Layered Contract, Enforcement Institutions, and Intermediaries

University Of California-San Diego, La Jolla CA

Investigators

Abstract

Most economic relationships (employer/employee, buyer/supplier, etc.) have some contractual element. The success of any particular relationship depends on how well contracts can be enforced. Contract enforcement is facilitated by several different institutions. The most visible institution is the public court system. In addition, there are many less formal institutions --- involving arbitrators, mediators, and other intermediaries --- that play a role. For instance, it is becoming more and more common for contracts to require parties to resolve disputes through binding arbitration, rather than using the court system. However, even if parties agree to such "alternative dispute resolution," the court system is still in play since the courts are ultimately needed to enforce the judgments of arbitrators. Parties in long-term relationships sometimes can enforce agreements on their own, but they still count on external institutions to some extent. Thus, the institutions that enforce contracts (e.g., the public courts, private arbitration systems, and informal convention) generally overlap and influence one another. This project focuses on the relative merits of, and the interaction between, enforcement institutions. It develops an understanding of how institutions determine the scope of contracting and how economic activity is impacted. The project has two components. The first component involves developing the theoretical tools necessary for economists to explicitly study the constituents of contract enforcement, to analyze the strategic aspects of contracting, and to compare features of various institutions. For example, institutions differ on the basis of renegotiation and enforcement costs and regarding the kind of information that can be utilized by authorities. This project produces a flexible, game-theoretic framework that makes explicit these costs and informational constraints. Specifically, the project shows how to combine "cooperative game theory" (which focuses on negotiation and the alternatives available to groups of people) with "non-cooperative game theory" (which focuses on individual incentives). The project also develops the concept of "layered contract," which describes how various institutions overlap. While the first component of the project is mainly geared toward economic theorists, the second component of the project involves detailed analysis of some actual contracting environments and legal systems. In particular, the project explores how the ability of parties to renegotiate their contracts influences whether their relationships will be successful. Renegotiation is partially controlled by institutions. For example, the U.S. court system generally supports efforts of parties to renegotiate their contracts, although there are instances where renegotiation is not allowed. This project examines the strategic effects of the ability of agents to recontract in an ongoing relationship. Moderate recontracting costs (rather than renegotiation being free or totally barred) are shown to have value in many contractual relationships, a fact which has important implications for the optimal design of legal rules. In addition, the project explains why different contractual relationships use different enforcement institutions (some use arbitrators, others use the courts, etc.). The project also studies optimal contractual arrangements in the face of constraints on allowable contract terms. For example, courts do not always enforce contracts verbatim, but often push aside provisions that clash with legal principle. Implications for the design of governance systems, specialized dispute resolution systems, and non-legal intermediation systems are explored. The research yields direct policy implications, informing the debate on how to structure the legal system and encourage the appropriate development of less formal enforcement institutions.