Crowding In: How Formal Sanctions Can Facilitate Informal Sanctions

A long line of legal scholarship has examined how formal or legal sanctions can deter misbehavior or facilitate cooperation. A second strand of legal scholarship asks how informal or reputational sanctions can accomplish these same goals. Insufficient attention has been paid to why, in reality, these two kinds of sanctions often co-exist and how they interact with each other. This paper attempts to fill this gap by analyzing how the two types of sanctions can be jointly deployed in a long-term, relational contract setting. The paper advances four claims. First, both legal and reputational sanctions are costly: legal sanctions require spending resources on litigation while reputational sanctions can lead to inefficient failures to trade. An optimal deterrence regime must, therefore, make a trade-off between these two types of costs. Second, in achieving optimal deterrence, the two sanctions function as both substitutes and complements. As substitutes, relying more on one type of sanction requires less of the other to reach any desired level of deterrence. As complements, formal sanctions—by revealing information about past misconduct—can improve the performance of the informal sanctions. Indeed, a desire to generate information can explain why contracting parties might want legal liability to turn on a fault-based standard (such as “best efforts,” “commercially reasonable efforts,” or “good faith”). Third, the paper argues that the most effective deterrence regime will often combine both types of sanctions. By keeping legal sanctions low, the regime keeps the litigation costs in check while taking advantage of the informational benefits of litigation. Reputational sanctions, then, can make up for any shortfall in deterrence. Finally, the paper shows how various empirical findings are consistent with the theoretical predictions. * Professor of Law, Washington University in St. Louis School of Law, and Albert C. BeVier Research Professor of Law, University of Virginia School of Law, respectively. We are grateful for helpful comments from Robert Ellickson, John Ferejohn, Gillian Hadfield, Lewis Kornhauser, Barak Richman, George Triantis, and Abe Wickelgren, and participants of workshops at New York University Law School, Seoul National University Law School, University of Texas Law School, University of Virginia Law School, and the 2013 American Law and Economics Association Annual Meeting. Comments are welcome to [email protected] and [email protected]. Baker and Choi Formal and Informal Sanctions Version: January 27, 2014