Scott Baker of Washington University in Saint Louis and Albert H. Choi of Virginia have written Crowding In: How Formal Sanctions Can Facilitate Informal Sanctions. Here's the abstract:
This paper examines the interaction between legal and reputational sanctions in the design of an optimal deterrence regime, particularly in a setting where two parties have a long term relationship. The paper makes three claims. First, both legal and reputational sanctions are costly: legal sanctions require spending resources on litigation while reputational sanctions can lead to inefficient failures to trade. An optimal deterrence regime must make a trade-off between these two types of costs. Second, in achieving optimal deterrence, the two sanctions function as both substitutes and complements. As substitutes, relying more on one type of sanction requires less of the other in reaching any desired level of deterrence. As complements, legal sanctions, through generation of relevant information, can facilitate reputational sanctions. Especially when fault-based standards (such as “best efforts,” “commercially reasonable efforts,” or “good faith”) are used, if the court’s decision produces information that correlates with the underlying behavior, that information can be used to better tailor reputational sanctions. Third, the paper argues that the most effective deterrence regime will often combine formal and informal sanctions. By keeping the formal sanctions low, the optimal regime keeps the litigation costs in check. Reputational sanctions, then, can make up for any shortfall in deterrence. Allowing some litigation also enables the parties to take advantage of the informational benefits of litigation. After establishing these points theoretically, the paper pivots to examine various empirical findings consistent with the theory.