Contracts, Liability Restrictions and Costly Verification

Abstract

This paper describes simple contract-theoretical settings where the parties optimally choose to stipulate unverifiable or unenforceable contracts. The only manner to achieve the first-best is to stipulate a roundabout contract that explicitly prohibits the optimal outcome, while secretly agreeing to breach this written agreement in equilibrium so as to achieve the first-best. We introduce a general representation of enforceability constraints that encompasses both technological and institutional constraints. Enforceable contracts are shown to be undominated if and only if verification is costless (so that the court's knowledge satisfies the axiom of positive introspection), and the parties are not subject to liability limitations such as a damage-compensation restriction on transfers, or individual liability rule.

Keywords: Liability rules, contract enforceability, verifiability, knowledge operators

JEL Classification: C72, K40