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. 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. 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).

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. Some authors have argued that the pros and cons of vertical integration can sometimes also be explained in complete contracting models. 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. 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. 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. In a more recent extension, Hart and Moore (2008) have argued that contracts may serve as reference points. The theory of incomplete contracts has been successfully applied in various contexts, including privatization, international trade, management of research & development, allocation of formal and real authority, advocacy, and many others.