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A Theory of Contracts with Limited Enforcement

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  • David Martimort

    (PJSE - Paris Jourdan Sciences Economiques - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement)

  • Aggey Semenov

    (NUS - National University of Singapore)

  • Lars Stole

    (Booth School of Business [Chicago] - University of Chicago)

Abstract

We develop a theory of contracts with limited enforcement in the context of a dynamic relationship. The seller is privately informed on his persistent cost, while the buyer remains uninformed. Public enforcement relies on remedies for breaches. Private enforcement comes from terminating the relationship. We first characterize enforcement constraints under asymmetric information. Those constraints ensure that parties never breach contracts. In particular, a high-cost seller may be tempted to trade high volumes at high prices at the beginning of the relationship before breaching the contract later on. Such "take-the-money-and-run" strategy becomes less attractive as time passes. It can thus be prevented by backloading payments and increasing volumes over a transitory phase. In a mature phase, enforcement constraints are slack and the optimal contract, although keeping memory of the shadow cost of enforcement constraints binding earlier on, looks stationary. Second-best distortions depend on a modified virtual cost that encapsulates this shadow cost of enforcement.

Suggested Citation

  • David Martimort & Aggey Semenov & Lars Stole, 2017. "A Theory of Contracts with Limited Enforcement," PSE-Ecole d'économie de Paris (Postprint) halshs-01509602, HAL.
  • Handle: RePEc:hal:pseptp:halshs-01509602
    DOI: 10.1093/restud/rdw024
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    3. Martimort, David & Semenov, Aggey & Stole, Lars, 2017. "Optimal stationary contract with two-sided imperfect enforcement and persistent adverse selection," Economics Letters, Elsevier, vol. 159(C), pages 18-22.
    4. Aggey Semenov, 2014. "Existence and continuity of the optimal contract in adverse selection models with constraints," Working Papers E1402E, University of Ottawa, Department of Economics.

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    More about this item

    Keywords

    Asymmetric information; Enforcement; Breach of contracts; Dynamic contracts;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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