Journal of Law, Economics, and Organization - Advance Access

Aligning Ambition and Incentives

Koch, A. K., Peyrache, E. — Wed, 11 Nov 2009 01:07:30 PST

Labor turnover creates longer term career concerns incentives that motivate employees in addition to the short-term monetary incentives provided by the current employer. We analyze how these incentives interact and derive implications for the design of incentive contracts and organizational choice. The main insights stem from a trade-off between "good monetary incentives" and "good reputational incentives." We show that the principal optimally designs contracts to create ambiguity about agents’ abilities. This may make it optimal to contract on relative performance measures, even though the extant rationales for such schemes are absent. Linking the structure of contracts to organizational design, we show that it can be optimal for the principal to adopt an opaque organization where performance is not verifiable, despite the constraints that this imposes on contracts. (JEL D82, J33, L14)

Ties that Truly Bind: Noncompetition Agreements, Executive Compensation, and Firm Investment

Garmaise, M. J. — Tue, 03 Nov 2009 15:07:56 PST

We study the effects of noncompetition agreements by analyzing time-series and cross-sectional variation in the enforceability of these contracts across US states. We find that tougher noncompetition enforcement promotes executive stability. Increased enforceability also results in reduced executive compensation and shifts its form toward greater use of salary. We further show that stricter enforcement reduces capital expenditures per employee. These results are consistent with a model in which enforceable noncompetition contracts encourage firms to invest in their managers’ human capital. On the other hand, our findings suggest that these contracts also discourage managers from investing in their own human capital and that this second effect is empirically dominant. (JEL D86, G31, J33, J62, K12)

Dynamic Contract Breach

Zhang, F. — Wed, 21 Oct 2009 01:55:55 PDT

This article studies the design of optimal liquidated damages when breach of contract is possible at multiple points in time. It offers an intuitive explanation for why cancellation fees for some services (e.g., hotel reservations) increase as the time for performance approaches and discusses the incentives to mitigate damages. It is shown that absent externalities, privately stipulated damages induce socially efficient breach and investment decisions, regardless of whether renegotiation is possible. (JEL K12)

The Economics of Scientific Misconduct

Lacetera, N., Zirulia, L. — Tue, 20 Oct 2009 09:04:31 PDT

This article presents a model of the research and publication process that analyzes why scientists commit fraud and how fraud can be detected and prevented. In the model, authors are asymmetrically informed about the success of their projects and can fraudulently manipulate their results. We show, first, that the types of scientific frauds that are observed are unlikely to be representative of the overall amount of malfeasance; also, star scientists are more likely to misbehave but less likely to be caught than average scientists. Second, a reduction in fraud verification costs may not lead to a reduction of misconduct episodes but rather to a change in the type of research that is performed. Third, a strong "publish or perish" pressure may reduce, and not increase, scientific misconduct because it motivates more scrutiny. Finally, a more active role of editors in checking for misconduct does not always provide additional deterrence. (OT1phvlslJEL A14, D82, K42, O31, Z13)

Product Safety, Buybacks, and the Post-Sale Duty to Warn

Spier, K. E. — Fri, 09 Oct 2009 10:54:11 PDT

A manufacturer learns a product's risks after it has been sold and distributed to consumers. When held strictly liable for product-related injuries, the manufacturer offers to repurchase the product when the risk exceeds a threshold. Consumers accept the offer when their private valuations of consumption are smaller than the buyback price. The manufacturer's private incentives to stage a buyback are insufficient, the buyback price offered is too low, and the continued product usage by consumers is excessive. The ability of the manufacturer to repurchase the product ex post reduces the incentive to design safer products ex ante. A negligence rule, the "post-sale duty to warn," implements the social welfare benchmark. (JEL K13, D18, L15, D82)

