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Journal of Law, Economics, and Organization Advance Access originally published online on September 13, 2006
Journal of Law, Economics, and Organization 2007 23(3):662-684; doi:10.1093/jleo/ewm017
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© The Author 2006. Published by Oxford University Press on behalf of Yale University. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Courts of Law and Unforeseen Contingencies

Luca Anderlini

Georgetown University

Leonardo Felli*

London School of Economics

Andrew Postlewaite

University of Pennsylvania

* Department of Economics, London School of Economics, Houghton Street, London WC2A 2AE, United Kingdom. Email: lfelli{at}econ.lse.ac.uk.

We study a contracting model with unforeseen contingencies in which the court is an active player. Ex ante, the contracting parties cannot include the risky unforeseen contingencies in the contract they draw up. Ex post, the court observes whether an unforeseen contingency occurred and decides whether to void or uphold the contract. If the contract is voided by the court, the parties can renegotiate a new agreement ex post. There are two effects of a court that voids contracts. The parties' incentives to undertake relationship-specific investment are reduced, and the parties enjoy greater insurance against the unforeseen contingencies that the ex ante contract cannot account for. In this context, we fully characterize the optimal decision rule for the court. The behavior of the optimal court is determined by the trade-off between the need for incentives and the gains from insurance that voiding in some circumstances offers to the agents.


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