Wednesday, July 30, 2003
Applying Economics to Champerty
posted by James
One perennial question is how much light economics can shed on legal issues. I happen to believe that it can be quite illuminating, but my viewpoint is far from universal. Champerty provides a good case study, partly because the analysis is accessible, but also because I think it is an example in which the economic analysis doesn't provide a conclusive answer. I started thinking about this after reading about a debate round on Phil's blog. It occurred to me that the round could probably have benefited from some economic analysis (although, who knows, you can't explain much in eight minutes without graphs). All of the following economic analysis comes from a lecture by Professor Nicholson at Amherst College.
Champerty is trading the right to sue for a particular harm. So, if I'm injured because of a faulty part in my car, for which the car manufacturer is liable, under champerty I can sell the right to sue to a third party. That party (probably an attorney or a law firm) would pay all the costs of bringing the case to trial, and would keep the entire payment in the case of victory or a settlement. A separate issue, which I might address later, is selling your right to sue for harms that haven't happened yet. That's distinct from champerty, though.
Clearly, the most a company will pay for the right to a suit is the expected value of that suit. Furthermore, the only reason a plaintiff would ever sell a suit for less than its expected value is if he is risk averse. Thus, other than a sort of insurance market, there doesn't seem to be much room for profitable exchange.
This ignores something called the “agency problem.” Specifically, most plaintiffs don't have a lot of legal expertise. A plaintiff has to depend on a lawyer to represent him as well as possible. The lawyer, on the other hand, is merely trying to maximize profits (within ethical guidelines). Consider a plaintiff who is bringing his suit to trial. He wants the lawyer to spend effort on the suit, but how much effort? If he has to pay his lawyer by the hour, he won't know how many hours to “purchase.” A right answer exists: he should purchase the amount of effort that maximizes the profit, which is the difference between the total cost and the total expected returns from the case.
One common arrangement is a “contingency fee,” in which the plaintiff pays his lawyer a share of the winnings in the case of victory, and nothing otherwise. We might ask the question, does this give the lawyer incentives to invest the right amount of effort? This is easy to illustrate graphically.
[note: Blogger wants to sell us an upgrade, so they've set it up so that the free version can't display images. At least, that's my theory right now; if anyone knows how to display images (which we've uploaded to a different website), please let me know. Sorry about the inconvenience of having to click to see the graphs.]
Graph 1
Graph 2
The first graph shows the expected value of the case as a function of how much effort the lawyer expends. The curve illustrates diminishing returns. The curve representing the lawyer's costs is linear. The lower curve represents the amount of the winnings that would go to the lawyer; in this graph it is 30% (usually lawyers aren't allowed to set contingency fees higher than 40% or so).
The second graph just shows the vertical distance between the different curves. The upper curve shows the overall profits for the plaintiff (overall profit – costs); the lower curve shows the share of those profits that go to the lawyer under a contingency plan (30% of overall profit – costs). Now we can easily see that contingency fees do not maximize profits. The lawyer will choose to exert the amount of effort that corresponds to the peak of the lower curve. This isn't nearly enough effort to maximize overall profits (which happens at the peak of the upper curve).
Now, consider a lawyer who has purchased a case through champerty. Since he gets all of the profits, his incentives are represented by the top curve. He will thus invest the optimal amount of effort, maximizing profits. We can now see why champerty might do more than create an insurance market for plaintiffs: by solving the agency problem, champerty increases the expected value of each case, so that the buyer gets more than the seller gives up. Of course, the insurance effect still exists, increasing the profit potential even further. Champerty also increases the incentives for companies to make safe products; an increase in the expected value of a case must come from a higher probability of victory or a higher payout from the defendant. This in turn will increase the desire of the company to avoid lawsuits in the first place.
Of course, there's no free lunch. While the attorney's incentives might be improved by champerty, there has to be a mechanism to ensure that the plaintiff will cooperate by testifying as if it mattered. Further, juries must be willing to give the same verdict regardless of who gets the money, which will be difficult for some jurors (even though ultimately a well-functioning champerty system primarily benefits plaintiffs).
Another objection is that plaintiffs will be somehow exploited. Note that this would be difficult to judge ex post; a large verdict might seem disproportionate to the price the plaintiff received, but ex ante it might have been perfectly fair. Perhaps plaintiffs will be poorly informed and easily fooled. This seems unlikely, if only because tort law is an incredibly competitive field. With so many bidders, it's difficult to imagine any significant market power being used. However ignorant of the law a plaintiff might be, he ought to be able to identify the highest bid and accept it.
