Contract Enforcement, Litigation, and Economic Development Baptiste Massenot∗ August 2011

Abstract This paper studies the economic consequences of litigation. Investors use litigation to enforce their financial contracts with entrepreneurs. A contest ensues in which both agents hire lawyers to increase their probability of winning the trial. The issue and the cost of the contest determine how much investors are willing to lend. More lawyers are hired if judicial efficiency is lower or damages are higher. Higher judicial efficiency and tighter restrictions on the supply of lawyers benefit the economy, while the impact of higher damages is ambiguous.

1

Introduction

An important precondition for economic growth is the allocation of resources to productive rather than to redistributive or rent-seeking activities. To support this claim, Magee et al. (1989) and Murphy et al. (1991) use the number of lawyers as a proxy for the size of the rent-seeking sector and document negative correlations between the number of lawyers and economic growth. At the core of these studies is the belief that litigation is Toulouse School of Economics; [email protected]. I am grateful to Stefanie Brilon, Chiara Canta, Catherine Casamatta, Carmine Guerriero, Mark Le Quement, Florencio L´opez de Silanes, Ernesto Past´en, Franck Portier, Gilles Saint-Paul, St´ephane Straub, David Thesmar, seminar participants at the Amsterdam Center for Law and Economics, the HEC Lausanne, the Toulouse School of Economics, and the University of Bonn for many helpful discussions. ∗

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primarily an instrument to redistribute wealth from one party to another. A popular explanation to account for both this fact and this belief is that lawyers are intrinsically bad people. This may be reasonable as, according to Galanter (1993), lawyers are portrayed by their critics as “corrupters of discourse, fomenters of strife, betrayers of trust, and economic predators”. Although frivolous litigation exists and the ethical behavior of some lawyers is probably not beyond reproach, it is difficult to imagine how enforcement by courts would function without lawyers. In a world regulated by scores of rules, it is natural to have some individuals specializing in learning these rules. Then, those other individuals focusing on production can count on lawyers to advise them on a proper course of action to follow or to be defended in court. This specialization should benefit the economy because it both improves the quality of enforcement and frees up time for producers. This leaves us with the following puzzle: Why are lawyers thought to harm economic growth whereas their purpose is to improve the allocation of resources? The paper develops a theory that answers this question and as a side benefit also provides predictions on the economic consequences of litigation. More specifically, I consider an investor who has to decide how much capital to lend to an entrepreneur and who faces the risk of not being repaid. In case no repayment occurs, the investor can ask for compensatory damages in court. The ensuing litigation process is modeled like a contest in which the lawyers hired by the litigants compete with each other by trying to present the most convincing case. First, the model predicts that the demand for lawyers increases with the level of damages and decreases with judicial efficiency. Intuitively, higher damages increase the stakes of the contest and thus increase the resources spent on the contest. Higher judicial efficiency by contrast is equivalent to a more competent referee. This latter makes it less profitable for the party in the wrong to spend resources in the contest. The other party also responds by spending less as he now expects to fight a less aggressive opponent. Massenot (2011) finds some empirical support for this prediction. The entrepreneur and the investor form expectations on the issue of a possible contest when they sign the financial contract. The investor is willing to lend more if the quality of contract enforcement (the probability 2

of convicting guilty entrepreneurs) is higher and if the cost of enforcement (total spending on lawyers) is lower. Then, higher judicial efficiency increases finance because it both increases the quality and decreases the cost of enforcement. Higher damages, by contrast, increase both the quality and the cost of enforcement and thus have an ambiguous impact on finance. A high demand for lawyers can have general equilibrium effects on production through the labor market by reducing the supply of other workers like, for example, engineers. The litigation environment thus affects economic development through two channels. First, through finance, that has a positive impact on investment and thus on production. Second, through the number of lawyers, that affects the cost for the final-good sector of hiring engineers. In the model, higher judicial efficiency unambiguously benefits the economy because it decreases the cost engineers – through a lower demand for lawyers – and increases finance. Higher damages increase the cost of engineers and have an ambiguous impact on finance. Then, the overall impact of higher damages on economic development is still ambiguous. Should the supply of lawyers be limited? In some countries, law departments have only recently been introduced in universities or the bar exam can be made more restrictive. Tighter restrictions on the supply of lawyers increase the wage of lawyers but, as less lawyers are hired, the effect on the total cost of litigation is nil in this simple model. Restricting the number of lawyers also reduces the cost of engineers. The overall effect of a lower cap on the supply of lawyers on the economy is thus predicted to be positive. We can now come back to our initial puzzle. Is the model consistent with a negative correlation between the number of lawyers and economic growth? The answer is yes if the large number of lawyers results from low judicial efficiency or from a large supply of lawyers. The answer is less clear if a large number of lawyers primarily signals high damages awarded by courts. Importantly, the model generates this negative correlation without assuming anything specific about lawyers, besides the fact that they use a technology that works like a contest. To build the model, I use a standard model of financial contracting with costly state verification (Gale and Hellwig, 1985). Then, I plug a standard model of litigation (Katz, 1988) into the costly state verification technology. 3

