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Chapter 13: Problem 10

Discuss a real-world example of a contractual situation with limited verifiability. How do the parties deal with this contractual imperfection?

Short Answer

Expert verified
Use milestone payments and clear criteria to manage contracts with limited verifiability.

Step by step solution

01

Understanding Limited Verifiability

Limited verifiability in contracts refers to situations where it's hard to verify if the terms of the agreement are being met. A real-world example might be a service contract between a software development company and a client. The difficulty lies in assessing whether the software meets the client’s expectations since these criteria can be subjective and not fully quantifiable.
02

Identify a Real-Life Example

Consider a freelance graphic designer hired by a company to create brand logos. The company desires unique designs that capture their brand identity, which are subjective and open to interpretation. The challenge is that 'unique' or 'aligned with brand identity' can't be easily measured or verified.
03

Contractual Strategies to Manage Limited Verifiability

To manage such situations, parties often use mechanisms like milestone payments. For our example, the designer and the company might agree on payments after key phases (initial draft, final design approval) to ensure compliance. Additionally, clear, shared criteria and feedback loops help ensure both parties agree on whether the work meets the contract terms.
04

Discuss the Resolution Process

In scenarios with disputes due to limited verifiability, often a third-party arbitrator or mediator may be involved. This neutral party assesses whether the contract's subjective aspects have been met, guided by any predefined criteria or standards outlined in the contract.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Limited Verifiability
In the realm of contract law, limited verifiability occurs when it is challenging to confirm if the terms of a contract are being fulfilled. This often arises in agreements involving subjective metrics or qualitative deliverables. For instance, consider a service contract between a software development firm and its client. While the software is developed, assessing whether it meets the client's expectations can be tricky due to the subjective nature of design or functionality criteria.
For example, a software might have specific features, yet the client might feel it doesn't fully "align with strategic goals," which is hard to verify objectively. Such contracts pose a verification challenge because they rely heavily on subjective assessments or criteria that are not easily measured quantitatively, such as quality or creativity.
Contracts with limited verifiability require careful negotiation and documentation to mitigate potential disagreements.
Contractual Imperfection
Contractual imperfection refers to the inherent flaws or challenges within a contract that result from limited verifiability or other ambiguities. In situations where terms are ambiguous or not easily quantifiable, parties face the risk of disputes. Moreover, imperfect contracts may lack the precise language needed to tackle every possible outcome or challenge.
The example of a freelance graphic designer creating brand logos highlights this well. Terms like "unique design" can be interpreted differently by parties involved, leading to differing expectations and dissatisfaction.
Strategies to handle contractual imperfections include thorough discussions and precise documentation of terms at the contract's outset. Both parties benefit from clearly defined criteria and expectations, which can minimize potential disagreements. Regular feedback loops and communication also ensure that both parties remain aligned throughout the contract duration.
Milestone Payments
Milestone payments are a strategic approach to manage contracts with limited verifiability and imperfections. This payment structure involves dividing the total payment into portions payable upon reaching specific project milestones. In practice, it helps ensure alignment between parties at various stages of a project.
For example, in our graphic design case, the design process can be split into phases such as initial drafts, revisions, and final approval. Payments could be released at each stage upon mutual agreement that the necessary work has been completed satisfactorily.
This approach not only provides financial incentives for service providers but also helps clients reduce risks by ensuring they pay only for work that meets the agreed-upon criteria. Furthermore, milestone payments create opportunities for feedback and adjustments, enhancing overall project satisfaction and reducing the risk of disputes.
Dispute Resolution
Dispute resolution is a vital component in contracts, especially those characterized by limited verifiability. When issues arise, an effective dispute resolution mechanism can guide parties to a satisfactory conclusion. Common methods include mediation and arbitration, which involve neutral third parties offering judgments or facilitating discussions.
In our context, if disputes occur over the subjective interpretation of a design's "uniqueness," a mediator might evaluate the designs against the contract's criteria and provide an impartial resolution. Alternatively, arbitration can yield a binding decision based on evidence and standards agreed upon in the contract.
Ensuring that these processes are well-defined within the contract can prevent prolonged disputes and maintain a professional and cooperative relationship between the parties. Effective dispute resolution doesn't just solve disagreements; it protects business relationships and provides a clear path forward when challenges arise.

