IDEAS home Printed from https://ideas.repec.org/p/hal/journl/halshs-01509602.html
   My bibliography  Save this paper

A Theory of Contracts with Limited Enforcement

Author

Listed:
  • David Martimort

    (PJSE - Paris Jourdan Sciences Economiques - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris Sciences et Lettres - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement)

  • Aggey Semenov

    (NUS - National University of Singapore)

  • Lars Stole

    (Booth School of Business [Chicago] - University of Chicago)

Abstract

We develop a theory of contracts with limited enforcement in the context of a dynamic relationship. The seller is privately informed on his persistent cost, while the buyer remains uninformed. Public enforcement relies on remedies for breaches. Private enforcement comes from terminating the relationship. We first characterize enforcement constraints under asymmetric information. Those constraints ensure that parties never breach contracts. In particular, a high-cost seller may be tempted to trade high volumes at high prices at the beginning of the relationship before breaching the contract later on. Such "take-the-money-and-run" strategy becomes less attractive as time passes. It can thus be prevented by backloading payments and increasing volumes over a transitory phase. In a mature phase, enforcement constraints are slack and the optimal contract, although keeping memory of the shadow cost of enforcement constraints binding earlier on, looks stationary. Second-best distortions depend on a modified virtual cost that encapsulates this shadow cost of enforcement.

Suggested Citation

  • David Martimort & Aggey Semenov & Lars Stole, 2017. "A Theory of Contracts with Limited Enforcement," Post-Print halshs-01509602, HAL.
    • Handle: RePEc:hal:journl:halshs-01509602
    DOI: 10.1093/restud/rdw024
    as

    Download full text from publisher

    To our knowledge, this item is not available for download. To find whether it is available, there are three options:
    1. Check below whether another version of this item is available online.
    2. Check on the provider's web page whether it is in fact available.
    3. Perform a search for a similarly titled item that would be available.

    Other versions of this item:

