Mutual Optimism and Risk Preferences in Litigation

Abstract

Why do some legal disputes fail to settle?  From a bird’s eye view, the literature offers two categories of reasons.  One consists of arguments based on informational disparities.  The other consists of psychological arguments.  This paper explores the psychological theory.  It presents a model of litigation driven by risk preferences and examines the model’s implications for trials and settlements.  The model suggests a foundation in Prospect Theory for the Mutual Optimism model of litigation.  The model’s implications for plaintiff win rates, settlement patterns, and informational asymmetry with respect to the degree of risk aversion are examined.

Keywords: prospect theory, mutual optimism, risk aversion, economics of litigation, settlement, Arrow-Pratt risk measure, risk-neutralizing probability measure