Bilateral Contracts and Social Welfare

This paper defines and analyzes default delegation, an indirect mechanism that describes how the government influences bilateral contracts to maximize social welfare. In default delegation, the government chooses the default contract and a possibly-limited set of contract terms it is willing to enforce. Our analysis of this mechanism provides a theoretical foundation for immutable and default rules in contract law: immutable rules mitigate externalities, while default rules achieve particular distributions of surplus in non-contractible states of the world. We derive conditions under which default delegation implements the entire set of first-best contracts. We then characterize how optimal default delegation responds to changes in the underlying contracting environment and in the social welfare function's weighting of efficiency, externalities and distributional concerns.