DP4197 Should Courts Always Enforce What Contracting Parties Write?

Author(s): Luca Anderlini , Leonardo Felli , Andrew Postlewaite

Publication Date: January 2004

Keyword(s): optimal courts , informational externalities , parties' ex-ante welfare

JEL(s): D74 , L14

Programme Areas: Industrial Organization

Link to this Page: www.cepr.org/pubs/dps/DP4197.asp

We find an economic rationale for the common sense answer to the question in our title - courts should not always enforce what the contracting parties write. We describe and analyse a contractual environment that allows a role for an active court. An active court can improve on the outcome that the parties would achieve without it. The institutional role of the court is to maximize the parties’ welfare under a veil of ignorance. We study a buyer-seller model with asymmetric information and ex-ante investments, in which some contingencies cannot be contracted on. The court must decide when to uphold a contract and when to void it. The parties know their private information at the time of contracting, and this drives a wedge between ex-ante and interim-efficient contracts. In particular, some types pool in equilibrium. By voiding some contracts that the pooling types would like the court to enforce, the court is able to induce them to separate, and hence to improve ex-ante welfare.