Regulating Contract Formation: Precontractual Reliance, Sunk Costs, and Market Structure

Abstract:     
This article challenges the plausibility of one of the cornerstones of the law and economics literature — the prospect of under-investment in precontractual reliance (PCR). It shows that a negotiating party may well be motivated to invest in PCR not only through her expectation to extract the benefits that the investment yields (Added-Value Motivation), but also through the effect of the investment on her position vis-à-vis her competitors (Competition-Based Motivation). It further demonstrates that the Competition-Based Motivation is frequently sufficient to induce optimal PCR, even without appropriate contractual provisions or legal intervention. Following this analysis several normative implications are suggested, key of which is the argument that legal intervention, which is aimed at encouraging PCR, is generally unwarranted. However, the discussion does not yield an unrestricted support of laissez-faire policy, of avoiding regulating the bargaining process. It shows that efficiency considerations may justify legal intervention that aims mainly to prevent over-investment in PCR. Specifically, legal intervention may be required to deter one side from illegitimately exploiting the competition between his potential contracting partners and to achieve optimal allocation of transferable PCR.

Number of Pages in PDF File: 49

Keywords: precontractual reliance, contract formation, sunk cost

JEL Classification: K12

working papers series