Arrunada Seminar: Stephen Hansen – Public Institutions and Endogenous Information in Contracting

19 January 2013 at 5:24 am Lasse 1 comment

| Stephen Hansen |

Public Institutions and Endogenous Information in Contracting

Benito Arruñada’s Institutional Foundations of Impersonal Exchange: Theory and Policy of Contractual Registries is an impressive and erudite study of the relationship between legal institutions and impersonal exchange. While clearly valuable for better understanding policies regarding formalization, in my mind it also introduces ideas that are relevant for contract theory more generally and yet hardly treated in the literature.

Since the 1970’s economic theorists have understood that information asymmetries between parties who write contracts are a key source of inefficiencies in exchange. Since then, a vast literature has developed exploring this idea from many different angles. Nevertheless, two key features usually appear. First, the set of parties who write contracts all observe each other, know they are contracting with each other, and (with some exceptions) observe the terms of the contracts agreed. Second, the information asymmetries are assumed to be a fixed, exogenous feature of relationships.

Benito’s book convincingly shows that both of these limit our understanding of trading frictions in the real world. A key insight is that, in addition to his “type” or “action” (to use the language of contract theory), the formal contracts that an economic agent has written with others may be unobservable. After reading the book, it became clear to me that this dimension of non-observability is just as important for generating market failure as others. The second, and intimately related, insight is that the degree of non-observability of contractual rights depends on public institutions, in particular registration systems. Whereas it is unclear how a public body would help contracting parties discover — to take a standard example — each other’s preferences over the good they are proposing to trade, Benito shows that they can affect the amount of information they have about each other’s formal legal rights. And, in line with what one would expect, when institutions can reduce this information asymmetry, the likelihood of efficient trades increases.

Putting these two ideas together provides an original and to me very exciting view on the value of legal systems. Economists often discuss “good” legal systems as those which enforce written agreements transparently at low cost. After reading Benito’s book, I recognized that legal systems also act to endogenously affect the amount of information that parties have available to reach those agreements in the first place. This deserves to be an influential idea in future discussions of law, economics, and contract theory.

Stephen Hansen. Assistant Professor. Economics Department. Universitat Pompeu Fabra. Barcelona, Spain

Entry filed under: - Lien -, Institutions, Law and Economics, New Institutional Economics, Theory of the Firm.

Arrunada Seminar: Corrado Malberti (2) – An Empirical Test on the Differences between Recordation and Registration Handbook of Organizational Economics

1 Comment Add your own

1. Benito Arruñada | 22 January 2013 at 5:55 am

Thanks, Stephen, for such an elegant comment. Two complementary comments:

First, the two features that you mention (inability of parties to observe each others and endogenous information asymmetries) are directly connected to the sequential nature of exchange: the fact that contracts interact with each other, and, in this interaction, in rem enforcement becomes the key element in contractual enforcement. (In general, if not purely with in rem effects, affecting the priority achieved by parties to different contracts, as it happens, most clearly, in corporate contracting).

Second, as you rightly point out, the dependence on public institutions is a key element that distinguishes this type of “legal” information asymmetry. Private ordering can handle “physical” information asymmetry on product quality or individual preferences more effectively than legal information asymmetries. Legal information asymmetries refer to title or contractual authority, and solving them poses harder problems for transactors: parties to relevant previous contracts are not present in subsequent contracts and judges are understandably disinclined to pay heed to private solutions in which such parties had not opportunity to participate. I think that their reluctance drives the empirical comparative advantage that public solutions seem to enjoy in this area.