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Should Courts Always Enforce What Contracting Parties Write?

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Author Info

  • Luca Anderlini

    ()
    (Department of Economics, Georgetown University)

  • Leonardo Felli

    ()
    (Department of Economics, London School of Economics)

  • Andrew Postlewaite

    ()
    (Department of Economics, University of Pennsylvania)

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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Bibliographic Info

Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 06-024.

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Length: 34 pages
Date of creation: 01 Nov 2003
Date of revision: 01 Oct 2006
Handle: RePEc:pen:papers:06-024

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Keywords: Optimal Courts; Informational Externalities; Ex-Ante Welfare;

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References

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  1. 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.
  2. Luca Anderlini & Leonardo Felli & Andrew Postlewaite, 2003. "Should Courts Always Enforce What Contracting Parties Write?," PIER Working Paper Archive 06-024, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania, revised 01 Oct 2006.
  3. Luca Anderlini & Leonardo Felli & Andrew Postlewaite, 2006. "Active Courts and Menu Contracts," Working Papers gueconwpa~06-06-08, Georgetown University, Department of Economics.
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