Law and Mechanism Design: Procedures to Induce Honest Bargaining

Abstract

A classic challenge in contract and property law is unstructured negotiation between two parties with asymmetric information (i.e., each party has different private information) under bilateral monopoly (each party must negotiate with the other to try to reach an agreement), which often leads to prohibitively high transaction costs and, if the parties fail to agree, social costs as well. In these situations, the law should incorporate principles of mechanism design, a methodology that employs structured procedures to give the parties incentives to reach agreement. In terms of contract theory, mechanisms constitute algorithmic altering rules that reduce if not eliminate inefficient transaction costs. We review two bargaining mechanisms that inherently elicit honesty by making it a dominant strategy and discuss two extensions for legal applications. In particular, we show that algorithmic procedures would reduce transaction costs and lead to more efficient bargaining in pretrial settlement negotiations and blockholder disclosure under section 13(d) of the Securities Exchange Act of 1934. The former is a straightforward application of mechanism design to a negotiation situation where the social externalities of non-agreement justify inducing the honest disclosure of reservation prices, or “bottom lines.” The latter is an example of using mechanism design to facilitate negotiated settlements in situations presently subject to a suboptimal mandatory rule.