Embedding Costly Litigation into Repeat Interactions

The paper analyzes the optimal incentive system when relational sanctions can be supplemented with legal sanctions. A firm sells a good to a sequence of consumers where the firm’s unobservable effort affects the good’s quality. To solve the moral hazard problem, the firm can promise to pay damages (warranty) to consumers, consumers can impose relational sanctions, or both. Both types of sanctions are costly, but legal sanctions have an advantage over relational sanctions. Raising damages creates both marginal (additional lawsuits) and infra-marginal (bigger recovery to existing lawsuits) effects, but increasing relational sanctions lacks the infra-marginal effect. Various extensions, such as litigation’s informational role, a comparison between warranties and damages, the interaction with one long-term buyer, and non-boycott punishment mechanisms (more generous damages or price drop), are also analyzed.