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http://ssrn.com/abstract=2195749
 
 

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Promoting Long-Term Relationships through Costly Litigation


Scott Baker


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

Abstract:     
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

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Date posted: January 2, 2013 ; Last revised: November 15, 2014

Suggested Citation

Baker, Scott and Choi, Albert H., Promoting Long-Term Relationships through Costly Litigation (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. Available at SSRN: http://ssrn.com/abstract=2195749 or http://dx.doi.org/10.2139/ssrn.2195749

Contact Information

Scott A. Baker
Washington University in Saint Louis - School of Law ( email )
Campus Box 1120
St. Louis, MO 63130
United States
Albert H. Choi (Contact Author)
University of Virginia School of Law ( email )
580 Massie Road
Charlottesville, VA 22903
United States

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