Contracting in the Shadow of the Law

Abstract

I propose the view that the law affects economic efficiency by shaping contractual litigation and contracting as a result. I build a model where judges subject to personal biases try to distort contract enforcement and consider two legal systems, one where judges wield discretion and another where they must follow a code. I find that the law affects contracting by shaping the way biased courts resolve contractual ambiguities: discretion fosters the use of sophisticated contingent contracts, codification the use of simpler non-contingent contracts. Beyond contract form, I find that legal systems fundamentally differ in their ability to enforce complex and innovative transactions, where performance is hard to verify. The code's bias is the cost of codification, the arbitrariness of judges and juries and their incompetence are the costs of discretion. The model sheds light on several findings in law and finance and product liability literatures and yields some implications on the costs and benfits of discretion across areas of law and at different levels of development.

JEL Classification: D23, G30, K12, K40