Academic journal article Stanford Law Review

Majoritarian vs. Minoritarian Defaults

Academic journal article Stanford Law Review

Majoritarian vs. Minoritarian Defaults

Article excerpt

Recent theoretical analysis of contract default roles has devoted significant attention to the use of penalty default roles as a way to induce a contractor to reveal private information. Penalty default roles demonstrate how efficient roles cannot be derived by simply asking what most parties would have contracted for had they written a complete contract. Such "majoritarian" default roles derive from an implicit assumption about the reason why a particular contract is incomplete. A fuller efficiency analysis tries to understand the reasons why contracts are incomplete and how different default roles affect the efficiency of the contracting process and the contracts themselves. Our goal here is to show how an understanding of the underlying causes of contractual incompleteness informs the optimal choice of default rules.

Barry Adler's fine article(1) correctly identifies a new reason why it may be difficult to use "penalty" or "information-forcing" defaults to induce contractors to reveal private information about their personal attributes (what game-theorists tend to call their "type"). In an earlier article,(2) we had shown that, when one side to a contract has private information and the other side has market power, the privately informed party may be reluctant to contract around a penalty default (and thereby reveal information) if doing so would allow the other side to extract more of the gains from trade.(3) But Adler has shown that even when the private information and the market power are on the same side of the contract--as when a privately informed buyer contracts in a market with competitive sellers--the privately informed party may still be reluctant to contract around a penalty default.(4) In our earlier model, the informed buyer was reluctant to contract around the penalty defaults because doing so would subject her to a supracompetitive price; in Adler's model, the informed party is reluctant to contract around penalty defaults because doing so would destroy the subsidized pricing that the privately informed party receives by hiding out in the undifferentiated pool.

Adler should be credited for identifying this additional reason why privately informed parties may be reluctant to contract around default rules. But showing that it may be harder to induce information revelation with a particular type of penalty default is not an argument in favor of setting "hypothetical" or "majoritarian" defaults. Efficiency gap filling should grow out of one's substantive theory of why particular contracts are incomplete. Adler's insight actually strengthens an implication of our earlier articles: The effect of a particular default rule on information revelation, and thus on efficiency, depends on numerous characteristics of the contracting environment that are independent of the "hypothetical contracting" inquiry--that is, merely assessing what the parties would have contracted for if there were no private information. Other factors, including the distribution of types, the magnitude of transaction costs, and the distribution of bargaining power, will all affect the likelihood that a particular penalty default will induce separation and enhance efficiency. Adler adds another factor to this list--the possibility that revealing information might eliminate an informed party's subsidy from pooling. Even these results underestimate the problem of predicting outcomes since they were derived in overly simplistic and unrealistic models of contract negotiations whose purpose was merely to show the possibility that penalty defaults could be efficient.

Majoritarian theories of default choice are implicitly derived from a transaction cost based theory of incomplete contracts. But when contracts are strategically incomplete because of one side's private information, then there is no reason to think that majoritarian or hypothetical default setting will conduce to efficiency. When transaction costs are low and contracts are incomplete because of private information, the potential welfare losses from choosing an inefficient default are largely independent of transaction costs and, as we have previously shown, can dwarf the mere out-of-pocket costs of contracting around. …

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