Authors: Benito Arruñada and Marco Casari

Journal of Economic Behavior & Organization, Vol. 129, 142-156, September, 2016

Contract enforcement does not only affect single transactions but the market as a whole. We compare alternative institutions that allocate enforcement rights to the different parties to a credit transaction: either lenders, borrowers, or judges. Despite all parties having incentives to enforce and transact, the market flourishes or disappears depending on the treatment: paying judges according to lenders’ votes maximizes total surplus and equity; and a similar result appears when judges are paid according to average earnings in society. In contrast, paying judges according to borrowers’ votes generates the poorest and most unequal society. These results suggest that parties playing the role of borrowers understand poorly the systemic consequences of their decisions, triggering under-enforcement, and hence wasting profitable trade opportunities.

This paper originally appeared as Barcelona GSE Working Paper 913