Limited Liability, Liability Cap, and Pretrial Negotiation

We examine how the possibility of limited liability will affect the trial likelihood when the plaintiff is uninformed of whether the defendant is financially constrained or not. The financially constrained defendant has a smaller incentive to settle because he has less to lose in court, and thus makes a lower settlement offer. Therefore, there is a separating equilibrium in which only the poor defendant goes to court, while the rich defendant makes a high offer that will be accepted for sure. We show that the liability cap restricting the judgment amount in court can increase the settlement rate by making both types of defendant solvent.