Majoritarian vs. minoritarian defaults.

• Author: Ayres, Ian
• Position: Response to article by Barry E. Alder in this issue, p. 1547

Recent theoretical analysis of contract default roles has devoted significant attention to the use of penalty default roles as a way to induce a contractor to reveal private information. Penalty default roles demonstrate how efficient roles cannot be derived by simply asking what most parties would have contracted for had they written a complete contract. Such "majoritarian" default roles derive from an implicit assumption about the reason why a particular contract is incomplete. A fuller efficiency analysis tries to understand the reasons why contracts are incomplete and how different default roles affect the efficiency of the contracting process and the contracts themselves. Our goal here is to show how an understanding of the underlying causes of contractual incompleteness informs the optimal choice of default rules.

Barry Adler's fine article(1) correctly identifies a new reason why it may be difficult to use "penalty" or "information-forcing" defaults to induce contractors to reveal private information about their personal attributes (what game-theorists tend to call their "type"). In an earlier article,(2) we had shown that, when one side to a contract has private information and the other side has market power, the privately informed party may be reluctant to contract around a penalty default (and thereby reveal information) if doing so would allow the other side to extract more of the gains from trade.(3) But Adler has shown that even when the private information and the market power are on the same side of the contract--as when a privately informed buyer contracts in a market with competitive sellers--the privately informed party may still be reluctant to contract around a penalty default.(4) In our earlier model, the informed buyer was reluctant to contract around the penalty defaults because doing so would subject her to a supracompetitive price; in Adler's model, the informed party is reluctant to contract around penalty defaults because doing so would destroy the subsidized pricing that the privately informed party receives by hiding out in the undifferentiated pool.

Adler should be credited for identifying this additional reason why privately informed parties may be reluctant to contract around default rules. But showing that it may be harder to induce information revelation with a particular type of penalty default is not an argument in favor of setting "hypothetical" or "majoritarian" defaults. Efficiency gap filling should grow out of one's substantive theory of why particular contracts are incomplete. Adler's insight actually strengthens an implication of our earlier articles: The effect of a particular default rule on information revelation, and thus on efficiency, depends on numerous characteristics of the contracting environment that are independent of the "hypothetical contracting" inquiry--that is, merely assessing what the parties would have contracted for if there were no private information. Other factors, including the distribution of types, the magnitude of transaction costs, and the distribution of bargaining power, will all affect the likelihood that a particular penalty default will induce separation and enhance efficiency. Adler adds another factor to this list--the possibility that revealing information might eliminate an informed party's subsidy from pooling. Even these results underestimate the problem of predicting outcomes since they were derived in overly simplistic and unrealistic models of contract negotiations whose purpose was merely to show the possibility that penalty defaults could be efficient.

Majoritarian theories of default choice are implicitly derived from a transaction cost based theory of incomplete contracts. But when contracts are strategically incomplete because of one side's private information, then there is no reason to think that majoritarian or hypothetical default setting will conduce to efficiency. When transaction costs are low and contracts are incomplete because of private information, the potential welfare losses from choosing an inefficient default are largely independent of transaction costs and, as we have previously shown, can dwarf the mere out-of-pocket costs of contracting around.(5)

The normative implication of Adler's analysis is not that policymakers should reflexively retreat to majoritarian defaults, but instead the message is that "life is hard." When contracts are incomplete because of a contractor's private information about her "type," it will be difficult for efficiency-minded lawmakers to identify the efficient default.(6) Penalty defaults at times will still be efficient,(7) but Adler shows there is a narrower range of circumstances where information-forcing rules will produce efficient separation making it difficult for lawmakers to determine when they will be effective.

Adler's analysis, however, is only about one type of minoritarian rule--a penalty default set to cause information about contractor's type.(8) In this comment, we develop a simple model that identifies four other rationales for minoritarian rules based on

(1) different private costs of contracting around,

(2) different private costs of failing to contract around,

(3) different public costs of filling gaps, and

(4) ignorance of the law.

