SETTLEMENT BARGAINING AND THE DESIGN OF DAMAGE AWARDS

An injurer undertakes precautions to reduce both the probability and t he severity of an accident. The damages that the victim suffers are pr ivately observed, and will be verified at a cost if the case is litiga ted. While finely tuned damage awards induce the injurer to take appro priate precautions ex ante, they increase the probability that the lit igants will disagree about the case, and thereby aggravate the settlem ent process. Flat damage awards reduce the level of costly litigation, but lead to underinvestment in precautions. We show that when the lit igation costs are small the optimal award is finely tuned to the actua l damages, and when litigation costs are large the optimal award is a flat penalty. Applications to scheduled damages and workers' compensat ion are discussed.