The Evolution of Criminal Law and Police during the Pre-modern Era

Allen, D. W., Barzel, Y. — Mon, 05 Oct 2009 07:25:21 PDT

Increased standardization was a by-product of technical innovations during the Industrial Revolution. An unfortunate side effect of standardization was enhanced opportunities for theft and embezzlement. Two significant modern institutions radically evolved during the eighteenth to mid-nineteenth centuries to control these growing problems: criminal law and public police. These institutions strongly interacted with the pace of the Industrial Revolution. Our argument explains this evolution and is tested through an analysis of several historical facts: the role of early police, the fall of the watch system, the creation of improvement commissions, the removal of possession immunity, the rise and fall of factory colonies, and the fall and rise of court cases during the eighteenth century. (JEL N43, K14)

Airing Your Dirty Laundry: Vertical Integration, Reputational Capital, and Social Networks

Gil, R., Hartmann, W. R. — Fri, 25 Sep 2009 06:53:08 PDT

This article explores the relationship between an ethnic-based social network and vertical integration decisions in the laundry services industry. We find that stores in the social network are significantly less likely to vertically integrate than nonmember stores. This has three primary implications. First, the social network may be lowering the costs of using the market more than facilitating in-house production. This implies better outsourcing opportunities in a social network and may explain a documented relationship between social networks and firm economic performance. Second, institutional details of our example and the estimated relationship suggest a role for opportunism and reputation as determinants of the boundaries of the firm in a setting without asset specificity. Finally, although we provide evidence that better access to credit can increase the likelihood of vertical integration, we show that better outsourcing opportunities have a dominant effect of the social network in this particular setting.

Privatization and Leverage

At, C., Morand, P.-H. — Mon, 21 Sep 2009 13:26:35 PDT

This article studies privatization methods when potential buyers can lever up strategically to maximize their probability of winning. We endogenize the optimal fraction of shares to be auctioned off when privatizing a company. There is a close correlation between the optimal fraction of shares to be sold off and the auction winner's debt level and hence the risk of bankruptcy. (JEL G38, D82)

Product Recall and Liability

Hua, X. — Wed, 09 Sep 2009 06:49:30 PDT

This article examines a firm's incentives to recall its product after learning that the product may harm consumers. It discusses whether courts should protect consumers who do not comply with recalls. Under the "no duty to return" rule, the firm bears the same liability no matter whether it has made a recall or not. The firm then may not recall the product as often as socially desired or provide insufficient reimbursement for consumers’ return costs. In contrast, the "full duty to return" rule denies the firm's future liabilities after it makes a recall. More consumers then return the product, which may reduce the firm's incentives to recall the product. We show that the "full duty to return" rule may or may not generate more product recalls or higher social welfare. We also discuss the "partial duty to return" rule, which partially reduces the firm's liability after it makes a recall. (JEL K13, L15)

Vertical Integration and Information Technology Investment in the Insurance Industry

Forman, C., Gron, A. — Mon, 07 Sep 2009 06:09:51 PDT

In this paper, we examine whether frictions created by differences in firm boundaries affect the speed with which firms adopt new Information Technology. Using a rich dataset on organizational characteristics and Internet investment by over 100 firms in the insurance industry, we show that vertical integration in distribution has a significant impact on the speed with which insurers adopt consumer Internet applications that complement the existing distribution relationship. Vertical integration, however, has no effect on the adoption of tools that enable electronic communication between an insurer and its sales force. Furthermore, vertical integration has no affect on the adoption of Internet technologies, such as basic access, that are not used in distribution. (JEL D23, L14, M15)

Noneconomic Damage Caps and Medical Malpractice Claim Frequency: A Policy Endogeneity Approach

Durrance, C. P. — Mon, 07 Sep 2009 06:09:34 PDT

Medical malpractice has received much attention in the media with highly publicized jury awards and reported consequences of excessive litigation. Health care and medical malpractice remain a prominent issue, especially in the current political climate. Policy endogeneity, however, plagues most analyses of various federal, state, or local policies. In this article, I analyze the effect of noneconomic damage caps on the frequency of positive payment medical malpractice claims, recognizing that these laws are likely endogenous. I construct a unique instrument using past and current values of state political composition and other factors. In contrast to previous literature, I find no evidence that caps on noneconomic damages are associated with a reduction in medical malpractice positive payment claim frequency. (JEL K13, I18)

