Punitive damage awards have been widely criticized for generating a plaintiff’s windfall (i.e., a payment in excess of the costs of pursuing the punitive claim), which promotes unnecessary litigation, the escalation of liability insurance premiums and over-deterrence. In an attempt to overcome these negative effects, several US states have implemented many different kinds of tort reform. Some reforms take the form of caps or limits on punitive damage awards while others, called “split-awardsâ€, have mandated that a share of the award be allocated to the plaintiff with the remainder going to the state. Our paper presents a strategic model of litigation under a negligence rule. We extend Spier's (1997) theoretical framework on litigation by explicitly modeling frivolous lawsuits. In this way, we capture the main welfare effects of punitive awards on firm's level of care and the likelihood of frivolous lawsuits. We derive sufficient conditions for a unique universally-divine mixed-strategy perfect Bayesian equilibrium (Banks and Sobel, 1987) in which some defendants choose to be negligent, but some meet the negligence standard. In this equilibrium, some lawsuits are not meritorious (frivolous lawsuits), and some lawsuits are dropped, some are resolved out-of-court and some go to trial. We then use this framework to analyze the welfare effect of punitive damages, and to explore the effect of split-awards and caps on the probability that firms choose to be careful, the probability that frivolous lawsuits are filed, and the probability that a lawsuit proceeds to the award stage of a trial. Consistent with Katz (1990), we predict that caps increase the likelihood of frivolous lawsuits. Given that the defendant does not know the type of plaintiff it is confronting and that only in meritorious cases punitive damages are awarded, the likelihood that the defendant makes an out-of-court settlement offer is negatively related to the amount of the award. Then, a reduction in the award due to a cap will increase the expected payoff for a frivolous plaintiff, generating additional incentives to file lawsuits. Consistent with Babcock and Pogarsky (1999) and Daughety and Reinganum (2003), we also find that caps and split-awards decrease the likelihood of trial. Furthermore, caps and split-awards reduce the likelihood that a firm chooses to be careful, because they lower the expected litigation costs. The firm reacts to these lower expected costs by reducing expenditures on safety. Finally, we find that the overall welfare effect of these reforms is ambiguous, because the reduction in the litigation costs of meritorious plaintiffs and defendants may be offset by an increase in the number of frivolous lawsuits and the likelihood of accidents.
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Find related papers by JEL classification: K41 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Litigation Process C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information