<<back to symposium home page



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.


<<back to symposium home page