1.  Assume that the law applicable to the case and the facts of the case are both crystal clear.  Both Plaintiff (P) and Defendant (D) estimate that P will win the case if it goes to trial, with a probability of 100% (= 1.0), and receive a damages award of $100,000.  Going to trial will cost P $20,000 (attorneys fees, lost time, etc.) and cost D $20,000 as well.
What is the estimated value (EV) to P of going to trial?
EV(P) = [(prob. of P winning) x (payoff to P from winning)] - cost of trial to P
 
 

What is the estimated (negative) value to D of going to trial?
EV(D) = negative [[(prob. of P winning) x (payoff to P from winning)] + cost of trial to D]
 
 

What will happen here?
 
 

2.  Now assume that there is some uncertainty as to the law or facts, or both.  Both P and D estimate that P will win the case if it goes to trial, with a probability of 70% (= 0.7), and receive a damages award of $100,000.  Going to trial will cost P $20,000 and cost D $20,000.
What is the estimated value (EV) to P of going to trial?
 
 

What is the estimated (negative) value to D of going to trial?
 
 

What will happen here?
 
 

3.  Now assume even more uncertainty as to the law or facts, or both.  P estimates that he will win the case if it goes to trial, with a probability of 60% (= 0.6) and receive a damages award of $100,000.  D estimates that there is only a 50/50 (= 0.5) chance that P will win if it goes to trial.  D thinks P would receive a $100,000 damages award if P does win.  Going to trial will cost P $20,000 and cost D $20,000.
What is the estimated value (EV) to P of going to trial?
 
 

What is the estimated (negative) value to D of going to trial?
 
 

What will happen here?
 
 

4.  Construct an example (similar to numbers 1-3) where settlement will not occur.
 
 
 
 
 
 
 
 
 
 

For much more on this, see

Kathryn E. Spier, Economics of litigation (from The New Palgrave Dictionary of Economics, 2008),
www.law.harvard.edu/faculty/spier/pdf/economicslitigationnewpalgrove2008.pdf (15 pages) and
Litigation (from Handbook of Law and Economics, 2007),
www.law.harvard.edu/faculty/spier/pdf/litigation.pdf (84 pages)

Andrew F. Daughety, Settlement (2000), encyclo.findlaw.com/7400book.pdf (64 pages)
updated as Andrew F. Daughety & Jennifer F. Reinganum, Settlement (2008), papers.ssrn.com/sol3/papers.cfm?abstract_id=1115299 (another source is www.vanderbilt.edu/econ/wparchive/workpaper/vu05-w08.pdf ) (40 pages)