    References listed on IDEAS

    as
    1. James M. Malcomson, 2016. "Relational Incentive Contracts With Persistent Private Information," Econometrica, Econometric Society, vol. 84, pages 317-346, January.
    2. Joel Watson, 2007. "Contract, Mechanism Design, and Technological Detail," Econometrica, Econometric Society, vol. 75(1), pages 55-81, January.
    3. Elisabetta Iossa & Giancarlo Spagnolo, 2008. "Contracts as Threats: on a Rationale For Rewarding A while Hoping For B," EIEF Working Papers Series 1022, Einaudi Institute for Economics and Finance (EIEF), revised Dec 2010.
    4. Rochet, Jean-Charles, 1985. "Bilateral monopoly with imperfect information," Journal of Economic Theory, Elsevier, vol. 36(2), pages 214-236, August.
    5. Laffont, Jean-Jacques & Tirole, Jean, 1996. "Pollution permits and compliance strategies," Journal of Public Economics, Elsevier, vol. 62(1-2), pages 85-125, October.
    6. Anja Schöttner, 2008. "Relational Contracts, Multitasking, and Job Design," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 24(1), pages 138-162, May.
    7. Jonathan Levin, 2003. "Relational Incentive Contracts," American Economic Review, American Economic Association, vol. 93(3), pages 835-857, June.
    8. Olivier Compte & Philippe Jehiel, 2009. "Veto Constraint in Mechanism Design: Inefficiency with Correlated Types," American Economic Journal: Microeconomics, American Economic Association, vol. 1(1), pages 182-206, February.
    9. Steven Shavell, 1984. "The Design of Contracts and Remedies for Breach," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 99(1), pages 121-148.
    10. Albert Marcet & Ramon Marimon, 2019. "Recursive Contracts," Econometrica, Econometric Society, vol. 87(5), pages 1589-1631, September.
    11. Noldeke, Georg & Samuelson, Larry, 2007. "Optimal bunching without optimal control," Journal of Economic Theory, Elsevier, vol. 134(1), pages 405-420, May.
    12. Joskow, Paul L, 1988. "Asset Specificity and the Structure of Vertical Relationships: Empirical Evidence," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 4(1), pages 95-117, Spring.
    13. Shleifer, Andrei & Vishny, Robert W, 1997. "A Survey of Corporate Governance," Journal of Finance, American Finance Association, vol. 52(2), pages 737-783, June.
    14. Daron Acemoglu & Davide Ticchi & Andrea Vindigni, 2011. "Emergence And Persistence Of Inefficient States," Journal of the European Economic Association, European Economic Association, vol. 9(2), pages 177-208, April.
    15. Abreu, Dilip, 1988. "On the Theory of Infinitely Repeated Games with Discounting," Econometrica, Econometric Society, vol. 56(2), pages 383-396, March.
    16. Parikshit Ghosh & Debraj Ray, 1996. "Cooperation in Community Interaction Without Information Flows," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 63(3), pages 491-519.
    17. Marina Halac, 2012. "Relational Contracts and the Value of Relationships," American Economic Review, American Economic Association, vol. 102(2), pages 750-779, April.
    18. George J. Mailath & Andrew Postlewaite, 1990. "Asymmetric Information Bargaining Problems with Many Agents," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 57(3), pages 351-367.
    19. Marco Battaglini, 2005. "Long-Term Contracting with Markovian Consumers," American Economic Review, American Economic Association, vol. 95(3), pages 637-658, June.
    20. Myerson, Roger B. & Satterthwaite, Mark A., 1983. "Efficient mechanisms for bilateral trading," Journal of Economic Theory, Elsevier, vol. 29(2), pages 265-281, April.
    21. Rafael La Porta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, 1998. "Law and Finance," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1113-1155, December.
    22. Edlin, Aaron S, 1996. "Cadillac Contracts and Up-Front Payments: Efficient Investment under Expectation Damages," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 12(1), pages 98-118, April.
    23. Paul Beaudry & Michel Poitevin, 1995. "Contract Renegotiation: A Simple Framework and Implications for Organization Theory," Canadian Journal of Economics, Canadian Economics Association, vol. 28(2), pages 302-335, May.
    24. Watson, Joel, 2002. "Starting Small and Commitment," Games and Economic Behavior, Elsevier, vol. 38(1), pages 176-199, January.
    25. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-932, September.
