Writing Legally Unenforceable Contracts to Facilitate Relationships

Hideshi Itoh (Hitotsubashi University)

Abstract: Transacting parties sometimes write contracts that are unenforceable in courts. Why do they write such contracts despite of ``ink costs''? To answer this question, I analyze contractual relationships in context in the sense that there is a large population of principals and agents, a principal and an agent are randomly matched and engage in transaction, and at the end of each period, they can choose to continue or terminate the current partnership. I adopt an extreme assumption that written contracts are never legally enforced. I then show that writing a contract can help relational contracting between principals and agents more enforceable than relying on tacit understanding of their agreement for three reasons: (i) ink costs of writing a contract make a new match more costly and hence continuing the current match more valuable; (ii) the existence of a written document, with signatures of a principal and an agent, helps parties in the matching pool to identify (some of) those who reneged in the previous transaction; and (iii) the existence of a written document can raise motivation to engage in prosocial behavior (e.g., go to court to punish reneging parties), and hence increasing the probability that the matching pool learns about past transaction.