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Completing Contracts in the Shadow of Costly Verification

29 Pages Posted: 24 Jan 2007 Last revised: 10 Dec 2015

Albert H. Choi

University of Virginia School of Law

George G. Triantis

Stanford Law School

Date Written: November 18, 2007

Abstract

Contract theory typically holds that verification costs are obstacles to complete contracting; yet, real world contracts often contain provisions that seem costly to verify. We show how a costly signal can play an important role in contracts. Verification (or litigation) costs operate as a screen on the promisee’s incentive to sue and as an effective sanction against the breaching promisor. So long as the court’s judgment is correlated with the promisor’s behavior, therefore, the parties can design a set of prices (including damages) so as to provide additional incentive to the promisor through an off-the-equilibrium, credible litigation threat. We show that the parties may prefer to adopt a costly signal over a costless signal. Rather than focusing solely on either the problems of adjudication or those of contracting (without sufficient regard to how the disputes will be resolved in the future), we have attempted to take a more comprehensive approach by looking at the design of contracts in anticipation of the path of the adjudication process.

Keywords: Incomplete Contracts, Costly Verification

Suggested Citation

Choi, Albert H. and Triantis, George G., Completing Contracts in the Shadow of Costly Verification (November 18, 2007). Available at SSRN: https://ssrn.com/abstract=958752 or http://dx.doi.org/10.2139/ssrn.958752

Albert H. Choi (Contact Author)

University of Virginia School of Law ( email )

580 Massie Road
Charlottesville, VA 22903
United States

George G. Triantis

Stanford Law School ( email )

559 Nathan Abbott Way
Stanford, CA 94305-8610
United States

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