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court costs, is vScS. The large firm’s expected expense, including court costs,

is vLcL. Thus, a proposed out-of-court settlement (call this P) is beneficial

for both sides if and only if

. [15.1]

This range of out-of-court settlements constitutes the zone of agreement. To

illustrate, suppose the firms’ assessments of the case are identical. Let’s say that

the expected litigation value is vSvL$1 million, and court costs are cS

$200,000 and cL$160,000, respectively. Then any out-of-court settlement

(i.e., a payment from the large firm to the small firm) between $800,000 and

$1.16 million is mutually beneficial. As always, the size of the zone of agree-

ment measures the total benefit at stake in reaching an agreement.

The collective benefit from an agreement is exactly equal to the sum of

the court costs the disputants save by avoiding litigation. (Let’s check this: The

size of the zone of agreement is 1,160,000 800,000 $360,000, which is

exactly the sum of the court costs.) The exact terms of the agreement dictate

how this benefit is split. For instance, under an agreement at P $1 million,

the parties settle for what each agrees is the expected litigation outcome. In the

process, each side saves its court costs. (Under an agreement at P $980,000,

each side saves $180,000 relative to its expected litigation outcome.)

Differences in Values

The preceding discussion and examples illustrate a basic principle:

Differences in values create opportunities for parties to craft mutually beneficial

agreements.

The following applications involve decisions under uncertainty and explore

two sources of value differences: differences in probability assessments and dif-

ferences in attitudes toward risk.

PROBABILITY ASSESSMENTS Even if two parties have identical preferences,

they may assess different values for a transaction due to different probability

assessments and forecasts. For instance, an agreement may be supported by

each side’s optimisticbelief that the transaction is substantially better than no

agreement at all. As Mark Twain said, “It is differences of opinion that make

horse races.” Many transactions involve an element of a bet: Each side believes

it has a better assessment of the transaction’s value than the other and will gain

(possibly) at the other’s expense. Of course, differences in probability assess-

ments also can work against negotiated agreements. The following application

makes the point.

vScSPvLcL

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