Screening in Courts: On the Joint Use of Negligence and Causation Standards

Feess, E., Muehlheusser, G., Wohlschlegel, A. — Sat, 05 Sep 2009 07:42:33 PDT

In legal systems all over the world, injurers are held liable only when the probability of having caused an accident exceeds a critical threshold (causation standard) and when behaving negligently. In a complete information framework, the joint use of the two instruments is puzzling as both whether a potential injurer has taken due care and whether he meets a specific causation standard depend only on his care level. We explain this puzzle with private information about injurers’ avoidance costs, and we derive conditions under which the joint use of both instruments can induce self-selection of different cost types. With self-selection, low-cost firms take due care, whereas high-cost firms behave negligently, thereby aiming at escaping liability via the causation standard. Compared to the optimal single-instrument policy, we derive conditions under which such self-selection policies are strictly welfare-enhancing. (JEL K13)

An Economic Analysis of Trade-Secret Protection in Buyer-Seller Relationships

Bechtold, S., Hoffler, F. — Fri, 21 Aug 2009 12:42:41 PDT

The economic analysis of trade-secret protection has traditionally focused on the interests of companies to conceal information from competitors in order to gain a competitive advantage through trade-secret law. This has neglected cases in which the interest is not in concealing information from competitors but from trading partners. We investigate trade-secret protection in such cases. Frequently, asymmetric information will lead to inefficient trade; at the same time, protecting private information might create incentives for socially desirable investments. We model this trade-off in a simple buyer-seller model and find that the optimal fine for violations of trade secrets is positive. In general, however, the welfare effects of increasing a fine are ambiguous. We discuss conditioning the legal protection on a minimum investment by the informed party to conceal the information and argue that this helps to apply trade-secret protection only when it increases welfare. This rationalizes important features of current legal practice. (JEL K2, D82)

Organizational Capacity

Ting, M. M. — Mon, 17 Aug 2009 18:25:17 PDT

Organizational capacity is critical to the effective implementation of policy. Consequently, strategic legislators and bureaucrats must take capacity into account in designing programs. This article develops a theory of endogenous organizational capacity. Capacity is modeled as an investment that affects a policy's subsequent quality or implementation level. The agency has an advantage in providing capacity investments and may therefore constrain the legislature's policy choices. A key variable is whether investments can be "targeted" toward specific policies. If it cannot, then implementation levels decrease with the divergence in the players’ ideal points and policy-making authority may be delegated to encourage investment. If investment can be targeted, then implementation levels increase with the divergence of ideal points if the agency is sufficiently professionalized, and no delegation occurs. In this case, the agency captures more benefits from its investment, and capacity is higher. The agency therefore prefers policy-specific technology. (JEL D72, D73)

A Theory of "Crying Wolf" : The Economics of Money Laundering Enforcement

Takats, E. — Thu, 13 Aug 2009 20:02:42 PDT

The article shows how excessive reporting, called "crying wolf", can dilute the information value of reports and how more reports can mean less information. Excessive reporting is investigated by undertaking the first formal analysis of money laundering enforcement. Banks monitor transactions and report suspicious activity to government agencies, which use these reports to identify investigation targets. Banks face fines should they fail to report money laundering. However, excessive fines force banks to report transactions which are less suspicious. The empirical evidence is shown to be consistent with the model's predictions. The model is used to suggest implementable corrective policy measures, such as decreasing fines and introducing reporting fees. (JEL G28, K23, L51, M21)

Party Organization and Electoral Competition

Crutzen, B. S. Y., Castanheira, M., Sahuguet, N. — Tue, 11 Aug 2009 21:34:48 PDT

We propose a model in which two parties select the internal organization that helps them win the election. Party choices provide incentives to the politicians who represent them. Depending on whether politicians are opportunistic or partisan, we identify four effects. First, a selection effect: intraparty competition gives parties more candidates to choose from. Second, an incentive effect: intraparty competition adds a hurdle and impacts on candidates' incentives. Third, a trust effect: because of the incentive effect, intraparty competition is a signal to uninformed voters. Finally, with partisan preferences, an ideology effect appears. Ideology is a public good in a competitive party and induces free riding. Intraparty competition is valuable when voters are badly informed or intraparty competition is weak. These results rationalize the introduction of direct primaries in the United States, the organizational changes in Western European parties since 1960, and the organizational differences between centrist and extreme parties. (JEL D23, D72, D81)

