Completing Contracts in the Shadow of Costly Verification

Abstract:     
Contract theory typically holds that verification costs are obstacles to complete contracting; yet, real world contracts often contain provisions that seem costly to verify. We show how a costly signal can play an important role in contracts. Verification (or litigation) costs operate as a screen on the promisee's incentive to sue and as an effective sanction against the breaching promisor. So long as the court's judgment is correlated with the promisor's behavior, therefore, the parties can design a set of prices (including damages) so as to provide additional incentive to the promisor through an off-the-equilibrium, credible litigation threat. We show that the parties may prefer to adopt a costly signal over a costless signal. Rather than focusing solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we have attempted to take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process.

Keywords: Incomplete Contracts, Costly Verification

Working Paper Series