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Should Courts always Enforce what Contracting Parties Write?

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Author Info
Luca Anderlini ()
Leonardo Felli ()
Andrew Postlewaite ()

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Abstract

We find an economic rationale for the common sense answer to the question in our title — courts should not always enforce what the contracting parties write. We describe and analyze a contractual environment that allows a role for an active court. An active court can improve on the outcome that the parties would achieve without it. The institutional role of the court is to maximize the parties’ welfare under a veil of ignorance. We study a buyer-seller multiple-widget model with risk-neutral agents, asymmetric information and ex-ante investments. The court must decide when to uphold a contract and when to void it. The parties know their private information at the time of contracting, and this drives a wedge between ex-ante and interim-efficient contracts. In particular, if the court enforces all contracts, pooling obtains in equilibrium. By voiding some contracts the court is able to induce them to separate, and hence improve ex-ante welfare. In some cases, an ambiguous court that voids and upholds both with positive probability may be able to increase welfare even further.

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Publisher Info
Paper provided by CESifo GmbH in its series CESifo Working Paper Series with number CESifo Working Paper No. 1847.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1847

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Related research
Keywords: optimal courts informational externalities ex-ante welfare

Other versions of this item:

Find related papers by JEL classification:
C79 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Other
D74 - Microeconomics - - Analysis of Collective Decision-Making - - - Conflict; Conflict Resolution; Alliances
D89 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Other
K40 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - General
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Luca Anderlini & Leonardo Felli & Andrew Postlewaite, 2006. "Active Courts and Menu Contracts," STICERD - Theoretical Economics Paper Series /2006/511, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE. [Downloadable!]
    Other versions:
  2. Barry Adler, 1999. "The Questionable Ascent of Hadley v. Baxendale," Berkeley Olin Program in Law & Economics, Working Paper Series 1042, Berkeley Olin Program in Law & Economics. [Downloadable!]
  3. Fudenberg, Drew & Tirole, Jean, 1991. "Perfect Bayesian equilibrium and sequential equilibrium," Journal of Economic Theory, Elsevier, vol. 53(2), pages 236-260, April. [Downloadable!] (restricted)
  4. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-32, September. [Downloadable!] (restricted)
    Other versions:
  5. Steven Shavell, 2003. "On the Writing and the Interpretation of Contracts," NBER Working Papers 10094, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Mailath George J. & Okuno-Fujiwara Masahiro & Postlewaite Andrew, 1993. "Belief-Based Refinements in Signalling Games," Journal of Economic Theory, Elsevier, vol. 60(2), pages 241-276, August. [Downloadable!] (restricted)
  7. Moore, John & Repullo, Rafael, 1988. "Subgame Perfect Implementation," Econometrica, Econometric Society, vol. 56(5), pages 1191-1220, September. [Downloadable!] (restricted)
  8. Elisabetta Iossa & Giuliana Palumbo, 2002. "Decision Rules and Information Provision:Monitoring versus Manipulation," Economics and Finance Discussion Papers 02-17, Economics and Finance Section, School of Social Sciences, Brunel University. [Downloadable!]
    Other versions:
  9. Luca Anderlini, Leonardo Felli & Andrew Postlewaite, . "Courts of Law and Unforeseen Contingencies," Working Papers gueconwpa~03-03-26, Georgetown University, Department of Economics. [Downloadable!]
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  10. Baliga, Sandeep & Corchon, Luis C. & Sjostrom, Tomas, 1997. "The Theory of Implementation When the Planner Is a Player," Journal of Economic Theory, Elsevier, vol. 77(1), pages 15-33, November. [Downloadable!] (restricted)
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  11. Steven Shavell, 2006. "On the Writing and the Interpretation of Contracts," Journal of Law, Economics and Organization, Oxford University Press, vol. 22(2), pages 289-314, October. [Downloadable!] (restricted)
  12. Alan Schwartz & Robert Scott, . "Contract Theory and the Limits of Contract Law," Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy Working Paper Series yale_lepp-1011, Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy. [Downloadable!]
  13. Eric Maskin, 2006. "On the Rationale for Penalty Default Rules," Economics Working Papers 0058, Institute for Advanced Study, School of Social Science. [Downloadable!]
  14. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 179-221, May. [Downloadable!] (restricted)
  15. Bebchuk, Lucian Ayre & Shavell, Steven, 1991. "Information and the Scope of Liability for Breach of Contract: The Rule of Hadley vs. Baxendale," Journal of Law, Economics and Organization, Oxford University Press, vol. 7(2), pages 284-312, Fall.
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  16. Murat Usman, 2002. "Verifiability and Contract Enforcement: A Model with Judicial Moral Hazard," Journal of Law, Economics and Organization, Oxford University Press, vol. 18(1), pages 67-94, April.
  17. Maskin, Eric & Tirole, Jean, 1992. "The Principal-Agent Relationship with an Informed Principal, II: Common Values," Econometrica, Econometric Society, vol. 60(1), pages 1-42, January. [Downloadable!] (restricted)
  18. Kreps, David M & Wilson, Robert, 1982. "Sequential Equilibria," Econometrica, Econometric Society, vol. 50(4), pages 863-94, July. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dana Heller & Ran Spiegler, 2005. "Contradiction as a Form of Contractual Incompleteness," Levine's Bibliography 122247000000000978, UCLA Department of Economics. [Downloadable!]
  2. Neil A. Doherty & Alexander Muermann, 2005. "Insuring the Uninsurable: Brokers and Incomplete Insurance Contracts," CFS Working Paper Series 2005/24, Center for Financial Studies. [Downloadable!]
  3. Mitchell Berlin & Yaron Leitner, 2005. "Courts and contractual innovation: a preliminary analysis," Working Papers 05-27, Federal Reserve Bank of Philadelphia. [Downloadable!]
  4. Luca Anderlini & Leonardo Felli & Andrew Postlewaite, 2006. "Active Courts and Menu Contracts," CESifo Working Paper Series CESifo Working Paper No. , CESifo GmbH. [Downloadable!]
    Other versions:
  5. Giovanni Maggi & Robert W. Staiger, 2008. "On the Role and Design of Dispute Settlement Procedures in International Trade Agreements," NBER Working Papers 14067, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Yaron Leitner, 2005. "Legal uncertainty and contractual innovation," Business Review, Federal Reserve Bank of Philadelphia, issue Q2, pages 26-32. [Downloadable!]
  7. Elisabetta Iossa & Giuliana Palumbo, 2006. "Reputational Concerns and Bias in Arbitration," Economics and Finance Discussion Papers 06-09, Economics and Finance Section, School of Social Sciences, Brunel University. [Downloadable!]
  8. Luca Anderlini & Leonardo Felli & Andrew Postlewaite, 2003. "Courts of Law and Unforeseen Contingencies," STICERD - Theoretical Economics Paper Series 447, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE. [Downloadable!]
    Other versions:
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