Enforceable vs. Non-Enforceable Contracts: A Theoretical Appraisal with Fair Players

Abstract

In this paper we provide a simple model examining the choice between enforceable and non-enforceable contracts when, on the one hand, drafting an enforceable contract is costly and, on the other hand, ful…lling a nonenforceable contract is left to parties'fairness. According to the previous literature we …nd that (1) the choice between the two contract settings in equilibrium depends on fairness and enfocement costs, and (2) whenever a non-enforceable contract is chosen in equilibrium it turns out welfareimproving. However, we are able to measure e¢ ciency and make punctual predictions of how distant the decentralized solution is from …rst-best. Precisely, we …nd that e¢ ciency is strongly conditioned by the stake of the transaction, so that both contracts allow for very high levels of e¢ cency in the presence of low-stake transactions, whereas e¢ ciency always collapses to very low levels for high-stake transactions. It implies that a social planner should intervene only in the last case, even in the presence of high levels of fairness. Our results are robust and hold in a repeated game, proving that reputation is not welfare improving unless the number of interactions exceeds a given threshold.