Abstract of the paper:
Quality of courts and contractual enforcement
Nicola Gennaioli
Harvard University
A recent but growing body of empirical evidence is pointing towards the existence of a significant link
between various economic outcomes and variables related to the judicial system. Yet, despite these empirical
contributions, theoretical accounts of the observed regularities are still lacking.
Casual observation and informal reasoning have motivated the search for empirical regularities so far. Clearly,
the judicial system, as the institution that interprets and enforces the content of laws, can be important for both the
political and economic life of a country on several grounds. Nevertheless, the understanding of the precise
mechanisms through which the effects work is missing. In this paper, I want to outline one of them.
Besides order and property rights, courts also enforce contracts struck down by private parties. In the latter
cases, when called upon to decide, they impose on the alleged violators damages, specific performances and the
like, that directly affect the economic relationship between private contractors. In this sense, the more detailed a
written contract is, the more it allows for intrusive intervention of the court inside the relationship, should a dispute
arise.
Clearly, while it is relatively safe to assume that the parties know the details of their relationship and
understand all its relevant aspects, the same is not guaranteed about courts. Except minor and indeed very broad
forms of specialization, courts are “universal” and judges’ training pretty uniform. Moreover, to the extent that each
contractual relationship is peculiar and “unique”, it is unlikely that courts will be able to fully understand the terms
of the relationship. It is precisely this lack of knowledge that justifies the assumptions of “observable but not
verifiable” or “noncontractible” state of the worlds, generally made in the incomplete contracts literature.
In this paper, I slightly depart from the usual way the “observable but not verifiable” assumption is justified.
Unverifiability is often considered an absolute technological bound on the possibility of proving the prevalence of a
certain situation to a third party.
While it is surely linked to objective aspects of the relationship such as its technological complexity, it also
depends on the degree to which courts are able to understand the issue at discussion. In this sense, I define a
judicial system as more efficient when there is a greater likelihood that courts will be able to understand the terms
of a contract, in the event of litigation.
By explicitly introducing the possibility of judicial mistakes, I analyse how it affects the choice of private
parties between “outside enforcement” (guaranteed by state law and courts), and “inside enforcement”, which relies
on self-enforcing agreements between the parties and on their perfect knowledge of the economic relationship
between them.
In the first part of the analysis, I consider a partial equilibrium model that describes a biperiodal economic
relationship, characterized by ex-ante unverrifiable investments, between two parties trying to realize the gains they
can obtain by coordinating their actions with the prevalent state of the world. They can achieve this goal by the use
of different means.
One option for them is to write a detailed contract, prescribing who chooses what in each contingency, and rely
on outside courts for its enforcement. The secon option available to them is instead to construct self-enforcing
mechanisms to discipline their relationship by themselves.
The main benefits of drafting a complete contract are twofold: court enforcement is free (although not for the
economy as a whole) and, the more it is efficient, the lesst it suffer from renegotiation, which reduces value via
standard underinvestment costs.
On the other hand, imperfect enforcement can induce parties to rely on systematic judicial mistakes. By
violating the contract in contingencies where their partner is particularly vulnerable, a party bets on a favourable
court ruling, which allows him to grab large rents following renegotiation. In this sense, judicial mistakes can be
used as an instrument to shift bargaining power.
To shutdown the possibility for such rent seeking behavior, parties can resort to an incomplete written
agreement and complement it with self enforcing decision rules. The problem with this solution, is that it imposes
renegotiation costs. While the relationship now goes on under perfect information, it is hard for the parties to
commit not to renegotiate issues on which the contract is silent.
Nevertheless, I assume that the benefits of superior information can be (at least partially) secured through the
use of costly precommitments that reduce the credibility of ex-post threats. Bilateral safeguards like hostages for
example, might improve ex-ante incentives and overall efficiency, although their cost must be taken into account.
This basic tradeoff shapes the choice between inside and outside enforcement. In particular I show that, ceteris
paribus, an inferior quality of judicial decisions induces the parties to opt-out formal justice by writing incomplete
contracts.
Moreover, I show that vertical integration and control rights allocation can be seen as two of the possibile
precommitments available to the parties to improve the performance of implicit contracts. Therefore, the worse the
quality of the judicial system, the more the parties will tend to be vertically integrated.
I also show that improved enforcement ability can be a source of complementarities per-se. If unverifiable
investments can be at least partially expropriated (think about knowledge, know-how, intangible assets…),
nonintegrated parties face the need to lock themselves into a stable bilateral relationship in order to avoid that one
of them walks away with the other’s investment.
In this case, precommitments can be seen as investments in specificity: instead of being an exogenous attribute
like in standard property rights models, specificity is in this case endogenously imposed on the relationship (by the
choice, for example, of a particular technology or a location site) in order to reduce the ex-post mobility of the
parties.
This lock in effect turns out to be very important for the cost-benefit analysis of self enforcing agreements:
while safeguards restore incentives to invest in a given relationship, they also reduce mobility of factors. When
precommitments are sunk, even a superior technology, held by new partners and nontransferable, might fail to enter
the market as it requires investment in new precommitments.
In this sense, inefficient courts, by inducing parties to increase the rigidity of their actual relationship, also
increase the rigidity of the economic system as a whole, possibly slowing down technology adoption and stifling
the initiative of efficient entrants.
A general equilibrium analysis is one of the extensions I want to pursue in order to evaluate the relative
strenght of the effects outlined above for the economic system. Another direction in which I want to move, is the
analysis of some of the factors that most likely determine the quality of formal justice.
Several dimensions can potentially be important. One is training of judges, another the rule according to which
they are promoted. Hot topics, like the degree of judicial independence and the way the lack of it can bias search
and inspection activities of judges and prosecutors, follow. But differences may also arise between regulatory
environments and “pure” court systems. Finally, incentives of judges (somehow related to their independence) are
likely to constitute an important dimension of the problem as well as their corruptibility.