The Law and Economics of Costly Contracting

In most of the contract theory literature, contracting costsare assumed either to be high enough to preclude certain formsof contracting or low enough to permit any contract to be written.Similarly researchers usually treat renegotiation as eithercostless or prohibitively costly. This article addresses themiddle ground between these extremes, in which the costs ofcontracting and renegotiation can take intermediate values andthe contracting parties can themselves influence these costs.The context for our analysis is the canonical problem of inducingefficient relation-specific investment and efficient ex posttrade. Among our principle results are: (i) The efficiency andcomplexity of the initial contract are decreasing in the costto create a contract. Hence the best mechanism design contractscan be too costly to write. (ii) When parties use the simplercontract forms, they require renegotiation to capture ex postsurplus and to create efficient investment incentives. In somecases, parties want low renegotiation costs. More interestingis that, in other cases, parties have a strict preference formoderate renegotiation costs. (iii) The effect of contract lawon contract form is significant but has been overlooked. Inparticular, the law's interpretive rules raise the cost of enforcingcomplex contracts, and thus induce parties to use simple contracts.Worse, the law also lowers renegotiation costs, which furtherundermines complex contracts and is also inappropriate for someof the simpler contracts.