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Licensed Unlicensed Requires Authentication Published by De Gruyter April 27, 2012

On the Optimal Regulation of Unread Contracts

  • Yuval Procaccia and Alon Harel
From the journal Review of Law & Economics

Most contracts in which we engage in the marketplace, we do not care to read. Consequently, a classic question arising in the law of contracts is whether, and to what extent, the content of such agreements ought to be subject to special scrutiny by courts, regulators or legislatures. This paper, accordingly, develops an economic theory of the optimal regulation of unread contracts. Under a prevalent view, when contract drafters are repeat players, there is little need for regulatory intervention, as the drafters’ concern for their reputation serves a disciplinary function, which guarantees the efficiency of the drafted terms. Alternatively it is often maintained that a small percentage of informed consumers can guarantee efficiency. Our paper revisits these insights and finds them flawed in three main respects. First, the mere assumption of repeat play does not, in and of itself, guarantee the sustainability of reputation. The socially desirable equilibrium, in which reputation disciplines sellers, is but one of many possible equilibria to which the market might converge and nothing guarantees that the optimal equilibrium would be selected. Second, even if the desirable equilibrium is sustained, it is expected to guarantee the efficiency of only some contractual provisions, not all. In particular, a reputation-minded drafter will tend to include efficient terms only to the extent that they pertain to high-probability contingencies, but not if they pertain to low-probability events. Finally, the influential conviction of contract law theorists that an informed minority of consumers is sufficient to guarantee the efficiency of contract terms is shown to be inapplicable when the majority’s lack of information emanates from their failure to read. We identify a regulatory framework that functions as a corrective measure to the above-mentioned failures. The suggested framework both serves to eliminate inefficient equilibria; and guarantees the efficiency of those aspects of the contract that reputation fails to remedy, i.e. provisions governing low probability contingencies. Although the rules of legal doctrine are not framed in the language of the proposed theory, we argue that the legal doctrine incorporates much of the same principles. Hence, the theory is not merely prescriptive, but also, to some extent, explanatory.

Published Online: 2012-4-27

©2012 Walter de Gruyter GmbH & Co. KG, Berlin/Boston

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