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Most popular questions from this chapter

Suppose that Shtinki Corporation operates a chemical plant, which is located on the Hudson River. Downstream from the chemical plant is a group of fisheries. The Shtinki plant emits some byproducts that pollute the river, causing harm to the fisheries. The profit Shtinki obtains from operating the chemical plant is a positive number \(X\). The harm inflicted on the fisheries due to water pollution is measured to be \(Y\) in terms of lost profits. If the Shtinki plant is shut down, then Shtinki loses \(X\) while the fisheries gain \(Y\). Suppose that the fisheries collectively sue Shtinki Corporation. It is easily verified in court that Shtinki's plant pollutes the river. However, the values \(X\) and \(Y\) cannot be verified by the court, although they are commonly known to the litigants. Suppose that the court requires the fisheries' attorney (player 1) and the Shtinki attorney (player 2 ) to play the following litigation game. Player 1 is supposed to announce a number \(y\), which the court interprets as the fisheries' claim about their profit loss \(Y\). Player 2 is to announce a number \(x\), which the court interprets as a claim about \(X\). The announcements are made simultaneously and independently. Then the court uses Posner's nuisance rule to make its decision. \({ }^{9}\) According to the rule, if \(y>x\), then Shtinki must shut down its chemical plant. If \(x \geq y\), then the court allows Shtinki to operate the plant, but the court also requires Shtinki to pay the fisheries the amount \(y\). Note that the court cannot force the attorneys to tell the truth. Assume the attorneys want to maximize the profits of their clients. (a) Represent this game in the normal form by describing the strategy spaces and payoff functions. (b) For the case in which \(X>Y\), compute the Nash equilibria of the litigation game. (c) For the case in which \(X

Consider the following two-player team production problem. Each player \(i\) chooses a level of effort \(a_{i} \geq 0\) at a personal cost of \(a_{i}^{2}\). The players select their effort levels simultaneously and independently. Efforts \(a_{1}\) and \(a_{2}\) generate revenue of \(r=4\left(a_{1}+a_{2}\right)\). There is limited verifiability in that the external enforcer (court) can verify only the revenue generated by the players, not the players' individual effort levels. Therefore, the players are limited to revenue-sharing contracts, which can be represented by two functions \(f_{1}:[0, \infty) \rightarrow[0, \infty)\) and \(f_{2}:[0, \infty) \rightarrow[0, \infty)\). For each player \(i, f_{i}(r)\) is the monetary amount given to player \(i\) when the revenue is \(r\). We require \(f_{1}(r)+f_{2}(r) \leq r\) for every \(r .\) Call a contract balanced if, for every revenue level \(r\), it is the case that \(f_{1}(r)+f_{2}(r)=r\). That is, the revenue is completely allocated between the players. A contract is unbalanced if \(f_{1}(r)+f_{2}(r)

Consider a two-player contractual setting in which the players produce as a team. In the underlying game, players 1 and 2 each select high (H) or low (L) effort. A player who selects H pays a cost of 3 ; selecting \(\mathrm{L}\) costs nothing. The players equally share the revenue that their efforts produce. If they both select \(\mathrm{H}\), then revenue is 10 . If they both select \(\mathrm{L}\), then revenue is 0 . If one of them selects \(\mathrm{H}\) and the other selects \(\mathrm{L}\), then revenue is \(x\). Thus, if both players choose \(\mathrm{H}\), then they each obtain a payoff of \(\frac{1}{2} \cdot 10-3=2\); if player 1 selects \(\mathrm{H}\) and player 2 selects \(\mathrm{L}\), then player 1 gets \(\frac{1}{2} \cdot x-3\) and player 2 gets \(\frac{1}{2} \cdot x\); and so on. Assume that \(x\) is between 0 and 10 . Suppose a contract specifies the following monetary transfers from player 2 to player \(1: \alpha\) if \((\mathrm{L}, \mathrm{H})\) is played, \(\beta\) if \((\mathrm{H}, \mathrm{L})\) is played, and \(\gamma\) if \((\mathrm{L}, \mathrm{L})\) is played. (a) Suppose that there is limited verifiability in the sense that the court can observe only the revenue \((10, x\), or 0\()\) of the team, rather than the players' individual effort levels. How does this constrain \(\alpha, \beta\), and \(\gamma\) ? (b) What must be true about \(x\) to guarantee that \((\mathrm{H}, \mathrm{H})\) can be achieved with limited verifiability?

Which remedy is more likely to achieve efficiency: expectation damages or restitution damages? Explain.

Consider a contractual setting in which the technology of the relationship is given by the following underlying game: Suppose an external enforcer will compel transfer \(\alpha\) from player 2 to player 1 if (N, I) is played, transfer \(\beta\) from player 2 to player 1 if (I, N) is played, and transfer \(\gamma\) from player 2 to player 1 if \((\mathrm{N}, \mathrm{N})\) is played. The players wish to support the investment outcome (I, I). (a) Suppose there is limited verifiability, so that \(\alpha=\beta=\gamma\) is required. Assume that this number is set by the players' contract. Write the matrix representing the induced game and determine whether (I, I) can be enforced. Explain your answer. (b) Suppose there is full verifiability, but that \(\alpha, \beta\), and \(\gamma\) represent reliance damages imposed by the court. Write the matrix representing the induced game and determine whether (I, I) can be enforced. Explain your answer.
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