provided by third-party investors, including litigation funders and insurance companies. The two parties (weakly) prefer to contract with the external capital market when third-party investors are risk neutral, litigation costs are exogenous, and the market is transaction-cost free. However, contracting with third parties increases the volume of litigation, the level of litigation spending, and the aggregate cost of risk bearing. Thus, third-party involvement in litigation reduces social welfare. Other applications of the model include the use of forward contracts to mitigate risk in the vertical chain of production.

Spier, Kathryn E and Prescott, JJ, Contracting on Litigation (April 8, 2016).

First posted 2016-04-18 06:25:44

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