A Model of Welfare-Reducing Settlement
While it is typically taken for granted that settlement of lawsuits increases social welfare, this paper shows that settlement can lower welfare. If the defendant has private information about the harm from his action both at the time of the action and the time of settlement bargaining, then defendants who cause different levels of harm can pay the same settlement amount in a partial pooling equilibrium. Settlement acts as a damage cap, preventing the defendant's liability from increasing with the harm over the full range of possible harms, leading to under-deterrence. This result holds even though the social planner can choose the socially optimal damage rule.
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Volume (Year): 3 (2004)
Issue (Month): 1 (May)
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