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Reputation and Litigation: Why Costly Legal Sanctions Can Work Better than Reputational Sanctions

42 Pages Posted: 2 Jan 2013 Last revised: 13 May 2017

Scott Baker

Washington University in St. Louis - School of Law

Albert H. Choi

University of Virginia School of Law

Date Written: May 12, 2017

Abstract

The paper analyzes the optimal incentive system when reputational sanctions can be supplemented with legal sanctions. A firm sells a good to a sequence of consumers where the firm's unobservable effort affects the good's quality. To solve the moral hazard problem, the firm can promise to pay damages (warranty), consumers can impose reputational sanctions, or both. Both types of sanctions are costly, but legal sanctions have an advantage over reputational sanctions. Raising damages creates both marginal (additional lawsuits) and infra-marginal (bigger recovery to existing lawsuits) effects, but increasing reputational sanctions lacks the infra-marginal effect. Various extensions, such as litigation's informational role, a comparison between warranties and damages, the interaction with one long-term buyer, and non-boycott punishment mechanisms (more generous damages or price drop), are also analyzed.

JEL Classification: D86, K12, L14

Suggested Citation

Baker, Scott and Choi, Albert H., Reputation and Litigation: Why Costly Legal Sanctions Can Work Better than Reputational Sanctions (May 12, 2017). 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: https://ssrn.com/abstract=2195749 or http://dx.doi.org/10.2139/ssrn.2195749

Scott A. Baker

Washington University in St. 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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