The Law and Economics of Costly Contracting

47 Pages Posted: 4 Jan 2002

See all articles by Alan Schwartz

Alan Schwartz

Yale Law School

Joel Watson

University of California, San Diego (UCSD) - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: December 2001

Abstract

In most of the contract theory literature, contracting costs are assumed either to be high enough to preclude certain forms of contracting, or low enough to permit any contract to be written. Similarly, researchers usually treat renegotiation as either costless or prohibitively costly. This paper addresses the middle ground between these extremes, in which the costs of contracting and renegotiation can take intermediate values and the contracting parties can themselves influence these costs. The context for our analysis is the canonical problem of inducing efficient relation-specific investment and efficient ex post trade. Among our principle results are: (i) The efficiency and complexity of the initial contract are decreasing in the cost to create a contract. Hence, the best mechanism design contracts can be too costly to write. (ii) When parties use the simpler contract forms, they require renegotiation to capture ex post surplus and to create efficient investment incentives. In some cases, parties want low renegotiation costs. More interesting is that, in other cases, parties have a strict preference for moderate renegotiation costs. (iii) The effect of Contract Law on contract form is significant but has been overlooked. In particular, the law's interpretive rules raise the cost of enforcing complex contracts, and thus induce parties to use simple contracts. Worse, the law also lowers renegotiation costs, which further undermines complex contracts and is also inappropriate for some of the simpler contracts.

Keywords: Contracts, contracting costs, renegotiation, investment, contract law

Suggested Citation

Schwartz, Alan and Watson, Joel, The Law and Economics of Costly Contracting (December 2001). Available at SSRN: https://ssrn.com/abstract=295659 or http://dx.doi.org/10.2139/ssrn.295659

Alan Schwartz (Contact Author)

Yale Law School ( email )

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Joel Watson

University of California, San Diego (UCSD) - Department of Economics ( email )

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United States
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619-534-7040 (Fax)

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