Promotions, Dismissals, and Employee Selection: Theory and Evidence

Frederiksen, A., Takats, E. — Mon, 03 Aug 2009 14:47:17 PDT

Firms offer highly complex contracts to their employees. These contracts contain a mix of incentives, such as fixed wages, bonus payments, promotion options, and dismissals or threats of dismissal. In this article, we show that firms having a production process that is sensitive to employee quality may find it optimal to combine cost-efficient incentives such as bonuses and promotions with dismissals. Based on this result, we derive a hierarchy of incentives. Furthermore, we demonstrate the close link between the optimal contract and the employee sorting and selection and use this to analyse the information conveyed in employment matches. (JEL J30, J41, M50)

Optimal Standards of Negligence When One Party Is Uninformed of the Standards

Lando, H. — Wed, 01 Jul 2009 10:59:07 PDT

This article analyzes optimal negligence standards when only one of two (future) parties will be informed of the standards. When the informed party is the injurer and acts first, the simple negligence rule is optimal, and under certain conditions, the first best standard of due care is optimal. The informed party will have an incentive to comply with the standard due to the discontinuity of the negligence rule, whereas the uninformed party may infer this and hence also take appropriate precautions. In general, the optimal policy for the court depends on who acts first and on who the injurer is. Thus, optimal rules are contributory negligence when the informed party is the victim and acts first, no liability when the uninformed party is the injurer and acts first, and strict liability without contributory negligence when the uninformed party is the victim and acts first. (JEL K10, K13, K14)

Even if it is not Bribery: The Case for Campaign Finance Reform

Daley, B., Snowberg, E. — Mon, 29 Jun 2009 20:34:22 PDT

We develop a dynamic multidimensional signaling model of campaign finance in which candidates can signal their ability by enacting policy and/or by raising and spending campaign funds, both of which are costly. Our model departs from the existing literature in that candidates do not exchange policy influence for campaign contributions; rather, they must decide how to allocate their efforts between policymaking and fundraising. If high-ability candidates are better policymakers and better fundraisers, then they will raise and spend campaign funds even if voters care only about legislation. Campaign finance reform alleviates this phenomenon and improves voter welfare at the expense of politicians. Thus, we expect successful politicians to oppose true campaign finance reform. We also show that our model is consistent with findings in the empirical and theoretical campaign finance literature. (JEL D72, D82)

Legislative Pivots, Presidential Powers, and Policy Stability

Crisp, B. F., Desposato, S. W., Kanthak, K. — Fri, 26 Jun 2009 06:49:53 PDT

We offer a general model of policy making across presidential systems, exploring how checks and balances interact with legislative party systems to determine the responsiveness of political systems to electoral change. Using the two dominant theories of policy making in the United States as a starting point, we formally model the legislative process across presidential regimes characterized by a wide array of institutional designs, simulate expected policy behavior, and then test our models empirically with data capturing economic policy choices. (JEL D72, D71, H11, C63)

The Incorporation Choices of Privately Held Corporations

Dammann, J., Schundeln, M. — Fri, 26 Jun 2009 06:49:36 PDT

Exploiting a large new database, this article explores the incorporation choices of closely held U.S. corporations. The majority of corporations in our sample incorporate in the state in which their primary place of business (PPB) is located. However, among the corporations with 1000 or more employees, only about half incorporate in their PPB state, and of those that do not, more than half are incorporated in Delaware. We find statistically significant and robust evidence that corporations from states with judiciaries that are held in low esteem are more likely to incorporate outside of their PPB state. Furthermore, corporations are more likely to migrate away from states where the risk of veil piercing is perceived to be high, that have adopted so-called exculpation statutes, or that offer a particularly generous level of minority shareholder protection. (JEL K22, G38, H70, R30)

