Contract Law s Solution to Prisoners Dilemma

Contract Law’s Solution to Prisoners’ Dilemma

Imagine you want to buy a house and need a mortgage. You are obviously better off if you can convince a bank to lend you money. Of course, you would be even better off if you could get the loan, and then not have to pay it back. Absent binding contracts, a bank probably wouldn’t lend you money because you would have an incentive to betray them and not repay. Similarly, you wouldn’t borrow from a bank that could foreclose on your house even if you made all the payments. Consequently, even though your taking out a loan could make both you and the bank better off, the loan would not be made unless contract law forced both of you to behave properly toward each other.

Parties often use legally binding contracts to overcome prisoners’ dilemmas. In many business situations you must trust someone with money or goods. Without contracts, the person you must trust would often be better off keeping your stuff. Contract law allows us to trust other people because if we are betrayed, we can sue and reclaim what was lost (minus attorney’s fees).

Prisoners’ dilemma limits investments in countries where many are exempt from the rule of law. Imagine that you are a mayor of a small town in a poor country. To increase your town’s prosperity you try to attract foreign investment by begging a colossal multinational firm to build a factory in your town. Your plan works and they construct a $10 million factory. Before the factory was built, you were dependent upon the mighty multinational. After the factory is completed, however, they are dependent upon you. The vulnerable multinational’s $10 million investment will be worthless if, say, they are denied the right to use water or electricity. Why shouldn’t this greedy multinational be forced to invest another $3 million in your town as the price for getting access to local roads? There are three outcomes to the game between you and the multinational:

1. No factory is built.

2. A factory is built and the multinational is treated fairly.

3. A factory is built and the multinational is exploited.

Outcome 3 is obviously the best for you and your town. Of course, the multinational won’t build the factory if they suspect that outcome 3 will manifest. To induce them to build, therefore, you promise never to exploit them. After they have built the factory, however, why not exploit them anyway? Shouldn’t the welfare of your town take precedence over a promise made to a foreign multinational?

Of course, the multinational should understand the game and not build the factory unless they know you couldn’t exploit them. Consequently, the multinational should invest only if the rule of law in your country prevents you from moving from outcome 2 to 3.