The Market for Legal Lemons
Abstract: This paper develops a theory of contracts where agents can legally commit their principals. In contrast with standard models, adverse selection arises even if the quality of the goods being exchanged is observable and verifiable. The reason is that a third party who contracts with the agent may be uninformed about the legal authority the agent has been granted by the principal and hence on the extent to which the agent’s acts commit the principal. Private ordering solutions to this “legal lemons” problem, such as voluntary disclosure of information by the principal, and certification of the agent’s authority by a professional, fail to achieve the first best. In a variety of circumstances, public ordering solutions, such as restrictions on the choice of the certifying professional, and the public registration of contracts, may be efficient. Our model explains numerous empirical regularities in both corporate and property law, including rules protecting good-faith third acquirers.
