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Completing Contracts in the Shadow of Costly Verification

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  • Albert Choi
  • George Triantis

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.

Suggested Citation

  • Albert Choi & George Triantis, 2008. "Completing Contracts in the Shadow of Costly Verification," The Journal of Legal Studies, University of Chicago Press, vol. 37(2), pages 503-534, June.
  • Handle: RePEc:ucp:jlstud:v:37:y:2008:i:2:p:503-534
    DOI: 10.1086/589665
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    References listed on IDEAS

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    Cited by:

    1. Macias, Antonio J. & Moeller, Thomas, 2016. "Target signaling with material adverse change clauses in merger agreements," Journal of Empirical Finance, Elsevier, vol. 39(PA), pages 69-92.
    2. Nicola Gennaioli & Giacomo A. M. Ponzetto, 2015. "Optimally vague contracts and the law," Economics Working Papers 1410, Department of Economics and Business, Universitat Pompeu Fabra, revised Jan 2017.
    3. 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.
    4. 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 28 Mar 2014.
    5. Albert H. Choi & George Triantis, 2021. "Contract Design When Relationship-Specific Investment Produces Asymmetric Information," The Journal of Legal Studies, University of Chicago Press, vol. 50(2), pages 219-260.
    6. Masaki Nakabayashi, 2018. "From the substance to the shadow: the role of the court in Japanese labour markets," Economic History Review, Economic History Society, vol. 71(1), pages 267-289, February.
    7. Albert H. Choi, 2015. "Non-Profit Status and Relational Sanctions: Commitment to Quality through Repeat Interactions and Organizational Choice," Journal of Law and Economics, University of Chicago Press, vol. 58(4).
    8. Constantine Boussalis & Yuval Feldman & Henry E. Smith, 2018. "Experimental analysis of the effect of standards on compliance and performance," Regulation & Governance, John Wiley & Sons, vol. 12(2), pages 277-298, June.

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