Reputation and Litigation : Why Costly Legal Sanctions Can Work Better than Reputational Sanctions

The paper reconsiders an old question in law and economics: will firms prefer to rely on legal sanctions or market sanctions as a means of committing to provide high quality goods? In the model, legal sanctions are expensive to deploy because of litigation costs, whereas market sanctions are expensive because they involve suspension of otherwise efficient trade. The firm can promise to pay damages for the delivery of low quality or it can limit damages by contract and only suffer follow on reputational sanctions in the event it delivers defective goods. Legal sanctions have a previously unrecognized advantage compared to reputational sanctions. By raising the damages (or warranty) promised, the firm creates a marginal effect: consumers who did not find filing a lawsuit cost-justified before now find it worthwhile. Further, the increase in damages means that the firm must pay higher damages on lawsuits that would have been filed anyway, creating an infra-marginal deterrence benefit. In deciding on the optimal size of the liquidated damages (or the generosity of the warranty), the firm balances the infra-marginal benefit against the cost of additional nuisance suits--suits consumer file even when they receive a high quality good. The paper also analyzes various extensions, such as litigation's informational role and the interaction with one long-term buyer