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Should Courts Always Enforce What Contracting Parties Write?

  • Luca Anderlini

    ()

    (Department of Economics, Georgetown University)

  • Leonardo Felli

    ()

    (Department of Economics, London School of Economics and Political Science)

  • Andrew Postlewaite

    ()

    (Department of Economics, University of Pennsylvania)

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 model with risk-neutral agents and asymmetric information. 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, inefficient pooling obtains in equilibrium. By voiding some contracts the court is able to induce them to separate, and hence improve ex-ante welfare.

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File URL: http://economics.sas.upenn.edu/system/files/working-papers/09-004.pdf
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Paper provided by Penn Institute for Economic Research, Department of Economics, University of Pennsylvania in its series PIER Working Paper Archive with number 09-004.

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Length: 16 pages
Date of creation: 23 Jan 2009
Date of revision:
Handle: RePEc:pen:papers:09-004
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