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A Theory of Contracts With Limited Enforcement

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Listed author(s):
  • Martimort, David
  • Semenov, Aggey
  • Stole, Lars

Abstract

We present a Theory of Contracts under costly enforcement in the context of a dynamic relationship between an uninformed buyer and a seller who is privately informed on his persistent cost at the outset. Public enforcement relies on remedies for breach. Private enforcement comes from severing relationships. We first characterize aggregate enforcement constraints ensuring that trading partners do not breach contracts unduly. Whether a long-term contract is enforceable does not depend on the distribution of penalties for breach between the buyer and the seller. While under complete information, the optimal contract would remain stationary, non-stationarity might arise under asymmetric information. Enforcement constraints are time-dependent and easier to satisfy as time passes. Indeed, 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. Yet, such take-the-money-and-run strategy becomes less attractive as time passes and can be prevented with backloaded payments. The optimal contract thus goes through two different phases. First, quantities and prices increase at the inception of the relationship. Later on, the contract looks more stationary. The public and private sides of enforcement plays different roles in determining the length of the earlier phase of contracting. Long-run screening distortions encapsulate the quality of enforcement, offering de facto a link between the quality of the legal system and contractual performances.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 53504.

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Date of creation: 07 Feb 2014
Handle: RePEc:pra:mprapa:53504
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Keywords: Asymmetric information; enforcement; breach of contracts; dynamic contracts;

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Find related papers by JEL classification:
  • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
  • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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Cited by:

  1. 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.
  2. Daniel Danau & Annalisa Vinella, 2015. "From fixed to state-dependent duration in public-private partnerships," Economics Working Paper Archive (University of Rennes 1 & University of Caen) 201504, Center for Research in Economics and Management (CREM), University of Rennes 1, University of Caen and CNRS.

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