Against Compromise: A Mechanism Design Approach

We consider the following situation. A risk-neutral plaintiff sues a risk-neutral defendant for damages that are normalized to one. The defendant knows whether she is liable or not, but the plaintiff does not. We ask what are the settlement procedure and fee-shifting rule (which, together, we call a mechanism) that minimize the rate of litigation subject to maintaining deterrence. Two main results are presented. The ?rst is a characterization of an upper bound on the rate of settlement that is consistent with maintaining deterrence. This upper bound is shown to be independent of the litigants' litigation cost. It is further shown that any mechanism that attains this upper bound must employ the English fee-shifting rule according to which all litigation costs are shifted to the loser in trial. The second result describes a simple practicable mechanism that attains this upper bound. We discuss our results in the context of recent legal reforms in the U.S. and U.K.