Threats to Sue and Cost Divisibility Under Asymmetric Information

Abstract

Not all disputes make it to the court system. Some claims are settled against the threat of litigation, whereas others are "lumped off" as claimants find the cost of pursuing them higher than their value. Threatened to be sued, a potential defendant would not agree to settle for any positive amount unless the plaintiff's threat to sue is credible. In this paper we analyze the effects of cost divisibility and information asymmetry on the credibility of the plaintiff's threat to sue. Previous literature has shown that under symmetric information divisibility of the plaintiff's litigation costs can enhance her ability to extract a positive settlement from the defendant. We show that when the defendant holds private information concerning his liability the plaintiff is discouraged from filing her suit when her total costs are sufficiently large, even if these costs are very finely divided. In equilibrium the defendant signals his information by refusing to settle, and thus the plaintiff always has to bear some of her litigation costs, reducing her expected payoff from the suit. The higher the plaintiff's litigation costs, the higher the level of information asymmetry and the lower the plaintiff's probability of success, the less pronounced is the effect of cost divisibility on the credibility of her threat to sue. Hence, under substantive rules that increase the variance of the possible judgment, such as negligence rules, cost divisibility would be less significant than under rules such as strict liability where the variance is lower. Also, increased divisibility would tend to encourage low probability--high stake suits more than high probability--low stake suits having the same expected judgment.

JEL Classification: C72, C78, D82, K41