Path Dependence, Information, and Contracting in Business Law and Economics

One of the central research problems in the law and economics of contracts concerns the incomplete contract paradigm, which focuses on the role of transaction costs and information in contracting and their implications for business. In legal scholarship, the incomplete contracting paradigm has given rise to an extensive literature addressing how parties trade off the costs of drafting provisions ex ante versus the costs of disputes ex post. Although focusing on transaction costs, this literature on incomplete contracts and contract design tends to abstract away from the process of how the legal terms of contracts themselves are created, treating the contracting process itself as a black box. This Essay explores the mechanisms of incomplete contracts, building on the more recent literature that explicitly takes into account the contracting process. The key contribution involves showing how the institutional details of contract drafting can explain not just the terms of individual contracts, but also persistent patterns of the industry-wide standards. In particular, this Essay incorporates the heuristics used by contract drafters to overcome the costs of contracting, particularly the use of precedent—the copying of past transactions to economize on the cost of writing contracts. This "precedent heuristic" is coupled with a second fact—that reviewing and editing contracts also has a cost, meaning the process of copying is itself imperfect and incomplete, leading to imperfections in the drafting process. The result of this imperfect copying is that the final text of any given agreement depends not only on the economic features of the transaction, but also on the ancestral path the series of precedents took to arrive at the final document. The fact that these “lineages” of ancestral language in contracts continue to influence contract language leads to a process of “speciation” in which contract terms diverge over time, not only because of changing exogenous conditions, but because of an endogenous process of drift. This Essay sketches the beginning of a theory of document evolutionary dynamics from micro-level drafting behavior to the macro-level effects on entire areas of contracting. In particular, the theory shows how drafting heuristics operate on individual documents and on lineages of documents—the “line of descent” from ancestor documents to descendant documents, feeding back into new documents and undermining overall standardization in the marketplace through a process of textual drift. The implications are that contracts are not just incomplete because of costs of anticipating and drafting for contingencies, nor solely because of strategic considerations. They also contain mismatched text, ill-fitting terms, anachronisms, and outright errors. They are mis-calibrated, and mis-calibrated not at random, but in part because of the path dependent process used by attorneys in the creation of these legal texts. This undermines the development of standards and itself reinforces the pattern by feeding back into the cost of reviewing and editing texts. Each of these observations has implications for the study of incomplete contracts in law and economics.