    26. Rustichini, A., 1998. "Lagrange multipliers in incentive-constrained problems," Journal of Mathematical Economics, Elsevier, vol. 29(4), pages 365-380, May.
    27. Akifumi Ishihara, 2016. "Role of Information Rents in Relational Contracts," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 25(4), pages 936-957, December.
    28. J. Luis Guasch & Jean-Jacques Laffont & Stephane Straub, 2003. "Renegotiation of Concession Contracts in Latin America," Edinburgh School of Economics Discussion Paper Series 103, Edinburgh School of Economics, University of Edinburgh.
    29. George Baker & Robert Gibbons & Kevin J. Murphy, 1994. "Subjective Performance Measures in Optimal Incentive Contracts," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(4), pages 1125-1156.
    30. Gibbons, Robert, 2005. "Four forma(lizable) theories of the firm?," Journal of Economic Behavior & Organization, Elsevier, vol. 58(2), pages 200-245, October.
    31. Robert Gibbons, 2005. "Incentives Between Firms (and Within)," Management Science, INFORMS, vol. 51(1), pages 2-17, January.
    32. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
    33. MacLeod, W Bentley & Malcomson, James M, 1998. "Motivation and Markets," American Economic Review, American Economic Association, vol. 88(3), pages 388-411, June.
    34. Philippe Jehiel & Olivier Compte, 2007. "On Quitting Rights in Mechanism Design," American Economic Review, American Economic Association, vol. 97(2), pages 137-141, May.
    35. Crocker, Keith J & Masten, Scott E, 1996. "Regulation and Administered Contracts Revisited: Lessons from Transaction-Cost Economics for Public Utility Regulation," Journal of Regulatory Economics, Springer, vol. 9(1), pages 5-39, January.
    36. Myerson, Roger B., 1982. "Optimal coordination mechanisms in generalized principal-agent problems," Journal of Mathematical Economics, Elsevier, vol. 10(1), pages 67-81, June.
    37. Messner Matthias & Pavoni Nicola & Sleet Christopher, "undated". "On the Dual Approach to Recursive Optimization," GSIA Working Papers 2012-E12, Carnegie Mellon University, Tepper School of Business.
    38. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 48(2), pages 289-309.
    39. Paul Beaudry & Michel Poitevin, 1994. "The Commitment Value of Contracts under Dynamic Renegotiation," RAND Journal of Economics, The RAND Corporation, vol. 25(4), pages 501-517, Winter.
    40. Ola Kvaløy & Trond E. Olsen, 2009. "Endogenous Verifiability and Relational Contracting," American Economic Review, American Economic Association, vol. 99(5), pages 2193-2208, December.
    41. Matthews, Steven A. & Postlewaite, Andrew, 1989. "Pre-play communication in two-person sealed-bid double auctions," Journal of Economic Theory, Elsevier, vol. 48(1), pages 238-263, June.
    42. repec:oup:restud:v:84:y::i:1:p:277-299. is not listed on IDEAS
    43. Klein, Benjamin & Leffler, Keith B, 1981. "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 615-641, August.
    44. Macho-Stadler, Ines & Perez-Castrillo, J. David, 2001. "An Introduction to the Economics of Information: Incentives and Contracts," OUP Catalogue, Oxford University Press, edition 2, number 9780199243273.
    45. Katherine Doornik, 2010. "Incentive Contracts with Enforcement Costs," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 26(1), pages 115-143, April.
    46. Keith J. Crocker & Scott E. Masten, 1988. "Mitigating Contractual Hazards: Unilateral Options and Contract Length," RAND Journal of Economics, The RAND Corporation, vol. 19(3), pages 327-343, Autumn.
    47. Johannes Hörner, 2002. "Reputation and Competition," American Economic Review, American Economic Association, vol. 92(3), pages 644-663, June.
    48. Paul Milgrom & Ilya Segal, 2002. "Envelope Theorems for Arbitrary Choice Sets," Econometrica, Econometric Society, vol. 70(2), pages 583-601, March.
    49. Akira Konakayama & Toshihide Mitsui & Shinichi Watanabe, 1986. "Efficient Contracting with Reliance and a Damage Measure," RAND Journal of Economics, The RAND Corporation, vol. 17(3), pages 450-457, Autumn.
    50. Timothy Besley & Torsten Persson, 2008. "Wars and State Capacity," Journal of the European Economic Association, MIT Press, vol. 6(2-3), pages 522-530, 04-05.
    51. Schmidt, Klaus M. & Schnitzer, Monika, 1995. "The interaction of explicit and implicit contracts," Economics Letters, Elsevier, vol. 48(2), pages 193-199, May.
    52. Jean-Jacques Laffont & Jean Tirole, 1993. "A Theory of Incentives in Procurement and Regulation," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121743, April.
