Incomplete Contracts, Self-Investments, Asymmetric Information, Breach of Contract and the Legal Remedies

Abstract

In the early models of incomplete contract neither party used to invest in the subject matter of the contract; those models primarily kept their focus on analyzing the effect of legal rules on parties' incentives to trade or to breach. The modern models stretched beyond that to include value enhancing investments into its purview and establish an important result: (legal) penalties often are necessary to induce efficient investment; otherwise 'hold-up' (underinvestment) a general phenomenon when contracts are incomplete. But most of these models' findings are limited to typically symmetric or complete information scenario. In reality, the contracting parties usually possess some non-contractible private information either on their reliance or on their out side trading options or both (since either it is costly to describe or non-verifiable) and there may be ex-ante uncertainty associated with their valuations. So far asymmetric information has played a very limited role in the analysis of hold up problem. Therefore, in light of new and asymmetric information that the parties expected to realize subsequent to a binding contract, a systematic analysis has been attempted to see - first, how the legal remedies can solve hold up problem when parties also bear ex ante private information; secondly, how the courts of law can play a greater role than that has been realized. Focus remains on the ex-ante design of the contract, which would serve as an implicit substitute to complete contracts. Under asymmetric participation to contract, one of our main results shows that although the expectation damage remedy maximizes the social surplus for the parties across different dimensions of asymmetry (uncertainty) but induces excessive reliance. It is also found that party designed liquidated damage remedy is superior to all other court imposed remedies when one-sided asymmetry is concern. Finally we show that when dual asymmetry (uncertainty) is present in a contracting situation a high damage measure (even higher that expectation damage) induces efficient reliance by the parties. These results bear serious implications for various contract doctrines and debates.