Pii: S0144-8188(00)00048-x

The efficiency of legal restrictions on private contracts has been analyzed by Aghion and Hermalin (1990). In their model of asymmetric information the authors assume that the informed party has only one signal. The analysis refers to a contract between an uninformed investor and an entrepreneur who needs to raise a capital to fund his project. The entrepreneur can be one of two types, who differ regarding the probability that their project fails: the investor would offer the fund at better terms if the entrepreneur is the one whose project is more likely to succeed, but he cannot distinguish between the two types. The contract is described by two variables (PF, PS), with PF being the price paid in case of failure and PS the price paid if the project succeeds. Since the good type entrepreneur has a higher probability to complete successfully the project, he would be willing to pay more in case of failure: thus PF can be used as a signal. What makes the free contracting inefficient is the bargaining power of the informed party, that is, the entrepreneur, who is supposed to draft and offer the contract. In fact, if the entrepreneur offers the contract and gets the whole surplus, the bad type will not internalize the cost of signaling, whereas if the investor offers contracts and gets the surplus, then he will completely internalize the cost of screening the two entrepreneurs and efficiency is maximized. Thus, with the aim to study if legal restrictions can enhance efficiency in absence of externalities, Aghion and Hermalin concentrate the analysis on the signaling situation, where the informed party with bargaining power offers the contract and the uninformed party can either accept or leave it.