Courts’ Decisions, Cooperative Investments, and Incomplete Contracts

Abstract

Buyers may try to motivate their sellers to make relationship-specific investments to reduce the probability that the design of the goods they procure is defective. In some countries, courts examine how much real authority the seller had in performing the work in their assignment of liability for a design failure. I show that the approach followed by courts induces the sellers to underinvest and the buyers to underspecify the design of the goods. I explore efficiency-based justifications for this approach, such as the facilitation of optimal relational contracting and the provision of incentives to engage in noncontractible coordinating activities.