Is the World Flat? Country- and Firm-Level Determinants of Law Compliance

Chong, A., Gradstein, M. — Fri, 26 Jun 2009 06:49:17 PDT

This research revisits the effects of a country's institutional framework on individual firms' behavior, focusing, in particular, on firms' propensity to comply with legal rules. We purport to explain the variation in compliance with legal rules by employing a rich data set on thousands of firms from dozens of countries. We find that most of the variation emanates from countrywide differences in institutional quality, although various firm characteristics play a role as well. We also find indications that differences across countries diminish with the level of development. (JEL D21, K42, O17, O57)

Organized Business, Political Competition, and Property Rights: Evidence from the Russian Federation

Pyle, W. — Tue, 23 Jun 2009 05:45:04 PDT

Political competition and "merchant group" pressures have been pointed to as forces that limit state threats to the property rights of firms. This article presents evidence confirming their importance and highlighting an interesting feature of their interaction. Drawing on separate surveys of managers at industrial enterprises and directors of business associations in the Russian Federation, we demonstrate that a firm's willingness to contest government predation, its ability to influence reforms to its institutional environment, and its propensity to invest in physical capital are positively related both to the membership in a business association and to the level of political competition in its region. Of particular note, the relationship between association membership and property rights strengthens in less politically competitive regions. Business community collective action, that is, appears to serve as a substitute for political competition in securing firms' property rights. (JEL D23, D71, P26)

Determinants of Nationalization in the Oil Sector: A Theory and Evidence from Panel Data

Guriev, S., Kolotilin, A., Sonin, K. — Tue, 23 Jun 2009 07:39:57 PDT

In this article, we study nationalizations in the oil industry around the world during 1960–2006. We show, both theoretically and empirically, that governments are more likely to nationalize when oil prices are high and when political institutions are weak. We consider a simple dynamic model of the interaction between a government and a foreign-owned oil company. Even though nationalization is inefficient, it does occur in equilibrium when oil prices are high. The model's predictions are consistent with the analysis of panel data on nationalizations in the oil industry around the world since 1960. Nationalization is more likely to happen when oil prices are high and the quality of institutions is low, even controlling for country fixed effects. (JEL D23, L33, L71, P48)

Disobedience and Authority

Marino, A. M., Matsusaka, J. G., Zabojnik, J. — Fri, 24 Apr 2009 05:03:14 PDT

This article presents a theory of the allocation of authority in an organization in which centralization is limited by the agent's ability to disobey the principal. We extend the concept of real authority by observing that not only does the principal have to be informed to give an order but also the worker must be willing to follow the order. We show that workers are given more authority when they are costly to replace or do not mind looking for another job, even if they have no better information than the principal. The allocation of authority thus depends on external market conditions as well as the information and agency problems emphasized in the literature. We explore the implications of this insight for hiring policies and managerial styles.

Early Entrant Protection in Approval Regulation: Theory and Evidence from FDA Drug Review

Wed, 22 Apr 2009 06:02:37 PDT

Early entrant protection in approval regulation exists when the first incumbents in an exclusive market niche receive more favorable regulatory treatment than later entrants. We show that this pattern can prevail for two reasons: regulatory capture and consumer co-optation. We consider a decision-theoretic model of dynamic product approval by an uncertain regulator. The model predicts early entrant protection even when later entrants offer quality improvements over market incumbents. We then test the model using duration analyses of New Drug Application approval times for 1080 new molecular entities submitted to the US Food and Drug Administration (FDA) from 1950 to 2006 and later approved. FDA approval times are shown to be increasing in order of market entry for the entire period studied and across numerous subsamples. A standard deviation rise in the log of order of entry is associated with a 3.6-month increase in expected FDA approval time. The entry-order gradient appears to be heavily influenced by disease-level variables but not by firm-level effects, supporting a consumer co-optation explanation and disfavoring capture and producer rent-seeking accounts. The gradient appears heightened by the 1962 Kefauver-Harris Amendments but unaffected by the 1992 Prescription Drug User Fee Act; the influence of some disease-level factors upon the gradient may have been reduced by the 1992 statute. (JEL C44, I18, L51, H11)

Competition, Monopoly, and Aftermarkets

Carlton, D. W., Waldman, M. — Tue, 07 Apr 2009 18:51:11 PDT

Consider a durable goods producer that has the option of monopolizing an aftermarket such as repair for its own product. An important question is whether such monopolization reduces welfare? We show that the answer to this question is frequently no. In particular, we explore three models that illustrate various ways in which aftermarket monopolization can reduce inefficiencies and thus increase social welfare and frequently also consumer welfare. Our article shows that efficiency enhancing aftermarket monopolization may be much more common than previous literature suggests. (JEL K21, L12, L49)

What Do We Talk About When We Talk About Corruption?

