Should Courts Always Enforce What Contracting Parties Write?
Georgetown University - Department of Economics
London School of Economics - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)
University of Pennsylvania - Department of Economics
January 23, 2009
PIER Working Paper No. 09-004
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.
Number of Pages in PDF File: 16
Keywords: Optimal Courts, Informational Externalities, Ex-Ante Welfare
JEL Classification: C79, D74, D89, K40, L14working papers series
Date posted: January 26, 2009
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