A Theory of Contracts with Limited Enforcement

69 Pages Posted: 14 Feb 2014

See all articles by David Martimort

David Martimort

Paris School of Economics (PSE)

Aggey Semenov

University of Ottawa

Lars Stole

University of Chicago - Booth School of Business

Date Written: October 11, 2013

Abstract

We present a Theory of Contracts under costly enforcement in the context of a dynamic relationship between an uninformed buyer and a seller who is privately informed on his persistent cost at the outset. Public enforcement relies on remedies for breach. Private enforcement comes from severing relationships. We first characterize aggregate enforcement constraints ensuring that trading partners do not breach contracts unduly. Whether a long-term contract is enforceable does not depend on the distribution of penalties for breach between the buyer and the seller. While under complete information, the optimal contract would remain stationary, non-stationarity might arise under asymmetric information. Enforcement constraints are time-dependent and easier to satisfy as time passes. Indeed, a high-cost seller may be tempted to trade high volumes at high prices at the beginning of the relationship before breaching the contract later on. Yet, such take-the-money-and-run strategy becomes less attractive as time passes and can be prevented with backloaded payments. The optimal contract thus goes through two different phases. First, quantities and prices increase at the inception of the relationship. Later on, the contract looks more stationary. Long-run screening distortions encapsulate the quality of enforcement, offering de facto a link between the quality of the legal system and contractual performances.

Keywords: contract theory, incentives, asymmetric information, enforcement, breach of contracts, dynamic contracts

JEL Classification: C70, D82

Suggested Citation

Martimort, David and Semenov, Aggey and Stole, Lars A., A Theory of Contracts with Limited Enforcement (October 11, 2013). Available at SSRN: https://ssrn.com/abstract=2396047 or http://dx.doi.org/10.2139/ssrn.2396047

David Martimort

Paris School of Economics (PSE) ( email )

48 Boulevard Jourdan
Paris, 75014 75014
France

Aggey Semenov

University of Ottawa ( email )

Lars A. Stole (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7309 (Phone)
773-702-0458 (Fax)

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