Courts' Decisions, Cooperative Investments, and Incomplete Contracts
49 Pages Posted: 14 Jun 2017
Date Written: June 13, 2017
Buyers are often concerned about the adequateness of the design of the goods they procure. To reduce the probability of a design failure, buyers may try to motivate the sellers to make relationship-specific investments. In this paper I study how courts’ decisions affect sellers’ cooperative investment and buyers’ specification of the good. In assigning liability for a defective design, in some countries courts examine how much real authority the seller had in performing the work, instead of considering how formal authority was contractually allocated between the parties. I show that this approach induces the sellers to invest, albeit suboptimally, but leads the buyers to inefficiently under-specify the design of the good. I find that this approach can also make it harder to sustain optimal relational contracting, leading to the conclusion that it cannot be justified on efficiency grounds.
Keywords: Cooperative Investments, Courts, Defective Specifications, Design Failure, Expectation Damages, Formal and Real Authority, Incomplete Contracts, Relational Contracts
JEL Classification: D23, D86, K12, L23, L24
Suggested Citation: Suggested Citation