Faculty Bibliography
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This paper explores the power of threats in the absence of binding commitment. The threatener cannot commit to carry out the threat if the victim refuses payment, and cannot commit not to carry out the threat if payment is made. An important assumption of the model is that once the threat is carried out it cannot be repeated. If exercising the threat is costly to the threatener, then the threat cannot succeed in extracting money from the victim. If exercising the threat would benefit the threatener, however, then the threat's success depends upon whether the threat may be repeated after a payment is made. In the equilibrium of a finite-period game, the threat is carried out and the victim makes no payments. In an infinite-horizon game, however, it is an equilibrium for the victim to make a stream of payments over time. The expectation of future payments keeps the threatener from exercising the threat.
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Revenue sharing contracts, in which retailers pay a royalty on sales to their suppliers, are now widely used in the video rental industry. We show that revenue sharing is valuable in vertically separated industries in which demand is either stochastic (unpredictable) or variable (e.g., systematically declining), downstream inventory is chosen before demand is realized and downstream firms engage in intrabrand competition. Unlike two-part tariffs, revenue sharing achieves the first best outcome by softening retail price competition without distorting retailers’ inventory decisions. Our theories are also consistent with trends in prices and availability following retailers’ adoption of revenue sharing contracts.
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Capital structure affects the bargaining position of a firm in the settlement of civil litigation when the civil judgment may cause the firm to become insolvent. We analyze this pretrial bargaining game under different bankruptcy priority rules. A leveraged capital structure can benefit the firm’s shareholders for two reasons. Most obviously, if the civil plaintiff will not receive top priority in bankruptcy, debt may serve to directly dilute the value of the civil claim. A more subtle effect, however, arises because the cost of a large civil judgment may be borne by the debtholders in bankruptcy. This can make the shareholders into tougher bargainers by narrowing the settlement range. This latter effect implies that even unsecured debt may be used strategically to dilute the value of civil claims, even when the civil plaintiff is given priority in bankruptcy. Welfare and legal implications are discussed.
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Perhaps the most widely discussed topic in the economics of legal procedure is the relation between litigation and settlement. This paper offers a critical introduction to the voluminous economic literature on this topic. This literature considers questions such as why the parties to a dispute choose to go to court, rather than settling the matter privately; what determines the likelihood that a case will settle, and the terms on which it is settled; how various legal instruments or rules influence parties' decision to settle or go to court; and how the choice between settlement and litigation affects social welfare. These issues have turned out to be surprisingly complex, and continue to receive extensive attention as commentators employ increasingly refined models to examine the many nuances of the problem. The present paper attempts to set forth in a concise and informal manner the major results of this work and some directions for future research.
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The private motives to settle civil lawsuits are seldom aligned with the interests of society. This article presents a simple model of a negligence rule where there is too much settlement. During pretrial bargaining, the injurer has private information about his care level. In equilibrium the injurer randomizes between taking due care and being negligent, and the uninformed victim randomizes between making a high settlement offer (playing tough) and making a low settlement offer (playing soft). It is shown that social welfare would be improved if the victim were committed to take a tougher stance in negotiations and, consequently, more cases went to trial. Three legal policies to help align the private and social motives to settle are discussed: litigation subsidies, punitive damages, and the English Rule for allocating legal costs.
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Two roles for stipulated damage provisions have been debated in the literature: protecting relationship-specific investments and inefficiently excluding competitors. Aghion and Bolton (1987) formally demonstrate the latter effect in a model without investment or renegotiation. Although introducing renegotiation alone destroys their result, introducing both renegotiation and investment restores it. In particular, if the entrant has market power and the seller's cost of production is observable but not verifiable, then privately stipulated damages are set at a socially excessive level to facilitate the extraction of the entrant's surplus. In contrast, if the entrant prices competitively (as typically is assumed in the law and economics literature on breach), then private stipulation is efficient. Whereas a simple legal restriction on the contract corrects for any inefficiency, standard court-imposed remedies do not.
