The Paradox of Contracting in Markets

Abstract

Contract design that motivates parties to invest and trade more efficiently occurs primarily in thin markets characterized by bespoke, bilateral agreements between commercial parties. In that environment, the cost of producing each contract is relatively high. Those costs are justified by offsetting design improvements in contractual incentives. In contrast, more efficient production of contract terms occurs in thick, multilateral markets where parties can realize the scale advantages of standardization. In this environment, the cost of producing individual contracts is relatively low but at the offsetting cost of undermining contractual incentives. These very different trade-offs are dictated by changes in the markets in which contracting occurs. As a consequence, parties in multilateral markets trade using contracts containing defective terms. Only by coordinating in a network around a common objective--to revise and update contract terms to eliminate or clarify latent defects --can parties in multilateral markets optimize the tradeoff between efficient contract design and efficient production of contracts. This analysis has important normative payoffs in refocusing the debate over the regulation of consumer transactions. The starting point here is to abandon the bilateral contract paradigm and focus instead on ways that the state can facilitate the formation of a regulatory network that improves the efficiency of standardized contract terms in multilateral consumer markets.