Incentive Contracts with Enforcement Costs

Legal enforcement of contracts is expensive and therefore parties will typically negotiate to avoid these costs. However, if negotiation takes place under asymmetric information, enforcement will occur in some states. We study a simple principal-agent model with risk neutrality and limited liability and assume costly, nonautomatic enforcement and private information by the principal. We show that the form of the contract systematically affects the likelihood of proceeding to court. In order to reduce the probability of enforcement, an optimal incentive contract must be one step. In addition, the principal may leave the agent with some surplus and effort will typically deviate from the productively efficient level. (JEL D82, D86, K40) The Author 2008. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.