This paper is more generally related to the theoretical literature studying the impact of judicial inefficiencies on the economy, like for example Gennaioli (forthcoming) and Massenot (forthcoming) on financial contracting and Gennaioli and Perotti (2010) on contractual codification. Sections 2 and 3 lay out the economic and legal foundations of the model. The optimal financial contract is solved in Section 4. The economic consequences of litigation are analyzed in Section 5. Section 6 shows how the economy responds to tighter restrictions on the supply of lawyers. 7 concludes.

2

The Economic Environment

Consider a one-period economy with two goods, capital k and final good y, and three types of individuals, workers, entrepreneurs, and investors. Capital is used to produce the final good and can be stored. The final good is used as numeraire or for consumption. Workers are endowed with one unit of labor which they supply inelastically either as lawyers or as engineers. Investors use their capital endowment to finance entrepreneurs. Each type of individuals is a continuum of size 1 and is risk neutral. Entrepreneurs make use of the following final-good production technology: y = F (k, ly ) = a ˜k α ly1−α , (1) where ly are engineers and a ˜ is a random productivity parameter that can be high (˜ a = a) with probability π or low (˜ a = 0) with probability 1 − π. Engineers are hired after productivity is realized. The cost of hiring engineers is given by the cost function: C(ly ) = wα ly .

(2)

The peculiar form of this cost function is motivated by tractability and will make it easier to solve for the equilibrium wage. Entrepreneurs are cashless and borrow capital k from investors. The ensuing contract specifies a return r to be repaid if the project is successful while nothing can be repaid if the project fails. The realization of productivity becomes common knowledge once the 4

capital has been installed. The problem is that although there is common knowledge on the true state of the world courts require hard evidence to enforce the contract. The entrepreneur may thus want to claim his project failed when it actually succeeded. To solve this conflict of interest, the investor and the entrepreneur can resort to litigation. They then hire lawyers whose job is to collect hard evidence on the realization of productivity and to present it in court. This litigation process is described in more detail in Section 3.

2.1

The Demand for Engineers

Productive entrepreneurs choose the number of engineers that maximizes their expected profit for a given financial contract and for a given wage: (3) max aF (k, ly ) − C(ly ), ly

The first-order condition gives us a standard demand function for engineers decreasing in the price: ly =

Ak , w

(4)

where A = ((1 − α)a)1/α . Once plugged into the production function of the entrepreneur, this gives: y = φ(w)k, (5)
1−α . A higher wage decreases the demand for engineers where φ(w) = A w and production.

3

The Litigation Environment

The purpose of the legal system is to induce entrepreneurs to repay investors. It relies on courts in which parties and their lawyers can present arguments to convince a judge of what the true state of the world is. If convicted, the entrepreneur has to pay damages d to compensate the investor. 5

Consider the following scenario. An entrepreneur claims that his project failed while it did not. The investor knows the entrepreneur is lying and decides to sue him to produce hard evidence on his productivity. Then, both parties hire lawyers who produce arguments according to the following production functions: I = ln(li )

(6)

