Ian A. MacKenzie, School of Economics Discussion Paper No. 535 November 2014, School of Economics, The University of Queensland.

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A central question in tort liability is how to induce a socially optimal level of precaution. In most analysis it is common to assume that litigation is either costless or the costs are exogenously fixed. Yet, in reality, litigation costs are large and litigants have the ability to choose their own level of litigation expenditure. In this paper we advance the theory of tort liability by investigating the incentive to invest in precaution when litigation efforts are endogenously chosen by parties. We outline a two-stage game where, in stage one, the injurer invests in a level of precaution. In stage two—if harm has been realized—the victim can sue for damages and go to trial. Parties then choose their level of litigation effort in order to win the trial. We model the court’s decision over liability as a stochastic ‘lottery’ contest, where the probability of being successful at trial depends on relative litigation efforts and inherent legal presumptions. We allow the level of precaution to compliment the injurer’s generation of evidence at trial. We show how the equilibrium litigation efforts are chosen and how this determines the equilibrium level of precaution. We compare both strict liability and negligence rules and also solve for the optimal damages to minimize social losses.