Costly Dispute Resolution Under Limited Commitment: A Mechanism Design Approach∗

Why do agents engage in costly dispute resolution such as litigation and arbitration when costless settlement is available? It has been argued that parties are asymmetrically informed about facts and the law surrounding a dispute. This causes the expected payoff from litigation for an agent to be unobservable to her opponent. This unobservability can lead to the break down of pre-trial bargaining. This approach leaves two fundamental questions unanswered: How does informational asymmetry between parties survive given the incentives for full disclosure of certifiable information? Does efficient settlement ensue if parties communicate in forms richer than bargaining? To address the first question I argue that pre-trial informational asymmetry could arise from inherently non-certifiable information, in particular through private valuation of the subject matter in dispute. The second question is tackled by adopting a mechanism design framework to show that there are conditions under which litigation must exist in equilibrium. This result arises when parties at the pre-trial stage, lack the ability to fully contract away their right to litigate. This in effect induces agents to exaggerate their true willingness to litigate in order to increase the settlement that their opponents are willing to offer. Consequently the credibility of statements made in pre-trial negotiations is destroyed and costly dispute resolution emerges as an equilibrium phenomenon.