Contractual Choice

Topics: Contract, Contractual term, Contract theory Pages: 19 (6054 words) Published: March 13, 2011
Scott E. Masten
Louis and Myrtle Research Professor of Business and Law, University of Michigan Business School
© Copyright 1999 Scott E. Masten
This chapter discusses alternative theories of contract choice and design with special emphasis on (i) the interaction between contract design and contract enforcement and (ii) the explanatory power of alternative theories. After discussing the primary functions of contract, the entry reviews the assumptions and implications for contract design of the three dominant approaches to contracting in economics. An overview of the empirical literature on contracting and contractual choice identifies the main empirical regularities and their relation to the theory. A final section addresses implications for contract law and enforcement and directions for future research. JEL classification: D23, K12, D82

Keywords: Contracting, Contract Enforcement, Incentives, Transaction Costs 1. Introduction
A contract, at its most basic level, is a legally enforceable agreement. Although economists - and occasionally lawyers - have used the term more expansively to describe essentially any transaction, the termc o n t r a c t as used in this chapter is reserved for formal, legal commitments to which each party gives express (though not necessarily written) approval and to which a particular body of law applies. ‘Breaching a contract’ differs from ‘canceling an order’, to use Stewart Macaulay’s (1963, p. 61) dichotomy. Ultimately, what distinguishes a contract from a mere transaction is the opportunity contracts afford transactors to invoke the formal dispute resolution machinery and coercive power of the state to enforce promises. Besides distinguishing true contracts from ‘implicit contracts’ or self-enforcing agreements, this definition of contract highlights the fundamental link between contract design, on the one hand, and contract enforcement, on the other: the choice of contract terms will depend in part on the legal rules and enforcement policies transactors expect courts to follow while, at the same time, the enforcement practices of efficiency-minded courts will depend on what courts perceive as the purpose and impediments to 26

Contractual Choice
contracting. In short, the analysis of contract law and enforcement presupposes a theory of contracting behavior, and vice versa.
Despite this interdependence, the literatures on contract design and contract enforcement have largely developed independently of one another. Economic theories of contracting, for the most part, give little explicit attention to enforcement issues, the presumption being that courts will see to it (subject only to verifiability constraints) that whatever terms contracting parties arrive at are fulfilled. Indeed, enforcing contracts as written is the court’so n l y function in mainstream contract theory (see, for example, Tirole, 1994). This judicial deference to contracts in economic theory contrasts with the far more intrusive role of courts in economic analyses of contractlaw, in which courts are called on to adjudicate disputes, fill gaps, and devise and implement default rules. Perspectives on contracting can be divided into three broad categories. The first consists of formal models associated with the principal-agent and asymmetric information literature, including theories of both complete and incomplete contracting; the second covers perspectives on contracting implicit in the law and economics literature on contract law and enforcement; while the third consists of what has come to be known as relational contracting theory, an approach often associated with transaction cost economics. Dimensions along which the theories differ include the functions of contracting, the impediments to contracting, and the role of courts and their implications for legal rules and contract enforcement. Last but not least, the theories differ in their ability to explain...
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