E = ln(le ),

(7)

where le is the number of lawyers hired by the entrepreneur, li the number of lawyers hired by the investor, I the number of arguments in favor of the investor, E the number of arguments in favor of the entrepreneur. The number of arguments produced increases with the number of lawyers hired and each additional lawyer produces fewer arguments. Finally, I assume that innocent entrepreneurs are never convicted so that it is never in the interest of investors to start a suit against them. Lawyers present these arguments to a judge, who himself produces J > 0 arguments in favor of the case of the investor. The parameter J can be interpreted either as the evidence collected by the judge in civil law countries, the merits of the case, or the competence of the judge. The entrepreneur is convicted if the number of arguments in his favor is less than the number of arguments against him plus some error term, that is, if and only if: I + J > E + Su, (8) where u is an error term that follows a logistic distribution the variance of which is proportional to S. The parameter S may be interpreted as the scrutiny in looking at the evidence, the complexity of interpreting the arguments, or the competence of the judge in weighing each argument. Finally, the probability of conviction can be found by plugging Equation (8) into the cumulative distribution function of the logistic distribution eu : 1+eu jli (9) X= jli + le with j = eJ/S ≥ 1. The parameter j can be interpreted as a general quality of the legal system or judicial efficiency. 6

The probability of conviction X has the following desirable properties: it increases with judicial efficiency j, increases with the number of lawyers li hired by the investor, and decreases with the number of lawyers le hired by the entrepreneur. To ensure the presence of litigation in equilibrium, I further assume that a proportion p of entrepreneurs are optimistic and anticipate a zero probability of being caught even though they are guilty. The remaining 1 − p are rational and anticipate the correct probability of being convicted. Note that the introduction of divergent expectations on the outcome of a trial is a standard trick used in the litigation literature to ensure the presence of litigation in equilibrium (Spier, 2007). The purpose of this assumption should become clearer once I solve the financial contract. Furthermore, I assume that entrepreneurs learn whether they are optimistic or rational only after they hired lawyers. This assumption is not crucial but it simplifies the presentation of the results by making the equilibrium symmetric.

3.1

Timing

For future reference, this section recalls the timing of events: 1. The financial contract is signed. 2. Productivity is realized. 3. Lawyers and engineers are hired. 4. Entrepreneurs learn whether they are optimistic or rational. 5. Entrepreneurs announce their productivity. 6. If the entrepreneur is lying, litigation ensues and hard evidence is produced. 7. The judge decides whether to convict the entrepreneur. As a consequence, the choice of the financial contract is made in anticipation of the numbers of lawyers and engineers hired. By contrast, these hiring decisions are made for a given financial contract. 7

le

6 leR

liR - li

Figure 1: Reaction curves

3.2

The Demand for Lawyers

Investors and entrepreneurs choose the number of lawyers that maximizes their expected payoff from litigation for a given wage and for a given number of lawyers hired by their opponent: max li

max le

pXd − wli ,

(10)

−pXd − wle .

(11)

The first-order conditions of this maximization program give the reaction functions: √ wpjdle − wle R li (le ) = . (12) wj √ wpjdli − wjli R . (13) le (li ) = w They give the number of lawyers that maximizes the utility of each litigant as a function of the number of lawyers hired by the other litigant. Figure 1 represents these reaction functions. They are first increasing in the number of lawyers hired by the opponent and then decreasing. In anticipation of a small number of lawyers, the optimal response is to respond aggressively by hiring more lawyers. This is true until some point where parties start playing more defensively. The intersections of these two curves are the possible solutions of this game. There are two solutions, first a corner solution where entrepreneurs 8

and investors do not hire any lawyers and a second solution where they both hire a positive number of lawyers. The corner solution is not defined because of the functional form of the production functions of arguments. This is consistent with a setting where, for example, legal representation in court is mandatory. Then, the demands for lawyers are given by the following symmetric solution: le (w) = li (w) =

pdj w(j + 1)2

(14)

The following result holds: Result 1 The demand for lawyers decreases with judicial efficiency j, decreases with the wage w, and increases with damages d. If judicial efficiency increases, both parties become less aggressive because they expect the judge to be more likely to find out the truth. Massenot (2011) finds some empirical support for this prediction. If the wage of lawyers increases, it becomes more costly to litigate and parties respond by hiring fewer lawyers. If damages increase, both litigants want to hire more lawyers because the stakes of the trial become higher. Replacing the expression for the demand for lawyers into the probability of conviction gives the equilibrium probability of conviction: X∗ =

j j+1

(15)

This probability of conviction increases with judicial efficiency because the judge produces more arguments against the entrepreneur. By contrast, the probability of conviction does not depend on damages or on the wage. This is because of the symmetric solution which leaves the relative quality of the cases unchanged for any damages or wage.

