Reputation and Litigation: Why Costly Legal Sanctions Can Work Better than Reputational Sanctions
47:1 Journal of Legal Studies 45 (2018)
Virginia Law and Economics Research Paper No. 2013-02
Washington University in St. Louis Legal Studies Research Paper No. 13-03-01
32 Pages Posted: 2 Jan 2013 Last revised: 8 Jun 2021
Date Written: December 31, 2017
Abstract
The paper reconsiders an old question in law and economics: will firms prefer to rely on legal sanctions or market sanctions as a means of committing to provide high quality goods? In the model, legal sanctions are expensive to deploy because of litigation costs, whereas market sanctions are expensive because they involve suspension of otherwise efficient trade. The firm can promise to pay damages for the delivery of low quality or it can limit damages by contract and only suffer follow on reputational sanctions in the event it delivers defective goods. Legal sanctions have a previously unrecognized advantage compared to reputational sanctions. By raising the damages (or warranty) promised, the firm creates a marginal effect: consumers who did not find filing a lawsuit cost-justified before now find it worthwhile. Further, the increase in damages means that the firm must pay higher damages on lawsuits that would have been filed anyway, creating an infra-marginal deterrence benefit. In deciding on the optimal size of the liquidated damages (or the generosity of the warranty), the firm balances the infra-marginal benefit against the cost of additional nuisance suits--suits consumer file even when they receive a high quality good. The paper also analyzes various extensions, such as litigation's informational role and the interaction with one long-term buyer.
JEL Classification: D86, K12, L14
Suggested Citation: Suggested Citation
Do you have a job opening that you would like to promote on SSRN?
Recommended Papers
-
The Cost to Firms of Cooking the Books
By Jonathan M. Karpoff, D. Scott Lee, ...
-
The Consequences to Managers for Financial Misrepresentation
By Jonathan M. Karpoff, D. Scott Lee, ...
-
Defense Procurement: Fraud, Penalties, and Contractor Influence
By Jonathan M. Karpoff, D. Scott Lee, ...
-
On the Nature of the Reputational Penalty for Corporate Crime: Evidence
-
Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers
By Amar Gande and Craig M. Lewis
-
Why Do Corporations Become Criminals? Ownership, Hidden Actions, and Crime as an Agency Cost
By Cindy R. Alexander and Mark A. Cohen
-
The Legal Penalties for Financial Misrepresentation
By Jonathan M. Karpoff, D. Scott Lee, ...
-
By Anup Agrawal and Tommy Cooper