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Completing Contracts in the Shadow of Costly Verification

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  • Albert Choi
  • George Triantis
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    Abstract

    Contract theory typically holds that verification costs are obstacles to complete contracting; yet real-world contracts often contain provisions that seem costly to verify. We show how verification (or litigation) costs operate as a screen on the promisee's incentive to sue and as an effective sanction against the breaching promisor. As long as the court's judgment is correlated with the promisor's behavior, the parties can design a set of prices (including damages) to provide additional incentive to the promisor through an off-the-equilibrium, credible litigation threat. We show that the parties may prefer to adopt a costly signal over a costless signal. Rather than focus solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process. (c) 2008 by The University of Chicago. All rights reserved..

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    File URL: http://www.journals.uchicago.edu/doi/pdf/10.1086/589665
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    Bibliographic Info

    Article provided by University of Chicago Press in its journal The Journal of Legal Studies.

    Volume (Year): 37 (2008)
    Issue (Month): 2 (06)
    Pages: 503-534

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    Handle: RePEc:ucp:jlstud:v:37:y:2008:i:2:p:503-534

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    Web page: http://www.journals.uchicago.edu/JLS/

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    Cited by:
    1. NAKABAYASHI, Masaki, 2014. "From the Substance to the Shadow: The Court Embedded into Japanese Labor Markets," ISS Discussion Paper Series (series F) f168, Institute of Social Science, The University of Tokyo, revised 18 Mar 2014.
    2. Liu, Zhiyong & Avraham, Ronen, 2012. "Ex ante versus ex post expectation damages," International Review of Law and Economics, Elsevier, vol. 32(4), pages 339-355.

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