Legal Restrictions and Optimal Contracts∗

Real-world transactions are often limited: Not all contracts are legal. As a result, I show economic examples where the only way to achieve first-best is as follows. First, the parties contractually commit to a different and ineffi cient different outcome. Then, they secretly violate the contract and coordinate play on first-best. If the parties were to contractually commit to first best, they would fail to achieve it. So, first best can only be achieved by signing a contract that appears to be over-specified, as it contains unenforceable prescriptions. I develop a novel theory of how contracts are shaped by legal constraints, and derive conditions such that the phenomenon I identify cannot take place. For example, this is the case if the court’s verification of events is costless and if all contracts that can be stipulated are legal. Under this condition, the standard contract-theoretical assumption that parties stipulate only enforceable contracts is without loss of generality. ∗I thank seminar audiences at University of Pennsylvania, University of California at Los Angeles, Columbia University and Princeton University, as well as Eddie Dekel, Faruk Gul, Philippe Jehiel, Steve Matthews, and especially Meg Meyer for very valuable comments. The usual caveat applies. †Department of Economics, University of Warwick