Efficient Penalty Clauses with Debiasing: Lessons from Cognitive Psychology

enrico baffi, Università degli Studi Roma Tre

Abstract

This paper builds upon the findings of cognitive psychology to revisit the prescriptive solutions proposed in the literature with respect to efficient penalty clauses. While refraining from generalizations regarding human behavior, generalizations that might lead to positions quite removed from reality and in part ideological, as was the case with rational choice theory. Rather, the paper seeks to distinguish one situation from another in order to identify the existence of decision debiasing mechanisms capable of justifying – in the case of the set of rules in question – hypotheses in which lesser control over the penalty clause would be justified by both the Common law and Civil law systems. It may be of interest that this paper makes use of cognitive psychology to expand rather than to restrict the contractual freedom. Particular attention was paid to the decisions taken within a firm, in consideration of its hierarchical organization. In this case, the importance of the paper lies in the fact that, whereas psychologists have often underscored the overoptimism of entrepreneurs, these same authors have often demonstrated that there are mechanisms in hierarchical organizations that increase risk aversion. This paper notes that these mechanisms also have an ability to debias decisions. More specifically, the paper emphasizes the importance of the “pressure of accountability” and “personal responsibility”. These two phenomena that characterize the hierarchical organization push it towards choices that are less corrupted by the biases of overoptimism and overconfidence. It is worth noting that no blanket statement can be made for all firms, because in corporations managers answer to the board of directors, whereas this is not the case with the individual businessman. Finally, it is worth noting that application of cognitive psychology without resorting to generalizations undoubtedly leads, aside for the case in question, to a more moderate paternalism than that supported by some scholars.