The Effect of Bargaining Power on Contract Design

Abstract

Over the past forty years, an irrelevance proposition has been prevalent in law-and-economics scholarship: bargaining power should affect only price and not nonprice terms of a contract. In contrast, practitioners and commentators in industry regularly invoke bargaining power to explain static and dynamic variance in nonprice contract terms. This Article unpacks and analyzes the assumptions of the strong- and weak-versions of this bargaining power irrelevance proposition to bridge the gap between theory and the real world. In the first half of the Article, we identify and discuss a variety of explanations for the effect of bargaining power on contract design. These include the effects of shifts in market supply and demand and the effect of negotiating price first and nonprice terms later. In the second half of the Article, we present an in-depth examination of one set of explanations, concerning the impact of bargianing power and information asymmetry on nonprice terms, when the value and cost of nonprice terms vary across contracting parties. In the extreme cases in which one or the other party enjoys overwhelming bargaining power, the efforts of that party to capture a larger share of the surplus by screening or signaling may compromise the efficiency of the nonprice terms. We show that this incentive disappears or is mitigated when bargaining power is more evenly shared between the parties: for example, when a monopolist faces the threat of competition, when the parties can renegotiate, or when they engage in bilateral bargaining with more even bargaining power. As a whole, the Article provides a theoretical basis for interpreting the intuition among market participants that the impact of bargaining power extends beyond price terms. Before concluding, we briefly suggest implications for legal policy, particularly the contract law doctrine of unconscionability.