Following on the theory of Coasian bargaining, this lecture discusses the economics of negotiation via litigation.

Civil courts are increasingly used as a high-cost, last-resort venue of business negotiation for parties who are unable to negotiate more economically.  Litigation is often just an economic war of attrition, where the litigants bleed cash until one of them gives up.  The typical outcome of litigation is painful, expensive compromise that leaves no one satisfied.

It is instructive to consider the economic incentives in legal institutions.  The US legal system has largely failed to control the high cost of litigation because it actually depends on these costs to ration scarce judicial resources.  The courts don't want to hear every minor dispute; they want people to resolve their own conflicts wherever possible.

While British courts typically charge both parties' court costs to the loser, American courts generally leave each party to pay its own legal costs, win or lose.  As a consequence, well-financed litigants can use the courts to run up the legal bills of their opponents in order to force them into unsatisfactory compromises.  US courts thus handle a much larger number of frivolous, nuisance lawsuits than British courts.  Although adopting a British "loser pays" rule would probably improve the efficiency and fairness of US civil courts, the American Trial Lawyers' Association lobby has so far succeeded in blocking this reform in Congress.

Instead of "loser pays," the US court system encourages contingency fee arrangements between plaintiffs and their lawyers.  The oft-cited justification is that contingency fees let deserving plaintiffs seek justice even if they can't afford an attorney up front.  Unfortunately, this tilts the economic advantage in favor of plaintiffs, since respondents don't get contingency-based defense.  So the plaintiff doesn't pay for her action, win or lose, while the defendant pays at least the cost of his defense even if he wins, and pays for his defense plus the judgment, including the plaintiff's lawyers, if he loses.  It is not surprising, therefore, that the US has more litigation per capita than any civilized nation, and that judgments tend to be higher in the US than Britain for equivalent injuries.

Easy access to the courts can promote insurance fraud.  For example, since traffic courts typically presume the rear vehicle in a rear-end collision is at fault, the contingency fee system provides incentives for some people to stage rear-end collisions and sue for alleged whiplash injuries.  A lawyer and doctor may be active accomplices in the fraud.  The defendant's insurance company usually finds it cheaper to settle and pay the damage claim rather than go to trial.

The use of contingency fees in US civil law has additional adverse consequences.  By giving lawyers an economic interest in the outcome of a case, it creates economic incentives for various types of unethical behavior, which further degrades the public image of the legal profession.  Contingency arrangements make it difficult for plaintiffs to change lawyers they are unhappy with.  Since lawyers need to cover the costs of representing unsuccessful complaints with the fees from judgments received from successful actions, contingency fees are high (often 40 percent of the judgment), and judgments sometimes appear grossly inflated.

Contingency fees can create something of a sweepstakes mentality in tort law.  They give many consumers the misconception that nuisance suits are cost-free and potentially very profitable, and they encourage lawyers to invent new categories of harm in order to maximize damage awards.  Awards for such things as "pain and suffering" or "loss of consort" are much more common in the US than in other countries.  Besides awarding conventional damages to deserving plaintiffs that compensate them for the harm they have suffered, US civil courts may also award "punitive damages" that are unrelated to any harm suffered by the plaintiff.  The plaintiff's lawyers on contingency get a percent of punitive damage award
too, and thus have a clear incentive to push for punitive damages whenever possible.   Punitive damages really blur the distinction between tort and crime.  It seems illogical for the plaintiff to receive additional compensation for harm the defendant caused society.  Such fines should be assessed in criminal courts, not civil courts, and should be paid to the court system.

A plaintiff's attorney can seek to have her case certified as a class-action if there are other potential plaintiffs who could claim equivalent harm from the defendant's actions.  An attorney really hits the jackpot if he can collect the contingency percentage negotiated for initial action from the entire class-action judgment.  Class-actions are supposed to provide scale economies in litigation, although the judgments may be all but eaten up in administrative expenses.  Unfortunately, some high-stakes class actions have spawned enormous amounts of secondary litigation over how the lawyers should divide up the contingency fees, and how the legal rights of subsequent plaintiffs who did not share in the judgment are affected.
The legal wrangling over how the lawyers divide up the huge legal fees from recent class action settlements with tobacco companies will go on for years.

A loser-pays rule would strike a simpler, fairer balance between plaintiff and defendant.  It would reduce the incidence of nuisance litigation by altering the terms of contingency arrangements, since such arrangements would presumably have to specify a cost share or percentage that the plaintiff's attorney would pay for a failed action.

Allowing attorneys to taken an economic interest in the outcome of their cases creates a number of socially undesirable incentives. Contingency fee arrangements in tort actions are really a form of champerty (aid provided by a third party to a litigant in exchange for a share of the judgment), which is illegal in many countries.