4

The Financial Contract

Investors compete with each other by offering financial contracts to entrepreneurs. These contracts are defined by a size of the loan k and an interest rate r. Entrepreneurs shop around and choose the contract that 9

maximizes their utility. In doing so, they are restricted by the following two constraints. First, rational entrepreneurs prefer to go to court if the expected damages X ∗ d are greater than the repayment rk. This constrains the maximum repayment that can be asked to entrepreneurs. This gives the following incentive compatibility constraint:1 rk ≤ X ∗ d

(16)

Second, investors only accept to lend if they get a positive profit. The expected profit of entrepreneurs is the sum of the repayment rk from successful and rational entrepreneurs (a proportion π(1 − p) of them), of the expected compensatory damages X ∗ d received from successful and optimistic entrepreneurs (the remaining proportion πp) minus their expected cost of litigation πwli (w) and their opportunity cost of lending that is equal to the return from storing k. This boils down to the following zero-profit condition: π(1 − p)rk + πpX ∗ d − πwli (w) − k ≥ 0. (17) It can be shown that Equations (16) and (17) are binding. Combining these two equations gives the optimal financial contract: k = πX ∗ d − πpwli (w)

(18)

X ∗d πX ∗ d − πwli (w)

(19)

r=

Equation (18) shows that the legal environment affects finance through two channels. The first effect is direct. Higher judicial efficiency j and higher damages d increase lending because they imply a higher quality of enforcement X ∗ d. This relaxes the incentive compatibility constraint and makes the investor willing to lend more. The second effect is indirect and goes through the number of lawyers. Result 1 tells us that lower judicial efficiency j and higher damages d increase the number of lawyers. A larger number of lawyers makes it more costly to enforce contracts and investors 1

It should now be clear why I impose p > 0. Because of this incentive compatibility constraint, the restriction p = 0 would imply no litigation and thus no lawyers.

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respond by lending less. Finally, the overall effect of higher judicial efficiency on lending is positive because it both increases the quality and decreases the cost of enforcement. By contrast, the impact of higher damages on lending is ambiguous because they increase both the quality and the cost of enforcement. We now replace the demand for lawyers by their analytical solutions given by Equation (14). The financial contract becomes: k∗ =

πdj(1 + j − p) (j + 1)2

(20)

1+j π(1 + j − p)

(21)

r∗ =

Then the following result holds:

Result 2 Higher judicial efficiency j and higher damages d have a positive impact on capital k. This result confirms the earlier intuition that higher judicial efficiency unambiguously increases finance. By contrast, the model predicts a positive effect of damages on lending. This latter result should be taken with caution as it is the sum of two contradictory effects and depends heavily on the model specification. Finally, lending is independent of the wage paid to lawyers. This is because although a higher wage makes enforcement more costly and thus discourages lending, it also reduces the demand for lawyers in such a way that the overall cost of enforcement is unaffected.

5

Economic Development

We finally close the model with a discussion of the economic consequences of litigation. The litigation environment affects economic development through two channels: First, through lending, which affects the stock of capital used in production. Second, through the demand for lawyers, which affects the equilibrium wage and thus the cost of hiring engineers. The equilibrium wage is given by the labor market clearing condition: π(ly (w) + le (w) + li (w)) = 1. 11

(22)

Replacing the demands for engineers and lawyers from Equations (4) and (14) into Equation (22) gives the equilibrium wage: w∗ = 2B + πAk ∗ ,

(23)

πpdj where B = (1+j) 2 is a constant. Higher judicial efficiency j or lower damages d increase the parameter B and k ∗ and thus the equilibrium wage w∗ . These effects come from the higher pressure on the labor market caused by the larger demands for lawyers and for engineers. From Equation 5, the equilibrium production is given by y ∗ = φ(w∗ )k ∗ . We get the following result:

Result 3 Higher judicial efficiency j and higher damages d have a positive impact on economic development y ∗ . According to Equation (5), production decreases with the equilibrium wage (because φ′ < 0) and with capital. Then, higher judicial efficiency increases production through both channels. By contrast, higher damages both increase the capital and the wage, and thus have an ambiguous impact on production. Although the model predicts an overall positive effect, this result should be taken with caution as it depends heavily on the functional forms of the model.

