November 23, 2005
Contracting in Law's Shadow
It's a truism that all contracting occurs in the context of the legal regime that governs contract enforcement. But what are the implications of that statement? In Contracting in the Shadow of the Law, Nicola Gennaioli of the Institute for International Economic Studies at Stockholm University offers a model of how different judicial approaches lead to different contracting practices. Here's the abstract:
I study how law shapes the form and efficiency of contracts. I build a model where judges subject to personal biases try to subvert contracts by distorting fact-finding and interpretation. I consider two adjudication regimes, one where judges wield discretion and another where they must follow a code. I find that, by affecting judicial behavior, the law shapes the form of optimal contracts: discretion fosters the use of contingent contracts, codification the use of non-contingent contracts. Beyond contract form, I find that adjudication regimes fundamentally differ in their ability to enforce complex transactions, where performance is hard-to verify. The code's bias is the cost of codification, the arbitrariness of judges and juries and their incompetence are the costs of discretion. I illustrate the costs and benefits of discretion across areas of law by discussing findings from law and finance and product liability.
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