Mendez, F., Sepulveda, F. — Tue, 03 Mar 2009 22:45:18 PST

In this article, we analyze the behavior of three objective measures of corruption: absolute corruption incidence, relative corruption incidence, and corruption rents. We present a theoretical model of bribery and investment in which these measures of corruption are defined and compared. We then study the changes that arise when key parameters of the model change and show that, under identical circumstances, the behavior of any particular corruption measure can differ completely from the behavior of the other measures. Furthermore, in our model high and low corruption lead to two types of equilibria. We show that the behavior of all three measures can vary substantially when the type of equilibrium changes. (JEL K42, D73, P37)

Opportunism in Organizations

Vafai, K. — Fri, 06 Feb 2009 19:37:30 PST

This article characterizes the incentive contracts that optimally immunize an organization against the opportunistic activities of its members. We analyze an agency relationship with moral hazard where a principal relies on a supervisor to obtain verifiable information about an agent's output. The supervisor's discretion allows him to engage in two types of individual opportunism, namely abuse of power and abuse of authority, as well as two types of group opportunism, namely collusion with the agent and collusion with the principal. Individual opportunism occurs when the supervisor asks a tribute to reveal information, whereas group opportunism occurs when the supervisor receives a bribe to conceal information. We find that the effective, and hence most noxious, form of opportunism is individual opportunism and derive the opportunism-proof contracts, that is, the optimal contracts that protect the organization against both individual and group opportunism.

"The essence of an organization is limitation of the autonomy of all its members or parts, since all are subject to power from the others ..." (Hickson et al. 1971: 217).

"Corruption in general is harmful to economic, political, and organizational development. But all forms of corruption are not created equal. Some forms are more harmful than others" (Klitgaard 1988: 46).

Population-Based Liability Determination, Mass Torts, and the Incentives for Suit, Settlement, and Trial

Daughety, A. F., Reinganum, J. F. — Thu, 05 Feb 2009 10:24:49 PST

We explore how the incentives of a plaintiff, when considering filing suit and bargaining over settlement, differ between suits associated with stand-alone torts cases and suits involving mass torts. We contrast "individual-based liability determination" (IBLD), wherein a clear description of the mechanism by which a defendant's actions translate into a plaintiff's harm is available, with "population-based liability determination" (PBLD), wherein cases rely on the prevalence of harm in the population to persuade a judge or jury to draw an inference of causation or fault. PBLD creates a "rational optimism effect" on the plaintiff's part that is inherent in many mass tort settings. This effect creates incentives for higher settlement demands and results in greater interim expected payoffs for plaintiffs and, thus, an increased propensity to file suit. Consequently, defendants in PBLD cases face increased ex ante expected costs compared with the IBLD regime, thereby increasing incentives to take care. (JEL K13, K41, D82)

Should Firms be Allowed to Indemnify Their Employees for Sanctions?

Mullin, W. P., Snyder, C. M. — Tue, 20 Jan 2009 12:54:54 PST

Policymakers have questioned whether firms should be allowed to indemnify their employees for personal sanctions for corporate crimes. This article provides the first formal analysis of this form of indemnification. Targeting employees with unindemnifiable sanctions carries the social cost of exposing employees of law-abiding firms to the risk of mistaken government prosecution. Deterrence is typically achieved more efficiently by sanctioning the firm alone. We find the circumstances under which the government should additionally sanction employees to be quite limited and the circumstances under which the government should ban indemnification of these sanctions to be more limited still. One circumstance is when an unindemnifiable employee sanction provides prosecutors with leverage to adjust the employee's sanction in exchange for his cooperation against the firm. (JEL K22, D82, L20)