Ultimately, though, the question can't be answered in merely economic terms. The question is whether it can be answered satisfactorily without reference to economics. In the case of champerty at least, economics is crucial to a complete understanding of the issue. This suggests that someone who wants to understand the complexities of law must first learn some economics.
Champerty is trading the right to sue for a particular harm. So, if I'm injured because of a faulty part in my car, for which the car manufacturer is liable, under champerty I can sell the right to sue to a third party. That party (probably an attorney or a law firm) would pay all the costs of bringing the case to trial, and would keep the entire payment in the case of victory or a settlement. A separate issue, which I might address later, is selling your right to sue for harms that haven't happened yet. That's distinct from champerty, though.
Clearly, the most a company will pay for the right to a suit is the expected value of that suit. Furthermore, the only reason a plaintiff would ever sell a suit for less than its expected value is if he is risk averse. Thus, other than a sort of insurance market, there doesn't seem to be much room for profitable exchange.
This ignores something called the “agency problem.” Specifically, most plaintiffs don't have a lot of legal expertise. A plaintiff has to depend on a lawyer to represent him as well as possible. The lawyer, on the other hand, is merely trying to maximize profits (within ethical guidelines). Consider a plaintiff who is bringing his suit to trial. He wants the lawyer to spend effort on the suit, but how much effort? If he has to pay his lawyer by the hour, he won't know how many hours to “purchase.” A right answer exists: he should purchase the amount of effort that maximizes the profit, which is the difference between the total cost and the total expected returns from the case.
One common arrangement is a “contingency fee,” in which the plaintiff pays his lawyer a share of the winnings in the case of victory, and nothing otherwise. We might ask the question, does this give the lawyer incentives to invest the right amount of effort? This is easy to illustrate graphically.
[note: Blogger wants to sell us an upgrade, so they've set it up so that the free version can't display images. At least, that's my theory right now; if anyone knows how to display images (which we've uploaded to a different website), please let me know. Sorry about the inconvenience of having to click to see the graphs.]
Graph 1
Graph 2
The first graph shows the expected value of the case as a function of how much effort the lawyer expends. The curve illustrates diminishing returns. The curve representing the lawyer's costs is linear. The lower curve represents the amount of the winnings that would go to the lawyer; in this graph it is 30% (usually lawyers aren't allowed to set contingency fees higher than 40% or so).
The second graph just shows the vertical distance between the different curves. The upper curve shows the overall profits for the plaintiff (overall profit – costs); the lower curve shows the share of those profits that go to the lawyer under a contingency plan (30% of overall profit – costs). Now we can easily see that contingency fees do not maximize profits. The lawyer will choose to exert the amount of effort that corresponds to the peak of the lower curve. This isn't nearly enough effort to maximize overall profits (which happens at the peak of the upper curve).
Now, consider a lawyer who has purchased a case through champerty. Since he gets all of the profits, his incentives are represented by the top curve. He will thus invest the optimal amount of effort, maximizing profits. We can now see why champerty might do more than create an insurance market for plaintiffs: by solving the agency problem, champerty increases the expected value of each case, so that the buyer gets more than the seller gives up. Of course, the insurance effect still exists, increasing the profit potential even further. Champerty also increases the incentives for companies to make safe products; an increase in the expected value of a case must come from a higher probability of victory or a higher payout from the defendant. This in turn will increase the desire of the company to avoid lawsuits in the first place.
Of course, there's no free lunch. While the attorney's incentives might be improved by champerty, there has to be a mechanism to ensure that the plaintiff will cooperate by testifying as if it mattered. Further, juries must be willing to give the same verdict regardless of who gets the money, which will be difficult for some jurors (even though ultimately a well-functioning champerty system primarily benefits plaintiffs).
Another objection is that plaintiffs will be somehow exploited. Note that this would be difficult to judge ex post; a large verdict might seem disproportionate to the price the plaintiff received, but ex ante it might have been perfectly fair. Perhaps plaintiffs will be poorly informed and easily fooled. This seems unlikely, if only because tort law is an incredibly competitive field. With so many bidders, it's difficult to imagine any significant market power being used. However ignorant of the law a plaintiff might be, he ought to be able to identify the highest bid and accept it.
Ultimately, though, the question can't be answered in merely economic terms. The question is whether it can be answered satisfactorily without reference to economics. In the case of champerty at least, economics is crucial to a complete understanding of the issue. This suggests that someone who wants to understand the complexities of law must first learn some economics.
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