Question: In a court case, a plaintiff claimed that the defendant should pay her $3 million for damages. She did not expect the judge to award her this amount; her expected value actually was $1 million. The defendant also did not believe that the court would award the full $3 million, and shared the plaintiff's expected value of $1 million.
a. Assuming that the plaintiff is thinking about the award in terms of gains, explain why you might expect her to be risk-averse in this situation. If she is risk-averse, what kind of settlement offer might she accept from the defendant?
b. Assuming that the defendant is thinking about the situation in terms of losses, explain why you might expect him or her to be risk-seeking. What would this imply about settlement offers to which the defendant might agree? (Draw an example of a risk-seeking utility curve over the possible negative payoffs for the defendant. Now find the CE.)
c. Discuss your answers to parts a and b. What are the implications for settlements in real-world court cases? What would happen if the defendant's expected value were less than the plaintiff's?