Incomplete contracts

This article is about the economic theory of incomplete contracts. For legal definitions and contract law, see Contract.

In economic theory, the field of contract theory can be subdivided in the theory of complete contracts and the theory of incomplete contracts.

The incomplete contracting paradigm was pioneered by Sanford J. Grossman, Oliver D. Hart, and John H. Moore. In their seminal contributions, Grossman and Hart (1986), Hart and Moore (1990), and Hart (1995) argue that in practice, contracts cannot specify what is to be done in every possible contingency.[1][2][3] At the time of contracting, future contingencies may not even be describable. Moreover, parties cannot commit themselves never to engage in mutually beneficial renegotiation later on in their relationship. Thus, an immediate consequence of the incomplete contracting approach is the so-called hold-up problem.[4] Since at least in some states of the world the parties will renegotiate their contractual arrangements later on, they have insufficient incentives to make relationship-specific investments (since a party's investment returns will partially go to the other party in the renegotiations). Oliver Hart and his co-authors argue that the hold-up problem may be mitigated by choosing a suitable ownership structure ex ante (according to the incomplete contracting paradigm, more complex contractual arrangements are ruled out). Hence, the property rights approach to the theory of the firm can explain the pros and cons of vertical integration, thus providing a formal answer to important questions regarding the boundaries of the firm that were first raised by Ronald Coase (1937).[5]

The incomplete contracting approach has been subject of a still ongoing discussion in contract theory. In particular, some authors such as Maskin and Tirole (1999) argue that rational parties should be able to solve the hold-up problem with complex contracts, while Hart and Moore (1999) point out that these contractual solutions do not work if renegotiation cannot be ruled out.[6][7][8] Some authors have argued that the pros and cons of vertical integration can sometimes also be explained in complete contracting models.[9] The property rights approach based on incomplete contracting has been criticized by Williamson (2000) because it is focused on ex ante investment incentives, while it neglects ex post inefficiencies.[10] It has been pointed out by Schmitz (2006) that the property rights approach can be extended to the case of asymmetric information, which may explain ex post inefficiencies.[11] The property rights approach has also been extended by Chiu (1998) and DeMeza and Lockwood (1998), who allow for different ways to model the renegotiations.[12][13] In a more recent extension, Hart and Moore (2008) have argued that contracts may serve as reference points.[14] The theory of incomplete contracts has been successfully applied in various contexts, including privatization,[15][16] international trade,[17][18] management of research & development,[19][20] allocation of formal and real authority,[21] advocacy,[22] and many others.

References

  1. ↑ Grossman, Sanford J.; Hart, Oliver D. (1986). "The costs and benefits of ownership: A theory of vertical and lateral integration". Journal of Political Economy 94: 691–719.
  2. ↑ Hart, Oliver D.; Moore, John (1990). "Property Rights and the Nature of the Firm". Journal of Political Economy 98: 1119–58.
  3. ↑ Hart, Oliver (1995). Firms, Contracts, and Financial Structure. Oxford University Press.
  4. ↑ Schmitz, Patrick W. (2001). "The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory". Bulletin of Economic Research 53 (1): 1–17. doi:10.1111/1467-8586.00114. ISSN 1467-8586.
  5. ↑ Coase, R. H. (1937). "The Nature of the Firm". Economica 4 (16): 386–405. doi:10.1111/j.1468-0335.1937.tb00002.x. ISSN 1468-0335.
  6. ↑ Maskin, Eric; Tirole, Jean (1999). "Unforeseen Contingencies and Incomplete Contracts". The Review of Economic Studies 66 (1): 83–114. doi:10.1111/1467-937X.00079. ISSN 0034-6527.
  7. ↑ Hart, Oliver; Moore, John (1999). "Foundations of Incomplete Contracts". The Review of Economic Studies 66 (1): 115–138. doi:10.1111/1467-937X.00080. ISSN 0034-6527.
  8. ↑ Tirole, Jean (1999). "Incomplete Contracts: Where do We Stand?". Econometrica 67 (4): 741–781. doi:10.1111/1468-0262.00052. ISSN 1468-0262.
  9. ↑ Schmitz, Patrick W. (2005). "Allocating Control in Agency Problems with Limited Liability and Sequential Hidden Actions". RAND Journal of Economics 36: 318–336.
  10. ↑ Williamson, Oliver E (2000). "The New Institutional Economics: Taking Stock, Looking Ahead". Journal of Economic Literature 38 (3): 595–613. doi:10.1257/jel.38.3.595. ISSN 0022-0515.
  11. ↑ Schmitz, Patrick W (2006). "Information Gathering, Transaction Costs, and the Property Rights Approach". American Economic Review 96 (1): 422–434. doi:10.1257/000282806776157722. ISSN 0002-8282.
  12. ↑ Chiu, Y. Stephen (1998). "Noncooperative Bargaining, Hostages, and Optimal Asset Ownership". American Economic Review 88: 882–901.
  13. ↑ Meza, David de; Lockwood, Ben (1998). "Does Asset Ownership Always Motivate Managers? Outside Options and the Property Rights Theory of the Firm". The Quarterly Journal of Economics 113 (2): 361–386. doi:10.1162/003355398555621. ISSN 0033-5533.
  14. ↑ Hart, Oliver; Moore, John (2008). "Contracts as Reference Points". Quarterly Journal of Economics 123: 1–48.
  15. ↑ Hart, Oliver; Shleifer, Andrei; Vishny, Robert W. (1997). "The Proper Scope of Government: Theory and an Application to Prisons". The Quarterly Journal of Economics 112 (4): 1127–1161. doi:10.1162/003355300555448. ISSN 0033-5533.
  16. ↑ Hoppe, Eva I.; Schmitz, Patrick W. (2010). "Public versus private ownership: Quantity contracts and the allocation of investment tasks". Journal of Public Economics 94 (3–4): 258–268. doi:10.1016/j.jpubeco.2009.11.009.
  17. ↑ Antràs, Pol; Staiger, Robert W (2012). "Offshoring and the Role of Trade Agreements". American Economic Review 102 (7): 3140–3183. doi:10.1257/aer.102.7.3140. ISSN 0002-8282.
  18. ↑ Ornelas, Emanuel; Turner, John L. (2012). "Protection and International Sourcing*". The Economic Journal 122 (559): 26–63. doi:10.1111/j.1468-0297.2011.02462.x. ISSN 1468-0297.
  19. ↑ Aghion, Philippe; Tirole, Jean (1994). "The Management of Innovation". The Quarterly Journal of Economics 109 (4): 1185–1209. doi:10.2307/2118360. ISSN 0033-5533.
  20. ↑ Rosenkranz, Stephanie; Schmitz, Patrick W. (2003). "Optimal allocation of ownership rights in dynamic R&D alliances". Games and Economic Behavior 43 (1): 153–173. doi:10.1016/S0899-8256(02)00553-5.
  21. ↑ Aghion, Philippe; Tirole, Jean (1997). "Formal and Real Authority in Organizations". Journal of Political Economy 105 (1): 1–29. doi:10.1086/262063. ISSN 0022-3808.
  22. ↑ Dewatripont, Mathias; Tirole, Jean (1999). "Advocates". Journal of Political Economy 107 (1): 1–39. doi:10.1086/250049.
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