9781118041581

The Economic Sources of Beneficial Agreements 637

SETTLEMENT NEGOTIATIONS REVISITED Let’s return to the patent dispute,

but now suppose the firms hold different, conflicting assessments about the

litigation value of the case. The small firm believes there is a .6 chance that its

side will win the case (i.e., there will be a finding of patent infringement). The

large firm assesses a .6 chance that itwill win the case (i.e., no infringement will

be found). Both sides estimate an expected damage award of $2 million for an

infringement finding and no damages otherwise. Therefore, the parties’

expected values are: vS(.6)($2.0) $1.2 million and vL(.4)(2.0) $.8

million. Accounting for the parties’ legal costs (as in constraint 15.1), the least

the small firm will accept out of court is $1 million, whereas the most the large

firm will offer is $960,000. Thus, there is no zone of agreement. In general, a

negotiated settlement is possible if and only if there is some price, P, such that

constraint 15.1 is satisfied. An equivalent constraint is

, [15.2]

which is derived by rearranging constraint 15.1. A mutually beneficial settle-

ment is possible if and only if the difference between the parties’ litigation

expectations is smaller than the combined court costs.

vSvLcScL

CHECK

STATION 2

Company A seeks to purchase a can manufacturing facility from its current owner, com-

pany B. Both parties agree that the potential value of the facility depends on the out-

come of a “bottle bill” recently proposed in the state legislature. The proposed bill

requires a deposit on all soft-drink cans. If the bill passes, use of cans will fall signifi-

cantly. (Cans will be replaced by larger glass and plastic containers.) If the bill is

defeated, the value of the facility is estimated to be $4 million; if it is passed, the value

will fall to $3 million. The transaction costs (lawyers’ fees and so on) of completing the

deal are estimated to be $50,000 for each side. Under what circumstances is a mutually

beneficial transaction possible?

RISK AVERSION Recall from the discussion in Chapter 12 that a risk-averse

agent assesses the value for an uncertain outcome to be significantly lower than

its expected value (EV). This value is termed the outcome’s certainty equivalent

(CE). In algebraic terms, CE EV. The greater the agent’s risk aversion and/or

the riskiness of the outcome, the greater the gap between the certainty equiv-

alent and expected value.

The presence of risk aversion motivates transactions that minimize and/or

distribute risks among the parties. For instance, consider the patent dispute once

again. We saw that, when each side assessed its winning chances at 60 percent, the

parties’ expected payoffs (court costs included) were $1 million and $960,000;

thus, no settlement was possible. However, because the litigation outcome is

highly uncertain, we can expect each risk-averse disputant to value going to court

at a CE value considerably below its EV. For example, suppose the small firm

c15BargainingandNegotiation.qxd 9/26/11 11:03 AM Page 637