Contracting Without a Plan: A Theory of Informal Justice

Abstract

This paper develops a novel positive model of informal contracting in which rewards and punishments are not determined by an ex ante optimal plan but instead express the ex post moral sentiments of an arbitrating party. Specifically, we consider a third party arbitrator mediating a one-shot relationship between two players, one of whom can exert an externality on the other. Importantly, formal contracts are not available and the arbitrator chooses transfers to maximize her ex post social preferences. We characterize the implicit incentive schemes induced by the arbitrator's preferences, contrast them with ex ante optimal contracts, and identify novel qualitative predictions about the way externalities are internalized in informal settings.

Keywords: informal contracts, incomplete contracts, social preferences, heuristics, arbitration, third party punishment