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Kathryn E. Spier & David E. Weinstein, Retaliatory Mechanisms for Eliminating Trade Barriers: Aggressive Unilateralism vs. GATT Cooperation, in Imperfect Competition in International Trade 231 (Winston W. Chang & Seiichi Katayama eds., 1995).
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The lack of effective mechanisms for the enforcement of international treaty obligations has become a major obstacle to the success of the General Agreement on Tariffs and Trade (GATT). While multilateral trade negotiations have reduced tariff levels to historic lows, nontariff barriers (NTBs) have emerged as one of the major impediments to trade flows. Since NTBs often vary in form across countries and products, adjudicating an alleged violation of a GATT obligation is often a long and difficult process. The GATT’s virtual inability to enforce sanctions against those countries that violate GATT obligations has resulted in laws, such as section 301 of the Omnibus Trade Act of 1988, that permit unilateral retaliation as a means of resolving these disputes.
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Legal rules for allocating the private costs of civil litigation, or ''fee-shifting'' rules, provide powerful incentives for settlement. Within the context of a direct-revelation mechanism, the fee-shifting rule that generates the highest probability of settlement bases the allocation of costs upon the proximity of the court's award to the pretrial announcements. This mechanism resembles Rule 68 of the Federal Rules of Civil Procedure and other offer-based rules. In a simple extensive-form game, if the litigants have asymmetric information about the level of damages (probability of prevailing), then Rule 68 increases (decreases) the settlement rate.
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An injurer undertakes precautions to reduce both the probability and the severity of an accident. The damages that the victim suffers are privately observed, and will be verified at a cost if the case is litigated. While finely tuned damage awards induce the injurer to take appropriate precautions ex ante, they increase the probability that the litigants will disagree about the case, and thereby aggravate the settlement process. Flat damage awards reduce the level of costly litigation, but lead to underinvestment in precautions. We show that when the litigation costs are small the optimal award is finely tuned to the actual damages, and when litigation costs are large the optimal award is a flat penalty. Applications to scheduled damages and workers' compensation are discussed.
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This paper considers government mechanisms for auctioning production rights in which both the winners and the market structure, doupoly (dual-sourcing), monopoly (sole-sourcing), or government-owned production, are a function of the bids. In designing the optimal mechanism, the government considers the tradeoffs among consumer surplus, producer surplus, and revenue. Under incomplete information, doupoly is implemented less frequently, and government production more frequently, than under complete information. When bidders are symmetric, the optimal mechanism can be implemented as a modified second-price auction. Applications to privatization, deregulation, and defense procurement are discussed.
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This paper presents a strategic model of temporarily high leverage. When the repayment of senior claims depends in part upon further investment, shareholders may be able to alter credibly their incentives to invest through an exchange of junior debt for equity and thereby force concessions from senior creditors. The authors focus on the conflict between shareholders and risk-averse workers and show that this strategic use of debt leads to an inefficient allocation of risk. They characterize conditions under which firms will undergo leveraged recapitalizations, their choice of debt instruments, and the dynamics of their capital structure.
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This volume presents a nontechnical treatment of issues that arise in procurement contracting, with an emphasis on major weapons systems procurement.
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This article presents a principal-agent model in which asymmetric information leads to contractual incompleteness. I show that in the presence of transactions costs, incompleteness may act as a signal of the principal's type. Two types of transactions costs are considered: those incurred ex ante (drafting costs) and those incurred ex post (enforcement or verification costs). I prove that in the presence of either of these costs asymmetric information leads to more contractual incompleteness than full information does.
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A model of sequential bargaining with one-sided incomplete information is analyzed where, if an agreement is not reached, the agents go to court. A “deadline effect” emerges where much settlement occurs just prior to the trial, and many cases proceed to court. If fixed costs are incurred during each bargaining period, a “U-shaped” pattern of settlement emerges. These patterns persist in the limit as the time between offers approaches zero. A model with an endogenous trial date is also considered, and it is shown that even with complete information, there exist inefficient equilibria where disputes are resolved in court.