Bargaining Power and Contract Design

Over the past 40 years, an irrelevance proposition has been embraced implicitly in law-andeconomics scholarship: bargaining power should affect only price and not non-price terms of a contract. This proposition is based on unstated assumptions that contracting is affected by neither transaction costs nor asymmetrical information and that the parties are risk neutral. In contrast, practitioners and commentators in industry regularly invoke bargaining power to explain static and dynamic patterns in non-price contract terms. The assumptions of the bargaining power irrelevance proposition, therefore, need to be unpacked and analyzed to bridge the gap between theory and the real world. In the first half of the paper, we identify and discuss a variety of explanations for the effect of bargaining power on contract design, under conditions of information asymmetry and positive transaction costs. These include the effects of shifts in market supply and demand and the effect of bargaining through lawyers. In the second half of the paper, we present an in-depth examination of one set of explanations, concerning the impact of bargaining power on screening and signaling incentives, when the value and cost of these terms vary across contracting parties, and when such values are private information. In the extreme cases in which one or the other party enjoys overwhelming bargaining power, the efforts of that party to capture a larger share of the surplus by screening or signaling may compromise the efficiency of the non-price terms. We show that this incentive disappears or is mitigated when bargaining power is more evenly shared between the parties: for example, when a monopolist faces the threat of a future entrant, when the parties can renegotiate, or when they are engaged in bilateral bargaining with even bargaining power. As a whole, the paper provides a theoretical basis for interpreting the intuition among market participants that the impact of bargaining power extends beyond price terms. Before concluding, we briefly suggest implications for legal policy, particularly the contract law doctrine of unconscionability. * Professor of Law, University of Virginia, and Professor of Law, Stanford University, respectively. The authors thank Isaac Belfer (Harvard Law 2011) and Neal Sangal (Stanford Law 2014) for their valuable research assistance. They are also grateful for helpful comments from [...] and participants at law school workshops at Harvard, Texas, Virginia, and Washington University. Triantis thanks the John M. Olin Center for Law, Economics, and Business at Harvard for financial support. Comments are welcome to [email protected] and [email protected]. Choi and Triantis Bargaining Power and Contract Design Version: February 24, 2012 Page 2 of 57