Information, strategy, and optimal responses to legal uncertainty

Scott Baker | Washington University in St Louis

We investigate how risk-neutral agents optimize their decisions that are subject to uncertain legal rules. We first address the settings where this choice depends only on the agent's information about the nature of legal uncertainty under plausible assumptions about selective enforcement by a budget-constrained enforcement agency. We show that agents will choose to take uncertain positions, that their positions will become stronger (more certainly legal) with an increase in the private benefit from taking the position, and with a stochastic increase in the level of compliance demanded by the legal standard. Counter-intuitively, we also find that even risk-neutral agents prefer greater legal certainty.

Next, we investigate a strategic setting where the outcome of the legal uncertainty depends on what other firms in the market do. In other words, the court consults "custom" in applying the legal rule. This setting produces an equilibrium in which a firm's choice of what position to take depends on his expectations of other firm's choices.

Firms tend to cluster: firms that have a tendency to take more aggressive legal positions will ramp down to more conservative positions. Firms with a tendency to be conservative will instead be more aggressive. Finally, the strategic setting presents the enforcement agency interesting tradeoffs in selecting the enforcement targets.