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Contracts in the Shadow of the Law: Optimal Litigation Strategies within Organizations

Author

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  • Aaron Finkle

    (Department of Economics, California State University San Marcos, U.S.A.)

Abstract

A principal can bring litigation against an agent for overstating the realized production costs. The lawsuit functions much like an audit; the principal's ability to bring suit against the agent can reduce the information rent and increase production efficiency by penalizing the agent misreporting costs. The principal benefits from higher trial awards depending on the ability of the principal to commit to a litigation strategy comprised of a frequency of and expenditure in litigation. While higher awards increase the agent's expected punishment for shirking, they also encourage excessive litigation expenditures by both parties ex post. When the principal can pre-commit to a probability of bringing suit, for large stakes in trial, the principal reduces the probability to maintain a constant expected punishment. Alternatively, if the principal were able to commit ex ante to a probability and intensity of litigation, even when stakes are large, the principal would litigate with certainty but reduce litigation intensity below what is ex post rational.

Suggested Citation

  • Aaron Finkle, 2010. "Contracts in the Shadow of the Law: Optimal Litigation Strategies within Organizations," International Journal of Business and Economics, College of Business and College of Finance, Feng Chia University, Taichung, Taiwan, vol. 9(2), pages 131-155, August.
  • Handle: RePEc:ijb:journl:v:9:y:2010:i:2:p:131-155
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    References listed on IDEAS

    as
    1. Gutierrez, M., 2000. "An Economic Analysis of Corporate Directors' Fiduciary Duties," Papers 0014, Centro de Estudios Monetarios Y Financieros-.
    2. Finkle, Aaron & Shin, Dongsoo, 2007. "Conducting inaccurate audits to commit to the audit policy," International Journal of Industrial Organization, Elsevier, vol. 25(2), pages 379-389, April.
    3. Alfredo Garcia & James Reitzes & Juan Benavides, 2005. "Incentive Contracts for Infrastructure, Litigation and Weak Institutions," Journal of Regulatory Economics, Springer, vol. 27(1), pages 5-24, September.
    4. Albert Choi & Chris William Sanchirico, 2004. "Should Plaintiffs Win What Defendants Lose? Litigation Stakes, Litigation Effort, and the Benefits of Decoupling," The Journal of Legal Studies, University of Chicago Press, vol. 33(2), pages 323-354, June.
    5. Aghion, Philippe & Tirole, Jean, 1997. "Formal and Real Authority in Organizations," Journal of Political Economy, University of Chicago Press, vol. 105(1), pages 1-29, February.
    6. Katz, Avery, 1988. "Judicial decisionmaking and litigation expenditure," International Review of Law and Economics, Elsevier, vol. 8(2), pages 127-143, December.
    7. Bharat Sarath, 1991. "Uncertain Litigation and Liability Insurance," RAND Journal of Economics, The RAND Corporation, vol. 22(2), pages 218-231, Summer.
    8. Daniel L. Rubinfeld & David E.M. Sappington, 1987. "Efficient Awards and Standards of Proof in Judicial Proceedings," RAND Journal of Economics, The RAND Corporation, vol. 18(2), pages 308-315, Summer.
    9. Farmer, Amy & Pecorino, Paul, 1999. "Legal Expenditure as a Rent-Seeking Game," Public Choice, Springer, vol. 100(3-4), pages 271-288, September.
    10. Anke S. Kessler, 2004. "Optimal Auditing in Hierarchical Relationships," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 160(2), pages 210-210, June.
    11. Gutierrez, Maria, 2003. " An Economic Analysis of Corporate Directors' Fiduciary Duties," RAND Journal of Economics, The RAND Corporation, vol. 34(3), pages 516-535, Autumn.
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    More about this item

    Keywords

    litigation; principal-agent model; evidence production;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
    • K41 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - Litigation Process

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