Promoting Long-Term Relationships through Costly Litigation
Washington University in Saint Louis - School of Law
Albert H. Choi
University of Virginia School of Law
November 14, 2014
Virginia Law and Economics Research Paper No. 2013-02
Washington University in St. Louis Legal Studies Research Paper No. 13-03-01
The paper analyzes designing of an optimal incentive system when both formal (legal) and informal (relational) sanctions are imperfect. A long-lived firm sells a good to a sequence of short-lived consumers, where the quality of the good depends on the firm's costly and unobservable effort. To solve the moral hazard problem, the firm can promise to pay damages (formal sanctions) or facilitate "relational" punishment, such as suspension or termination of trade, by future consumers (informal sanctions). Formal sanctions engender litigation costs and possible court error while informal sanctions lead to inefficient failures to trade. The model shows that formal sanctions have an advantage that informal sanctions lack. Increasing damages raises incentive by both inducing more lawsuits (a marginal effect) and making existing lawsuits a stronger deterrent (an infra-marginal effect). Increasing relational 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 (created by court error) does not outweigh the infra-marginal benefit. We extend the analysis to a setting with one long-run buyer and also examine other informal punishment strategies, such as having to offer larger damages or a lower price.
Number of Pages in PDF File: 37
JEL Classification: D86, K12, L14
Date posted: January 2, 2013 ; Last revised: November 15, 2014
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