Verifiability and contract enforcement: a model with judicial moral hazard

Abstract

I model the litigation of a contract containing a variable not observable by courts, hence nonverifiable, unless the rational and self-interested judge exerts effort. He values the correct ruling but dislikes effort. Judicial effort is discretionary. I show that effort cost is inconsequential-"always breach" is equilibrium for any effort cost. But there exists another equilibrium where a small breach rate is achieved even with significant effort costs. Maximal remedies for breach are not optimal. Because effort is discretionary, low effort cost increases breach. Pretrial negotiations can have a substantial negative impact on verifiability under arbitrarily small deviations from full rationality.