The Unexpected Value of Litigation: A Real Options Perspective

In this Article, we suggest that litigation can be analyzed as though it is a competitive research and development project. Developing this analogy, we present a two-stage real option model of the litigation process that involves sequential information revelation and bargaining over the surplus generated by early settlement. Litigants are risk-neutral and have no private information. The model generates results that, we believe, have analytic and normative significance for the economic analysis of litigation From an analytic perspective, we demonstrate that negative expected value (NEV) lawsuits are analogous to out of the money call options held by plaintiffs and that every NEV lawsuit is credible if the variance of the information revealed during the course of the litigation is sufficiently large. This finding helps explain the prevalence of a class of lawsuits that has proved puzzling to traditional, expected value-based modes of litigation analysis. The model also suggests that risk-neutral defendants can act as though they are risk-averse and that risk-neutral plaintiffs can act as though they are risk-seeking because increases in variance can increase a lawsuit\u27s settlement option value just as it increases a call option\u27s value without regard to the holder\u27s degree of risk aversion. Models that presume defendants\u27 relative risk aversion may therefore rely on an unnecessary assumption. Our model also suggests that a lawsuit\u27s option settlement value is not a monotonically increasing function of the variance of the information revealed during the litigation. In particular, at low levels of variance a lawsuit\u27s option settlement value may equal its traditional expected value, but as variance increases its option settlement value can display a discontinuity after which its option settlement value becomes a monotonically increasing function of variance. NEV lawsuits can also display dead zones - regions of variance over which the claim is not credible even though it is credible over higher or lower levels of variance. Comparative statics analysis also quantifies the extent to which a lawsuit\u27s settlement value increases as plaintiff\u27s litigation expenses occur later in the litigation process, as the ratio of defendant-to-plaintiff litigation expense increases and as plaintiff bargaining power increases. From a normative perspective, we offer an impossibility conjecture suggesting that the mere presence of an irreducible degree of uncertainty endemic to the litigation process can be sufficient to prevent private litigation incentives from equating to socially optimal incentives, even if one adopts all other assumptions necessary to equate private and social incentives. It follows that it may be impossible to articulate normative principles of law through substantive standards that ignore the uncertainty inherent in the litigation process and the procedural environment in which the litigation occurs

The Unexpected Value of Litigation: A Real Options Perspective

In this Article, we suggest that litigation can be analyzed as though it is a competitive research and development project. Developing this analogy, we present a two-stage real option model of the litigation process that involves sequential information revelation and bargaining over the surplus generated by early settlement. Litigants are risk-neutral and have no private information. The model generates results that, we believe, have analytic and normative significance for the economic analysis of litigation From an analytic perspective, we demonstrate that negative expected value (NEV) lawsuits are analogous to out of the money call options held by plaintiffs and that every NEV lawsuit is credible if the variance of the information revealed during the course of the litigation is sufficiently large. This finding helps explain the prevalence of a class of lawsuits that has proved puzzling to traditional, expected value-based modes of litigation analysis. The model also suggests that risk-neutral defendants can act as though they are risk-averse and that risk-neutral plaintiffs can act as though they are risk-seeking because increases in variance can increase a lawsuit\u27s settlement option value just as it increases a call option\u27s value without regard to the holder\u27s degree of risk aversion. Models that presume defendants\u27 relative risk aversion may therefore rely on an unnecessary assumption. Our model also suggests that a lawsuit\u27s option settlement value is not a monotonically increasing function of the variance of the information revealed during the litigation. In particular, at low levels of variance a lawsuit\u27s option settlement value may equal its traditional expected value, but as variance increases its option settlement value can display a discontinuity after which its option settlement value becomes a monotonically increasing function of variance. NEV lawsuits can also display dead zones - regions of variance over which the claim is not credible even though it is credible over higher or lower levels of variance. Comparative statics analysis also quantifies the extent to which a lawsuit\u27s settlement value increases as plaintiff\u27s litigation expenses occur later in the litigation process, as the ratio of defendant-to-plaintiff litigation expense increases and as plaintiff bargaining power increases. From a normative perspective, we offer an impossibility conjecture suggesting that the mere presence of an irreducible degree of uncertainty endemic to the litigation process can be sufficient to prevent private litigation incentives from equating to socially optimal incentives, even if one adopts all other assumptions necessary to equate private and social incentives. It follows that it may be impossible to articulate normative principles of law through substantive standards that ignore the uncertainty inherent in the litigation process and the procedural environment in which the litigation occurs

