Contracts in the Shadow of the Law:Optimal Litigation Strategies within Organizations

Abstract

A principal can bring litigation against an agent for overstating the realized production costs. The lawsuit functions much like an audit; the principal’s ability to bring suit against_x000D_ the agent can reduce the information rent and increase production efficiency by penalizing_x000D_ the agent misreporting costs. The principal benefits from higher trial awards depending on_x000D_ the ability of the principal to commit to a litigation strategy comprised of a frequency of_x000D_ and expenditure in litigation. While higher awards increase the agent’s expected_x000D_ punishment for shirking, they also encourage excessive litigation expenditures by both_x000D_ parties ex post. When the principal can pre-commit to a probability of bringing suit, for_x000D_ large stakes in trial, the principal reduces the probability to maintain a constant expected_x000D_ punishment. Alternatively, if the principal were able to commit ex ante to a probability and_x000D_ intensity of litigation, even when stakes are large, the principal would litigate with certainty_x000D_ but reduce litigation intensity below what is ex post rational.