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The Journal of Law, Economics, and Organization V18 I1
© 2002 Oxford University Press

Original Article

Verifiability and Contract Enforcement: A Model with Judicial Moral Hazard

Murat Usman

Koç University

Abstract

I model the litigation of a contract containing a variable not observable by courts, hence nonverifiable, unless the rational and self-interested judge exerts effort. He values the correct ruling but dislikes effort. Judicial effort is discretionary. I show that effort cost is inconsequential—"always breach" is equilibrium for any effort cost. But there exists another equilibrium where a small breach rate is achieved even with significant effort costs. Maximal remedies for breach are not optimal. Because effort is discretionary, low effort cost increases breach. Pretrial negotiations can have a substantial negative impact on verifiability under arbitrarily small deviations from full rationality.


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