Managing Reputation with Litigation: Why Legal Sanctions Can Work Better than Market Sanctions
Washington University in Saint Louis - School of Law
Albert H. Choi
University of Virginia School of Law
August 20, 2013
Virginia Law and Economics Research Paper No. 2013-02
Washington University in St. Louis Legal Studies Research Paper No. 13-03-01
A long-lived firm sells a good to a sequence of short-lived consumers, where the quality of the good imperfectly depends on the firm's costly, unobservable effort. To solve the moral hazard problem, the firm can promise to pay damages (formal sanctions) or facilitate reputational punishment by future consumers (informal sanctions). Formal sanctions create litigation costs and the potential for court error (two elements of verification cost), while informal sanctions lead to inefficient failures to trade. We show that formal sanctions are generally better at deterrence than informal sanctions. Increasing damages raises deterrence by both inducing more lawsuits (marginal effect) and making existing lawsuits a stronger deterrent (infra-marginal effect). Increasing reputational sanctions, by contrast, lacks the second, infra-marginal effect. In equilibrium, the firm relies on formal sanctions as much as it can, so long as the cost of nuisance suits (induced by court error) does not outweigh the infra-marginal benefit.
Number of Pages in PDF File: 26Accepted Paper Series
Date posted: January 2, 2013 ; Last revised: August 21, 2013
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