What Behavioral Economics Can Teach Lawyers About Settlement Discussions

Frequently, defense attorneys involved in settlement discussions become frustrated when what they believe to be perfectly reasonable settlement offers are rejected by the plaintiff. They encounter this situation most often when dealing with novice plaintiff lawyers, or plaintiffs who have not previously been involved in civil litigation. Why does this happen? Is it because the plaintiff is irrational or stupid (as many defense lawyers posit in this situation) or is there another reason? We can answer this question by taking a look at something called the "endowment effect"--a major precept of behavioral economics.

The "endowment effect" was recently discussed in an article in The Economist ("Economic Focus: To Have and to Hold," August 30, 2003, 56) as it related to trading in the stock market. But it clearly applies to economic transactions among parties in civil litigation. Neoclassical economics is based on the idea that humans behave rationally and act to maximize their gains or utility (a view unfortunately held to bad effect by many defense lawyers, too).

Over the past couple of decades, we have seen the rise of a new economics: behavioral economics and prospect theory that are based on a different model of man. Here people are seen to "tend to judge their well-being relative to others, not in absolute terms; their actions are based on the way choices are presented; [and] they fear loss more than they crave gain" (The Economist).

Prospect theory has found support for the "endowment effect"--the idea that people will place additional value on things that they already own. A person's house will have value to the owner that is greater than its value in the marketplace because ownership, itself, imbues the house with more value for the owner. The disutility of giving up an object is greater than the utility associated with acquiring it.

This finding may explain generally why plaintiffs ascribe more value to "their lawsuit" than do defendants. But it does not explain why this happens more often among inexperienced plaintiffs. Extending a classic experiment in the field of prospect theory conducted at Cornell in the 1990s [Kahneman, D., Knetsch J., and Thaler, R., "Experimental Tests of the Endowment Effect and the Coax Theorem," Journal of Political Economy 98 (1990), pp. 1325-1348], John List was able to demonstrate that the endowment effect is manifest among less sophisticated and inexperienced traders, but that neoclassical man emerges among sophisticated and knowledgeable traders ("Neoclassical Theory Versus Prospect Theory: Evidence from the Marketplace," John A. List, June, 2003, at www.arec.umd.edu/jlist/JLISTMArevision.pdf).

List conducted his experiment at a convention of sports card traders. He identified those traders who were more or less sophisticated in the market of sports card trading. He gave each person in his sample either a chocolate bar or a coffee mug, of approximately equal value. No matter what their preference, the less experienced traders were far less likely to want to trade what they had been given, confirming the endowment effect. The more experienced traders were more likely to trade, confirming the model of economic man that comes from neoclassical economics.

In the "trading" that goes on in settlement discussions, defense lawyers typically feel more comfortable dealing with experienced litigants or plaintiff lawyers. The less sophisticated litigants and plaintiff lawyers are more likely to be affected by the endowment effect. For them, losses loom larger than gains. The disutility of giving up the lawsuit is greater than the utility associated with acquiring its true value. Consequently, they are more likely to have unreasonable settlement demands. In List's experiment, he found that over time the less experienced traders began to behave more like experienced traders: they learned.

If we try and apply this lesson to settlement discussions, it may be worthwhile for defense attorneys to teach their opponents and their clients as much as possible about the value of their suit in the marketplace by presenting data on what similar cases have settled for, what percentage have been won at trial, and what the jury awards have been.

Further education can be provided by sharing the results of any jury research that has been done on the case. Clearly, non-binding summary jury trials are a good teaching tool. An alternative to educating the other side is to make an initial offer that is higher than that which might have typically been made in order to validate the opponent's analysis of the value his case.