A Theory of Contract Law under Conditions of Radical Judicial Error

Abstract

This paper introduces an informal model of contracting where courts are assumed to be radically incompetent, that is, they are unable to determine whether a party in a contract dispute has engaged in opportunistic behavior (breach), although they can determine whether parties intended to enter a legally enforceable contract. Under this assumption courts cannot perform their normal function in standard economic analysis of contract law, where they deter opportunistic breach because they can verify the promisor's behavior. Nonetheless, the model shows that despite judicial incompetence people will voluntarily enter legally enforceable, jointly valuable contracts. The reason is that when parties care about their reputations, and are engaged in repeated interaction, they can deter certain forms of otherwise profitable opportunism by credibly threatening a mutually destructive lawsuit. The law, on this theory, generates value not by directly deterring bad behavior, but by supplying parties with the ability to retaliate when they are harmed. The paper explores the model's implications for understanding contracting and contract law.