Prohibitions on Punishments in Private Contracts

We study legal restrictions on private contracting in the form of limitations on the severity of non-monetary punishments. We locate the rationale for such restrictions in externalities that parties impose on future relationships: punishments that lower an agent's future productivity may lower social welfare, and the agent may not take this into account. These externalities assume two forms: (1) future principals' interests are not taken into account by private parties; and (2) consonant with much of the legal literature, agents who are boundedly rational take insufficient account of their ``future selves'' and may need protection. In the first instance, we derive results on the dependence of socially inefficient contracting on the relative bargaining powers of principals and agents, on growth rates and uncertainty about productivity, and on the number of trading partners. For the second case, we focus on over-confidence and note that its effects are ambiguous: although over-confidence may lead agents to accept contracts they ought to reject, it actually reduces the private need to engage in severe punishments