Monday, January 19, 2004

Efficient contract avoidance

Will posts about contracts and asks why contracts that make people better off often never materialize.

An interesting question. University of Chicago Professor Lisa Bernstein asks a similar question about the diamond industry in New York: Why the prevelance of orthodox Jews?* The answer, she writes, is that the orthodox Jewish community faces much lower transaction costs by opting out of the legal system. They operate with a high level of mutual trust, which in turn lowers transaction costs, allowing members of that particular group to operate at costs at which unaffiliated merchants cannot compete. Thus, a partial answer to Will's question may be not contract aversion, or transaction costs but actually a rational preference. The contract may make people better off for that single transaction (the one that goes bad), but overall it decreases utility. Under certain circumstances opting out of private law arrangements that require resort to courts for enforcement is efficient. It's tempting to criticize this thought process ex post, but ex ante, if parties do not know which engagements will go sour, they will choose to operate in order to maximize the expected value of the sum of the interactions.

This is not an isolated phenomenon. Parties typically rely on extralegal enforcement, not out of transaction costs and regardless of the underlying legal rule. Sometimes it's just much more efficient. For example, it may not really matter what the legal rule is that attaches to corporate management's liability for accounting fraud because reputational consequences are far more powerful than any punishment offered by law. (Not really, of course, as Ken Lay can attest. But hopefully the point is somewhat clear.)

This is somewhat more difficult to argue with regard to marriage, especially because marriage is not (usually) a repeated event... Anywho, those are my thoughts on the subject.

*See "Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry," 21 Journal of Legal Studies 115 (1992) (not available on Lexis, nor on Westlaw, but available through HeinOnline, I believe, if you are an on-campus student). Also discussed in Epstein's Simple Rules for a Complex World.

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