Auditing and property rights

This is the official published version. Copyright @ 2004 RANDThird-party audit provides incentives to an agent whose actions affect the value of an asset. When audit intensity and outcome are unverifiable, we show that with interim-participation constraints the optimal mechanism may use only the auditor's report, disregarding the agent's information. Furthermore, the auditor obtains the asset and the agent a monetary compensation, when a high asset value is reported. This suggests regulating renewable resources or utility networks by giving entrants the option to buy the right to use the asset at a predetermined price, and financially rewarding incumbents for good performance.The second author used financial support of the Communaute francaise de Belgique (projet ARC 98/03-221) and EU TMR Network contract no. FMRX-CT98-0203

Mediation in Situations of Conflict and Limited Commitment

We study the reasons and conditions under which mediation is beneficial when a principal needs information from an agent to implement an action. Assuming a strong form of limited commitment, the principal may employ a mediator who gathers information and makes non-binding proposals. We show that a partial rev-elation of information is more effective through a mediator than through the agent himself. This implies that mediation is strictly helpful if and only if the likelihood of a conflict of interest is positive but not too high. The value of mediation depends non-monotonically on the degree of conflict. Our insights extend to general models of contracting with imperfect commitment

An economic analysis of trade-secret protection in buyer-seller relationships

The economic analysis of trade-secret protection has traditionally focused on the interests of companies to conceal information from competitors in order to gain a competitive advantage through trade-secret law. This has neglected cases in which the interest is not in concealing information from competitors, but from trading partners. We investigate the social efficiency effects of trade-secret protection in such cases. Many results from economic theory state that asymmetric information (and therefore also its legal protection) is socially undesirable since it leads to inefficient trade. At the same time, protecting private information might create incentives for socially desirable investments. We model this trade-off in a simple buyer-seller model and find that, indeed, trade-secret protection has ambiguous welfare effects. However, a simple, informationally undemanding rule, conditioning the applicability of legal protection on a minimum investment by the informed party to conceal the information, helps to apply trade-secret protection only when it increases welfare. This rationalizes important features of current legal practice.disclosure of information, hold-up problems, trade secrets

Exit Options and the Allocation of Authority

We analyze the optimal allocation of authority in an organization whose members have conflicting preferences. One party has decision-relevant private information, and the party who obtains authority decides in a self-interested way. As a novel element in the literature on decision rights, we consider exit option contracts: the party without decision rights is entitled to prematurely terminate the relation after the other party's choice. We show that under such a contract it is always optimal to assign authority to the informed and not to the uninformed party, irrespective of the parties' conflict of interest. Indeed, the first-best efficient solution can be obtained by such a contract

Reliance Investments, Expectation Damages and Hidden Information

A setting of reliance investments is explored where one of the parties to a contract obtains private information concerning his utility or cost function that remains hidden to the other party and to courts. As a consequence, it will be a difficult task to award expectation damages corrrectly to a party with private information who sufffers from breach of contract. While a revelation mechanism would exist that leads to the first best solution, assessing expectation damages correctly turns out to be at odds with ex post efficiency. I conclude that, under asymmetric information, the performance of expectation damages falls short of what more general mechanisms could achieve

Third-Party Data Providers Ruin Simple Mechanisms

Motivated by the growing prominence of third-party data providers in online marketplaces, this paper studies the impact of the presence of third-party data providers on mechanism design. When no data provider is present, it has been shown that simple mechanisms are "good enough" -- they can achieve a constant fraction of the revenue of optimal mechanisms. The results in this paper demonstrate that this is no longer true in the presence of a third-party data provider who can provide the bidder with a signal that is correlated with the item type. Specifically, even with a single seller, a single bidder, and a single item of uncertain type for sale, the strategies of pricing each item-type separately (the analog of item pricing for multi-item auctions) and bundling all item-types under a single price (the analog of grand bundling) can both simultaneously be a logarithmic factor worse than the optimal revenue. Further, in the presence of a data provider, item-type partitioning mechanisms---a more general class of mechanisms which divide item-types into disjoint groups and offer prices for each group---still cannot achieve within a $\log \log$ factor of the optimal revenue. Thus, our results highlight that the presence of a data-provider forces the use of more complicated mechanisms in order to achieve a constant fraction of the optimal revenue