Berkeley Program in Law and Economics

The concept of “contract” has similar but not identical interpretations for lawyers and economists. Both Economic and Legal theories distinguish transactions from contracts based on the possibility to rely on court enforcement. Formal and informal promises are enforceable by courts, however there is not a clear distinction between a contract and an agreement since agents do not know a priori the competence of courts to interpret and enforce promises. The measurement branch of transaction cost economics proposes that economic actors are motivated to protect legal and economic rights, adopting reputation mechanisms when they foresee that courts face measurement difficulties to allocate property rights in case of disputes on a specific transaction dimension. Otherwise an external contract is expected to be chosen. The present paper introduces the effect of capabilities that affect the ability to adjudicate. This concept adds to the measurement cost theory as it stands, being part of the theoretical construct of shifters that affect the choice between formal contracts and informal agreements. Two concepts are introduced in this paper: measurement competence of contract parties and competence of courts to adjudicate. The paper introduces dynamic effects in the measurement cost theory since competences are cumulative, knowledge is dispersed and courts develop routines to organize the knowledge. As a result, the paper closes a gap between the measurement branch of transaction cost theory and the capabilities perspective, opening new veins for empirical analysis.