Binding and Non-Binding Contracts: A Theoretical Appraisal

In a fully self-enforcing environment, individuals can execute market transactions exclusively on the basis of trust. However, the presence of individuals showing self-regarding preferences causes serious impediments to the development and even the existence of market transactions. An enforcing legal system helps to control for the lack of trust existing in every modern society. The article provides a theoretical investigation accompanied by a numerical simulation of the impact of the introduction of a costly legal system that makes contracts binding. Therefore, it investigates the choice between legally binding contracts, which are costly to verify and enforce, and non-binding contracts, which simply rely on trust, in both one-shot and repeated interactions. We find that a legal system protecting property rights mainly produces benefits when effort is particularly valuable. In the other circumstances, the benefits are marginal. A subset of parameters also exists in which the legal system is detrimental. This is especially the case of standardized production. Finally, reputation unleashes its welfare-enhancing properties when effort is very valuable, otherwise the benefits are trivial.