Litigation Cost Allocation Rules, Judicial Detection Skill, and the Propensity to International Trade

The paper analyzes the effects of different litigation cost allocation rules, detection skill of judges (judicial errors), and the mode of enforcement of foreign judgments on the home bias in trade and sheds a new light on the so-called border-effect puzzle. In our model the border effect or home bias is due to a violation of the contractual compliance constraint. Three types of transaction costs play a role in this context: costs of opportunistic suits (litigation opportunism), costs of legitimate suits and costs of cheating (contractual opportunism). Two rules of international procedural law regarding the enforcement of foreign judgments are considered: automatic enforcement of foreign judgments and enforcement after a judicial review. Our theoretical analysis suggests that both the British as well as the American rule of litigation cost allocation can, in principle, induce bilateral contractual compliance, but only if judges possess positive detection skill. It depends on the specification of the parameters of the international legal order and the features of a transaction which rule is the better one. Finally, the paper discusses a recent empirical study and data from a report by the World Bank which are consistent with the paper's theoretical findings