A Theory of Contracts With Limited Enforcement

David Martimort, Aggey Semenov and Lars Stole

MPRA Paper from University Library of Munich, Germany

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.

Keywords: Asymmetric information; enforcement; breach of contracts; dynamic contracts (search for similar items in EconPapers)
JEL-codes: D82 D86 (search for similar items in EconPapers)
Date: 2014-02-07
New Economics Papers: this item is included in nep-cta, nep-mic and nep-reg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Related works:
Journal Article: A Theory of Contracts with Limited Enforcement (2017)
Working Paper: A Theory of Contracts with Limited Enforcement (2017)
Working Paper: A Theory of Contracts with Limited Enforcement (2017)
Working Paper: A Theory of Contracts with Limited Enforcement (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:53504

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