A Theory of Informal Justice∗

This paper develops a positive model of informal justice in which rewards and punishments are not determined by an ex ante optimal contract but instead express the ex post moral sentiments of the arbitrating party. In our model, a third party arbitrator mediates a one-shot relationship between two players, one of whom can exert an externality on the other. Importantly, formal contracts are not available and the arbitrator chooses transfers to maximize her ex post social preferences. We characterize the implicit incentive schemes induced by the arbitrator’s preferences, contrast them with ex ante optimal contracts, and identify novel qualitative predictions about the way externalities are internalized in informal settings.