The choice of an efficient default does not boil down merely to a choice between the majoritarian rule (for which most contractors would have contracted) and a penalty default designed to induce a contractor to reveal information about her type. Instead, efficiency-minded lawmakers will often need to consider the other four factors to decide whether it is more efficient to choose a default that only a minority values.

In our original article,(9) we intended to use the possibility of penalty defaults as a particularly vivid example of why the efficiency-maximizing law might at times diverge from majoritarian gapfilling. We were not the first to see that certain defaults--the Hadley default in particular--could induce contracting that revealed information,(10) but we were the first to see that penalty defaults were inconsistent with the then dominant theory of choosing gapfillers that minimized the need of private parties to contract around.(11) Information-forcing defaults try to induce explicit contracting that might have been avoided with the use of alternative defaults. But there are other rationales besides "information forcing" that might justify setting nonmajoritarian gapfillers.

1. RATIONALES FOR MINORITARIAN RULES

   In an earlier article, we sketched a simple model of default choice.(12) In this section, we extend the model to show not only when majoritarian rules will be efficient, but also to show a variety of reasons why minoritarian rules might be superior.(13) Imagine that a policymaker is choosing between two different defaults: "one" and "two." Imagine that for i equal to 1 or 2:

   [[Alpha].sub.i] = the percentage of the population of contracting parties that, in a world without private information, would prefer to use default i; [[Beta].sub.i] = the percentage of type i contracting parties who, in equilibrium, would expressly contract for rule i if the other rule were the default; [c.sub.i] = the private costs of expressly "contracting" for rule i; [f.sub.i] = the inefficiency generated if a type i contracting party "fails" to expressly contract for rule i when the other rule is the default;(14) [e.sub.i] = the expected "externalized" public cost of filling the gap for a type i contracting party who fails to expressly contract around default rule i.(15) These five variables can be used to assess the private and public cost of particular defaults. For example, the costs associated with default one will be:

   (1) [c.sub.2][[Beta].sub.2] + [f.sub.2]([[Alpha].sub.2] - [[Beta].sub.2] + [e.sub.1](1 - [[Beta].sub.2]).

   A corresponding expression exists for the costs associated with default two.(16) This expression captures the private costs of contracting ([c.sub.2] [[Beta].sub.2]), the private costs of failing to contract ([f.sub.2]([[Alpha].sub.2] - [[Beta].sub.2])), and the public costs of filling gaps ([e.sub.1](1 - [[Beta].sub.2])). One could imagine more complicated models where there were also public costs of interpreting express contracts, or where some type i contractors would expressly contract for i even when the default rule was i, but these assumptions are sufficient to generate a wide variety of minoritarian rationales.(17) In this simpler model, efficiency-minded lawmakers would choose the default that produced the lowest expected social costs. Comparing the expression in (1) to the corresponding expression for the costs of default two, it is possible to deduce that default one will only be efficient if:

   (2) [[Alpha].sub.1][is greater than] [f.sub.2] + [e.sub.1] (1 - [[Beta].sub.2]) - [e.sub.2](1 - [e.sub.1]) + [[Beta].sub.2]([c.sub.2] - [f.sub.2]) - [[Beta].sub.1]([c.sub.1] - [f.sub.1]) / [f.sub.1] + [f.sub.2].

   The complexity of the right-hand side sharply distinguishes this model from naive majoritarianism which would suggest that rule one is the efficient default if [[Alpha].sub.1] [is greater than] .5. However, in a world without private information, even this relatively complex model will often simplify to something much closer to a majoritarian analysis. Without private information, this model predicts extreme equilibria where either all or none of the disfavored type would contract around the governing default. For example, if rule one were the default, type two contractors would all contract expressly for rule two when [c.sub.2] [is less than][f.sub.2]--so that in equilibrium [[Beta].sub.2] = [[Alpha].sub.2]. Or in the alternative, when [c.sub.2] [is greater than][f.sub.2], the model would predict that none of the type two contractors would contract around so that [[Beta].sub.2] = 0. Majoritarianism can fare well at either extreme. When [[Beta].sub.i] = [[Alpha].sub.i], then simplifying...