Incomplete contracts are a fundamental concept in contract law and economic theory. They are contracts that are defective or uncertain in a material respect, meaning they do not provide for the rights, obligations, and remedies of the parties in every possible state of the world.
What are incomplete contracts?
According to the incomplete contracting paradigm, pioneered by Sanford J. Grossman, Oliver D. Hart, and John H. Moore, contracts cannot specify what is to be done in every possible contingency. 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.
Why do incomplete contracts matter?
Incomplete contracts matter because they can lead to inefficiencies and hold-up problems. The hold-up problem occurs when parties have insufficient incentives to make relationship-specific investments because they know that they will renegotiate their contractual arrangements later on. This can result in suboptimal outcomes for both parties.
History of incomplete contracts
The incomplete contracting approach has been subject to ongoing discussion in contract theory. In particular, some authors have argued that rational parties should be able to solve the hold-up problem with complex contracts, while others have pointed out that these contractual solutions do not work if renegotiation cannot be ruled out. 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.
Examples of incomplete contracts
Incomplete contracts can be found in various areas of life, including business and economics. For example, a company may sign a contract with a supplier without specifying what will happen in the event of a natural disaster that affects the supply chain. Similarly, a employee may sign a contract with an employer without specifying what will happen in the event of a job change or termination.
Key facts
- Incomplete contracts are contracts that are defective or uncertain in a material respect.
- They do not provide for the rights, obligations, and remedies of the parties in every possible state of the world.
- The incomplete contracting approach was pioneered by Sanford J. Grossman, Oliver D. Hart, and John H. Moore.
- Incomplete contracts can lead to inefficiencies and hold-up problems.
- The property rights approach based on incomplete contracting has been criticized for neglecting ex-post inefficiencies.
FAQ
What is the main limitation of incomplete contracts? Incomplete contracts are limited by the fact that they cannot specify what is to be done in every possible contingency.
How do incomplete contracts lead to inefficiencies? Incomplete contracts can lead to inefficiencies because they do not provide for the rights, obligations, and remedies of the parties in every possible state of the world, leading to hold-up problems.
Can incomplete contracts be solved with complex contracts? Some authors have argued that rational parties should be able to solve the hold-up problem with complex contracts, while others have pointed out that these contractual solutions do not work if renegotiation cannot be ruled out.
What is the property rights approach based on incomplete contracting? The property rights approach based on incomplete contracting focuses on ex-ante investment incentives, but neglects ex-post inefficiencies.