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What
Do Formal
Contracts Do?
Hideshi Itoh,
Hitotsubashi University
In
this paper I attempt to provide an overview
of roles formal contracting plays. The main reason to use contracting
is to
lock in a commitment ex ante that one or both parties would otherwise
not wish to
honor ex post. To establish such a commitment, the formal contract must
be
enforced in the way the trading parties anticipate. Economists are,
however,
generally optimistic about courts as the contract-enforcing institution
and
assume that contractual terms contingent on verifiable states and/or
actions
are perfectly enforced. Judicial enforcement is more complicated and
depends on
contract law, courts' discretion, the parties' ex post costly action
(e.g.,
submit evidence), and parties' ex ante costly contracting (e.g., costs
of
thinking of future contingencies and writing documents). I summarize
recent economics
literature attempting to relax the standard extreme assumptions on
enforcement
and to incorporate some of these features into formal analysis. I also
explore
how formally enforceable contracting interacts with informal
enforcement
mechanisms such as relational contracting and community enforcement.
Commitment
via legal enforcement is not the only reason to use contracting,
however.
Formal contracts function as a coordination device when there are
multiple
equilibria. Contracts provide records that help parties who suffer from
imperfect recall or have to delegate performance to their successors.
And I in
particular emphasize the communication function of formal contracting.
Writing
a formal contract, even if it were legally unenforceable, sends
information about
the contracting parties in their bilateral relationships from one of
the
parties to the other, or to the third parties who are potential future
trading
partners, and hence can be useful in maintaining a smoothly functioning
relational contract. I study these less discussed functions of
contracting
using illustrative formal models.
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