    53. Baron, David P. & Besanko, David, 1984. "Regulation and information in a continuing relationship," Information Economics and Policy, Elsevier, vol. 1(3), pages 267-302.
    54. Thomas, Lionel, 2002. "Non-linear pricing with budget constraint," Economics Letters, Elsevier, vol. 75(2), pages 257-263, April.
    55. MacLeod, W Bentley & Malcomson, James M, 1989. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Econometrica, Econometric Society, vol. 57(2), pages 447-480, March.
    56. Steven Shavell, 1980. "Damage Measures for Breach of Contract," Bell Journal of Economics, The RAND Corporation, vol. 11(2), pages 466-490, Autumn.
    57. Mathias Dewatripont, 1989. "Renegotiation and Information Revelation Over Time: The Case of Optimal Labor Contracts," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 104(3), pages 589-619.
    58. Laffont,Jean-Jacques, 2005. "Regulation and Development," Cambridge Books, Cambridge University Press, number 9780521549486, September.
    59. repec:cup:cbooks:9780521840187 is not listed on IDEAS
    60. ,, 2010. "Dynamic monopoly with relational incentives," Theoretical Economics, Econometric Society, vol. 5(3), September.
    61. Bull, Jesse & Watson, Joel, 2004. "Evidence disclosure and verifiability," Journal of Economic Theory, Elsevier, vol. 118(1), pages 1-31, September.
    62. Alan Schwartz, 2004. "The Law and Economics of Costly Contracting," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 20(1), pages 2-31, April.
    63. Lewis, Tracy R. & Sappington, David E. M., 1989. "Countervailing incentives in agency problems," Journal of Economic Theory, Elsevier, vol. 49(2), pages 294-313, December.
    64. Joskow, Paul L, 1987. "Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets," American Economic Review, American Economic Association, vol. 77(1), pages 168-185, March.
    65. Oliver D. Hart & Jean Tirole, 1988. "Contract Renegotiation and Coasian Dynamics," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 55(4), pages 509-540.
    66. Seungjin Whang, 1992. "Contracting for Software Development," Management Science, INFORMS, vol. 38(3), pages 307-324, March.
    67. Rey, Patrick & Salanie, Bernard, 1996. "On the Value of Commitment with Asymmetric Information," Econometrica, Econometric Society, vol. 64(6), pages 1395-1414, November.
    68. Guesnerie, Roger & Laffont, Jean-Jacques, 1984. "A complete solution to a class of principal-agent problems with an application to the control of a self-managed firm," Journal of Public Economics, Elsevier, vol. 25(3), pages 329-369, December.
    69. James M. Malcomson, 2012. "Relational Incentive Contracts [The Handbook of Organizational Economics]," Introductory Chapters,, Princeton University Press.
    70. Clive Bull, 1987. "The Existence of Self-Enforcing Implicit Contracts," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 102(1), pages 147-159.
    71. Joel Sobel, 1985. "A Theory of Credibility," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 52(4), pages 557-573.
    72. Carl Shapiro, 1983. "Premiums for High Quality Products as Returns to Reputations," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 98(4), pages 659-679.
    73. Alan Schwartz & Joel Watson, "undated". "The Law and Economics of Costly Contracting," Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy Working Paper Series yale_lepp-1004, Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy.
    74. Narayana R. Kocherlakota, 1996. "Implications of Efficient Risk Sharing without Commitment," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 63(4), pages 595-609.
    75. Stefan Krasa & Anne P. Villamil, 2000. "Optimal Contracts when Enforcement Is a Decision Variable," Econometrica, Econometric Society, vol. 68(1), pages 119-134, January.
    76. Stefan Krasa & Anne P. Villamil, 2003. "Optimal Contracts when Enforcement is a Decision Variable: A Reply," Econometrica, Econometric Society, vol. 71(1), pages 391-393, January.
    77. Watson, Joel, 1999. "Starting Small and Renegotiation," Journal of Economic Theory, Elsevier, vol. 85(1), pages 52-90, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Daniel Danau & Annalisa Vinella, 2017. "From fixed to state‐dependent duration in public‐private partnerships," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 26(3), pages 636-660, September.
