Contracting in the Presence of Judicial Agency

Abstract

While a key function of contracts is to provide incentives, the incentives of judges to enforce the terms of a contract have rarely been examined. This paper develops a simple model of judicial agency in which judges are corrupt and can be bribed by contracting parties. Higher-powered contracts expose contracting parties to more frequent and more severe corruption, which in turn lessens the incentives actually provided by the contract. Consequently the model predicts that individuals will commonly refrain from writing high-powered contracts, even when such contracts would be valuable absent judicial agency. I show that similar implications can also be obtained by considering other forms of imperfection in contract enforcement, such as variable expenditures on legal representation. I use the model to develop implications for the optimal punishment of individuals who are extorted by corrupt judges, and to establish circumstances under which a right-of-appeal is optimal.