Optimism & Expenditures: The Effect on Settlements

Abstract This article challenges the conventional wisdom in economic models of litigation that optimism necessarily increases the likelihood of trial and that pessimism increases the chances of settlement. We show that optimism may, to the contrary, expand the settlement range. By increasing the perceived value at stake in litigation, optimism may induce parties to invest additional resources in a dispute, which increases the overall bargaining range. Because of the strategic nature of litigation expenditures, optimistic litigants may spend an amount that outweighs the negative impact of optimism on the bargaining surplus. Whether optimism increases or decreases the settlement rate ultimately depends on whether, in concrete instances, the negative effects of optimism on the bargaining surplus outweigh the positive effects created by the additional investments in litigation. Our results provide counterintuitive insights into the selection of disputes for litigation. (JEL K00, K21).