6

Limited Supply of Lawyers

In some countries, the supply of lawyers is limited. For example, law departments were inexistent in Japanese universities until recently or admission rates to the bar exam may be lowered. This section studies the consequences of limiting the supply of lawyers on the economy. The overall effect is not obvious. First, a smaller number of lawyers should be beneficial because it reduces the cost of enforcement. Second, the labor market reacts to this limited supply of lawyers by increasing the wage of lawyers and decreasing the wage of engineers. The former effect harms production because it increases the cost of enforcement while the second effect is beneficial because it allows entrepreneurs to hire more engineers. 12

Constrain the supply of lawyers by an upper bound ¯l. If ¯l ≥ le (w)+li (w), the capacity constraint on lawyers does not bind and we are back to the equilibrium previously described. Then, a small increase in the capacity constraint on lawyers ¯l has no impact on production. If ¯l < le (w) + li (w), the equilibrium is affected and a wedge between the wages of engineers and lawyers appears. Let wy be the wage of engineers and wl the wage of lawyers. The supply of engineers is now 1 − ¯l. The demand for engineers is given by Equation (4). The equilibrium wage of engineers is then given by: 1 − ¯l wy∗ = (24) Ak The supply of lawyers is ¯l. The demands for lawyers are given by Equation (14). The equilibrium wage of lawyers is given by: 2B wl∗ = ¯ . l

(25)

Equilibrium production is now given by y ∗ = φ(wy∗ )k ∗ . Then, the following result holds: Result 4 A smaller supply of lawyers (a lower ¯l) has a positive impact on economic development y. A smaller supply of lawyers decreases the wage of engineers and increases the one of lawyers. Cheaper engineers increase production (because φ′ < 0). By contrast, from Equation 20, the price of lawyers does not affect the stock of capital and thus production.

7

Discussion

This paper studies the economic consequences of litigation in the context of financial contracting and develops a model that makes it possible to derive predictions on the effect of various characteristics of the legal system on the number of lawyers, on financial and economic development. In line with the literature, the paper points out the beneficial effect of judicial efficiency on economic development. By modeling explicitely litigation, it further predicts an ambiguous economic impact of higher damages and of 13

a tighter supply of lawyers, that increase both the cost and the quality of enforcement. Note that the model is kept deliberately stylized to emphasize the main forces at work. Future research should aim to assess the quantitative importance of these forces. The paper also contributes to the debate on the economic impact of lawyers. It predicts a negative correlation between the number of lawyers and economic development if a high number of lawyers is generated by low judicial efficiency or to a lesser extent by high damages or by a large supply of lawyers. These results do not rely on assumptions about the ethics of lawyers or the rent-seeking dimension of litigation but instead on modeling litigation like a contest. Finally, finance is not the only channel through which litigation affects the economy. Other channels could be worth considering in future research, for example, the effects of patent litigation on innovation or of property litigation on investment.

References Galanter, M., “Predators and Parasites: Lawyer-Bashing and Civil Justice,” Georgia Law Review, 1993, 28, 633. Gale, D. and M. Hellwig, “Incentive-Compatible Debt Contracts: The One-Period Problem,” The Review of Economic Studies, 1985, pp. 647– 663. Gennaioli, N., “Optimal Contracts with Enforcement Risk,” Journal of the European Economic Association, forthcoming. and E. Perotti, “Standardized Enforcement: Access to Justice vs Contractual Innovation,” Working paper, 2010. Katz, A., “Judicial Decisionmaking and Litigation Expenditure,” International Review of Law and Economics, 1988, 8 (2), 127–143. Magee, S.P., W.A. Brock, and L. Young, Black Hole Tariffs and Endogenous Policy Theory: Political Economy in General Equilibrium, Cambridge University Press, 1989. 14

Massenot, B., “Why do some countries have so many lawyers than others?,” Working paper, 2011. , “Financial Development in Adversarial and Inquisitorial Legal Systems,” Journal of Comparative Economics, forthcoming. Murphy, K.M., A. Shleifer, and R.W. Vishny, “The Allocation of Talent: Implications for Growth,” The Quarterly Journal of Economics, 1991, 106 (2), 503–530. Spier, K.E., “Litigation,” Handbook of Law and Economics, 2007, 1, 259– 342.

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