Legal Remedies and Reputation as Solutions to Moral Hazard in Contracting

It is well known that noncooperative pursuit of individual gain may often result in a smaller total return than is otherwise possible. One purpose of contracts is to allow parties to commit themselves to courses of action which maximize their joint return. However, transaction and enforcement costs often create situations in which agreements between parties are either legally unenforceable or at least unenforceable in practice. This thesis explores solutions to this problem in two different contexts. In both cases it is assumed that the contract only specifies that an exchange will occur at a given price. In the first case the value of the exchange to the buyer and/or seller is random at the time of contracting and the buyer has an opportunity to engage in expenditures prior to the date of the contract performance which will enhance the value of performance to him. These expenditures are called reliance. The legal institution which requires that a breaching party must pay the breachee an amount of money called damages, substitutes for an exhaustive contract specifying reliance behavior and behavior under all states. An unambiguous ranking of the six most common damage measures is obtained in terms of efficiency of the reliance decision. In the second case, the quality of the product is variable. Buyers cannot judge the quality of the good they receive until after they consume it. Even then they may make mistakes in their judgments. This thesis derives the equilibrium quality distribution for goods produced and the equilibrium distribution of firms by the quality of good they produce, and identifies the specific factors which produce a reputation effect. Comparative statics allow analysis of the effects of restrictions on information flow and barriers to entry.