    2. Martimort, David & Semenov, Aggey & Stole, Lars, 2017. "Optimal stationary contract with two-sided imperfect enforcement and persistent adverse selection," Economics Letters, Elsevier, vol. 159(C), pages 18-22.
    3. Karakoç, Gülen & Pagnozzi, Marco & Piccolo, Salvatore, 2022. "The value of transparency in dynamic contracting with entry," International Journal of Industrial Organization, Elsevier, vol. 85(C).
    4. Aggey Semenov, 2014. "Existence and continuity of the optimal contract in adverse selection models with constraints," Working Papers E1402E, University of Ottawa, Department of Economics.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Joel Watson, 2021. "Theoretical Foundations of Relational Incentive Contracts," Annual Review of Economics, Annual Reviews, vol. 13(1), pages 631-659, August.
    2. James M. Malcomson, 2012. "Relational Incentive Contracts [The Handbook of Organizational Economics]," Introductory Chapters,, Princeton University Press.
    3. W. Bentley MacLeod, 2006. "Reputations, Relationships and the Enforcement of Incomplete Contracts," CESifo Working Paper Series 1730, CESifo.
    4. Joel Watson, 2013. "Contract and Game Theory: Basic Concepts for Settings with Finite Horizons," Games, MDPI, vol. 4(3), pages 1-40, August.
    5. Lewis A. Kornhauser & W. Bentley MacLeod, 2012. "Contracts between Legal Persons [The Handbook of Organizational Economics]," Introductory Chapters,, Princeton University Press.
    6. Ola Kvaløy & Trond E. Olsen, 2009. "Endogenous Verifiability and Relational Contracting," American Economic Review, American Economic Association, vol. 99(5), pages 2193-2208, December.
    7. W. Bentley MacLeod & James M. Malcomson, 2023. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment: Thirty Years On," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 179(3-4), pages 470-499.
    8. Cremer, Jacques & Khalil, Fahad, 1992. "Gathering Information before Signing a Contract," American Economic Review, American Economic Association, vol. 82(3), pages 566-578, June.
    9. Ola Kvaløy & Trond E. Olsen, 2016. "Incentive Provision when Contracting is Costly," Economica, London School of Economics and Political Science, vol. 83(332), pages 741-767, October.
    10. Elisabetta Iossa & Giancarlo Spagnolo, 2008. "Contracts as Threats: on a Rationale For Rewarding A while Hoping For B," EIEF Working Papers Series 1022, Einaudi Institute for Economics and Finance (EIEF), revised Dec 2010.
    11. Lang, Matthias, 2019. "Communicating subjective evaluations," Journal of Economic Theory, Elsevier, vol. 179(C), pages 163-199.
    12. Joel Watson & David A. Miller & Trond E. Olsen, 2020. "Relational Contracting, Negotiation, and External Enforcement," American Economic Review, American Economic Association, vol. 110(7), pages 2153-2197, July.
    13. Kartal, Melis & Müller, Wieland & Tremewan, James, 2021. "Building trust: The costs and benefits of gradualism," Games and Economic Behavior, Elsevier, vol. 130(C), pages 258-275.
    14. Joel Watson, 2007. "Contract, Mechanism Design, and Technological Detail," Econometrica, Econometric Society, vol. 75(1), pages 55-81, January.
    15. Erkal, Nisvan & Wu, Steven Y. & Roe, Brian E., 2014. "Strategic Incomplete Contracts: Theory and Experiments," IZA Discussion Papers 8704, Institute of Labor Economics (IZA).
    16. Daniel Barron & Jin Li & Michał Zator, 2022. "Morale and Debt Dynamics," Management Science, INFORMS, vol. 68(6), pages 4496-4516, June.
    17. Hideshi Itoh, 2023. "What do contracts do to facilitate relationships?," The Japanese Economic Review, Springer, vol. 74(3), pages 333-354, July.
    18. Marina Halac, 2012. "Relational Contracts and the Value of Relationships," American Economic Review, American Economic Association, vol. 102(2), pages 750-779, April.
    19. De Chiara, Alessandro, 2020. "Precontractual investment and modes of procurement," European Economic Review, Elsevier, vol. 124(C).
    20. Robert Gibbons & Rebecca Henderson, 2012. "Relational Contracts and Organizational Capabilities," Organization Science, INFORMS, vol. 23(5), pages 1350-1364, October.

    More about this item

    Keywords

    Asymmetric information; Enforcement; Breach of contracts; Dynamic contracts;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:hal:journl:halshs-01509602. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: CCSD (email available below). General contact details of provider: https://hal.archives-ouvertes.fr/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.