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The Economic Sources of Beneficial Agreements 635

regulators and business, and legal disputes. As we will see, the resolution of an

ongoing dispute offers exactly the same kind of mutual benefits as the forging of

a new agreement. The following typical example makes the point.

A PATENT CONFLICT A small manufacturer of a specialty pump used in oil

refineries and nuclear reactors has filed a $4 million lawsuit against a leading

pump company for patent infringement. Three years after the small firm suc-

cessfully introduced its pump, the large firm began to sell a similar pump at

lower prices. The small firm claims its rival “reverse engineered” its pump and

then copied it, making only small modifications. At the time of development, the

small firm filed numerous patents on the pump’s “unique” valves and circuitry—

patents that it claims have been infringed upon. The large company has filed its

own patents and claims the pump it developed is unique (and, indeed, is more

similar in design to its own 10-year-old model than to the small firm’s model).

The firms’ legal representatives are conducting negotiations aimed at

reaching an out-of-court settlement. Both sides recognize that a full-scale trial

will be very costly—in all likelihood more costly for the small firm because,

unlike its larger rival, it does not maintain an in-house legal department. How

should each side approach the negotiations? Can the parties reach a mutually

beneficial out-of-court agreement?

For either side, an optimal negotiating strategy depends critically on its

best estimate of the expected monetary outcome if the case goes to court. After

all, the court outcome is the relevant alternative to a negotiated agreement.

The problem is that the court outcome is highly uncertain. The court’s award

of monetary damages (if any) can vary over a wide range. Under a “no infringe-

ment” ruling, the large firm would owe zero damages. Alternatively, if a broad

infringement is found, the large firm could be ordered to cease sale of the

pump altogether and pay maximum damages. Outcomes in between include

narrowly defined infringements (of a particular valve, for instance), with dam-

ages based on larger or smaller estimates of the resulting economic loss suf-

fered by the small company.

Given these multiple uncertainties, each side would be well advised to take

a cue from Chapters 12 and 13 and construct a decision tree incorporating the

sequence and probabilities of the different possible outcomes and monetary

consequences. Suppose each side has done this and has averaged back its tree

to compute the expected litigation value of the case (i.e., the amount on aver-

age that the court will order the large firm to pay the small firm). Let vSand

vLdenote the small and large firms’ respective expected values. Because the two

sides are likely to see the risks and possible outcomes differently, these esti-

mates will also differ from each other. In addition, the firms have in hand esti-

mates of the total costs (legal and other) of fighting the case in court. We

denote these costs by cSand cL, respectively.

With this information in hand, it is easy to evaluate the monetary implica-

tions for each side of going to court. The small firm’s expected profit, net of

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