Carrots, Sticks, and the Multiplication Effect

Dari-Mattiacci, G., Geest, G. D. — Tue, 20 Jan 2009 10:33:55 PST

Although a punishment can be applied only once, the threat to punish can be repeated several times. This is possible because when parties comply, the punishment is not applied and can thus be used to support a new threat. We refer to this feature of sticks as the "multiplication effect." The same is not possible with promises to reward since carrots are used up every time a party complies; hence, at each round a new reward is needed. We show that the multiplication effect of sticks has pervasive consequences in economics and law and provides a unified explanation for seemingly unrelated phenomena such as comparative negligence, legal aid, the dynamics of riots and revolutions, the use of property rules, the commons problem, and the most-favored-nation clause in settlement negotiations. (JEL K14, K42)

Incentive Contracts with Enforcement Costs

Doornik, K. — Sat, 20 Dec 2008 12:01:57 PST

Legal enforcement of contracts is expensive and therefore parties will typically negotiate to avoid these costs. However, if negotiation takes place under asymmetric information, enforcement will occur in some states. We study a simple principal-agent model with risk neutrality and limited liability and assume costly, nonautomatic enforcement and private information by the principal. We show that the form of the contract systematically affects the likelihood of proceeding to court. In order to reduce the probability of enforcement, an optimal incentive contract must be one step. In addition, the principal may leave the agent with some surplus and effort will typically deviate from the productively efficient level. (JEL D82, D86, K40)

Double-Sided Moral Hazard, Efficiency Wages, and Litigation

Gurtler, O., Krakel, M. — Tue, 09 Dec 2008 07:49:19 PST

We consider a moral-hazard problem in a principal-agent relationship. Each party can renege on the signed contract since verification of effort is costly and subject to uncertainty. It is shown that ex-post litigation can restore incentives of the agent. Moreover, when the litigation can be settled by the parties, the pure threat of using the legal system may suffice to implement the first-best solution. This finding is quite robust. In particular, it holds for situations where the agent is protected by limited liability, where the parties have different technologies in the litigation contest, or where the agent is risk averse. (JEL D86, J33, K41)

Chilling, Settlement, and the Accuracy of the Legal Process

Friedman, E., Wickelgren, A. L. — Fri, 05 Dec 2008 19:19:17 PST

In this article, we ask the basic question: Is it necessarily the case that allowing or promoting settlement of lawsuits enhances social welfare? Our answer is not necessarily; there are circumstances where actually prohibiting settlement generates more social welfare than allowing it. Settlement can lower social welfare because it reduces the accuracy of legal outcomes. Reducing this accuracy reduces the ability of the law to deter harmful activity without chilling legitimate activity that might be mistaken for harmful activity. In some circumstances, the welfare loss from the chilling of legitimate activity can outweigh the gains from litigation cost savings, even if there are no restrictions on the damage rule. (JEL K00, K41, D82, C78)

Disagreement and the Allocation of Control

Van den Steen, E. — Wed, 03 Dec 2008 21:30:51 PST

This article studies the allocation of control when there is disagreement—in the sense of differing priors—about the right course of action. People then value control rights since they believe that their decisions are better than those of others. More disagreement (due to, e.g., fundamental uncertainty) increases the value that players attach to control. The article shows that all income and control of a project should then be concentrated in one hand: income rights should go more to people with more control since such people value income higher (because they have a higher opinion of the decisions made); control rights should go more to people with more income since they care more (and believe that they make better decisions). Different projects may be optimally "owned" by different people. Furthermore—with residual income exogenously allocated—complementary decisions should be more co-located, whereas substitute decisions should be more distributed. Confident people with a lot at stake should—in a wide range of settings—get more control. (JEL D7, D8, L2, M1)

Putting the "Con" into Constitutions: The Economics of Prison Gangs

Skarbek, D. — Fri, 07 Nov 2008 11:33:04 PST

This paper investigates the internal governance institutions of criminal enterprise by examining the law, economics, and organization of the La Nuestra Familia prison gang. To organize effectively within the confines of penitentiaries, the gang needs to provide a credible commitment for member safety to potential entrants and a means of preventing predation and misconduct within the gang. I analyze the governance structure outlined in the gang's written constitution and show how it solves the collective action problems associated with multilevel criminal enterprises. (JEL D23, K42, L23, P16)

