Hold Up Under Costly Litigation and Imperfect Courts of Law

Abstract

Most of the incomplete contracting literature assumes courts of law perfectly distinguish verifiable from nonverifiable variables and that only claims related to the former can be brought to courts. We consider a more realistic enforcement technology: Parties are able to sign "vague contracts" and, by spending resources on litigation, get the court to hear and rule on cases even if they have bogus grounds and-or the claim is related to nonverifiable variables. We reexamine the results obtained in the literature on contractual solutions to the hold-up problem. In contrast to Che and Hausch (1999 "Cooperative Investment and the Value of Contracting," 89 American Economic Review 125--47.) , we find that a simple contract can be valuable and even the first-best might be achievable in the cooperative investment case. For the case of selfish investment, the efficient result of Edlin and Reichelstein (1996 "Holdups, Standard Breach Remedies, and Optimal Investment," 86 American Economic Review, 478--501.) does not hold in general if attention is restricted to simple contracts. Our model predicts that, if allowed to do so, the parties will--by choosing the appropriate contract--manipulate the litigation costs and court rulings in opposite directions, depending on the nature of investment. (JEL: D20, D78, K10, K40, L22) The Author 2012. Published by Oxford University Press on behalf of Yale University. All rights reserved. For Permissions, please email: journals.permissions@oup.com, Oxford University Press.