A Screening Role of Enforcement Institutions

This paper examines scenarios where opportunistic behavior in contracts leads to the Prisoner's dilemma. In such instances, formal enforcement can encourage cooperation by raising the cost of defection. However, opting to cooperate even with weak enforcement signals unobservable characteristics, potentially enhancing desirability as a partner in the future. Consequently, the optimal welfare-maximizing enforcement quality may not always maximize cooperation. Depending on the distribution of unobservables, the impact of increased enforcement on cooperation can be influenced by reputation concerns. The payoffs of cooperators and defectors are non-monotonic in the quality of the enforcement institution. In cases where institutional quality is endogenously determined, the equilibrium level of enforcement tends to exceed the optimal level.