Professionals or Politicians: The Uncertain Empirical Case for an Elected Rather than Appointed Judiciary

Choi, S. J., Gulati, G. M., Posner, E. A. — Wed, 05 Nov 2008 14:50:50 PST

Conventional wisdom holds that appointed judges are superior to elected judges because appointed judges are less vulnerable to political pressure. However, there is little empirical evidence for this view. Using a data set of state high court opinions, we construct measures for three aspects of judicial performance: effort, skill, and independence. The measures permit a test of the relationship between performance and the four primary methods of state high court judge selection: partisan election, non-partisan election, merit plan, and appointment. Appointed judges write higher quality opinions than elected judges do, but elected judges write more opinions, and the evidence suggests that the large quantity difference makes up for the small quality difference. In addition, elected judges are not less independent than appointed judges. The results suggest that elected judges focus on providing service to the voters, whereas appointed judges care more about their long-term legacy as creators of precedent.

If the state has a problem with judicial impartiality, it is largely one the state brought upon itself by continuing the practice of popularly electing judges.

Justice O'Connor, concurring in Republican Party of Minn. v. White, 536 U.S. 765, 792 (2002).

An Institutional Explanation for the Stickiness of Federal Grants

Brooks, L., Phillips, J. H. — Fri, 12 Sep 2008 12:07:35 PDT

Researchers have struggled to understand why federal block grants, contrary to economic theory, have a large stimulative effect on the spending of state and local governments. This article proposes and tests an institutional explanation for this effect. We argue that certain budgetary rules, by limiting the ability of subnational governments to respond to voter demands for increased spending, may systematically force lawmakers to under-provide public goods. When this occurs, governments are likely to treat grant revenue as a supplement to total expenditures and not return this money to voters in the form of a tax cut as suggested by existing theory. To evaluate our hypothesis, we use data on the Community Development Block Grant program and municipal tax and expenditure limitations. Results show that restrictive fiscal institutions significantly increase the stimulative power of federal grant revenue. (JEL H7, H4, R5)

A Right to Silence for Civil Defendants?

Wickelgren, A. L. — Mon, 08 Sep 2008 08:17:25 PDT

The Fifth Amendment guarantees criminal defendants the right to silence, blocking the court from drawing adverse inferences from the defendant's silence. This article investigates the conditions under which extending such protection to civil defendants might increase (or decrease) social welfare. If discovery is imperfect, then defendants who acquire information about the dangerousness of their actions may hide this evidence at trial if it is bad. This tends to make the private benefit from acquiring such information exceed the social benefit. Furthermore, the private benefit from acquiring this information is greater when the court will infer the information is bad if the defendant does not present it. Thus, there are situations in which a right to silence may be necessary to prevent a defendant from acquiring information for which the social costs exceed the social benefit. On the other hand, if it is hard to hide damaging information and the release of damaging information tends to induce lawsuits, then a right to silence may dampen already insufficient incentives to acquire information. (JEL K40, K41)

Growing Pains: The School Consolidation Movement and Student Outcomes

Berry, C. R., West, M. R. — Thu, 28 Aug 2008 16:12:59 PDT

Between 1930 and 1970, average school size in the United States increased from 87 to 440 students and average district size increased from 170 to 2300 students, as over 120,000 schools and 100,000 districts were eliminated through consolidation. We exploit variation in the timing of consolidation across states to estimate the effects of changing school and district size on student outcomes using data from the Public-Use Micro-Sample of the 1980 US census. Students educated in states with smaller schools obtained higher returns to education and completed more years of schooling. Reduced form estimates confirm that students from states with larger schools earned significantly lower wages later in life. Although larger districts were associated with modestly higher returns to education and increased educational attainment in most specifications, any gains from the consolidation of districts were far outweighed by the harmful effects of larger schools. (JEL I2, H7, H4)