Background
The concept of an incomplete contract is integral to understanding contractual relationships in economics. The term refers to agreements that do not account for every possible outcome or state of the world due to various limitations. Such contracts require provisions to deal with unforeseen contingencies that may arise during the contracting period.
Historical Context
Incomplete contracts emerged as a significant area of study in the late 20th century. Economists like Oliver Hart and John Moore played pioneering roles in formalizing this concept. They examined the dynamic nature of contractual obligations and proposed frameworks to address the inevitable gaps in contracts.
Definitions and Concepts
An incomplete contract is defined as a contract that specifies the outcomes in some, but not all, possible states of the world. This incompleteness can occur due to poor drafting or because some distinctions between different future states are not publicly verifiable or measurable. For instance, an employment contract may be incomplete if it cannot account for individual effort in team-based work where individual contributions are difficult to isolate.
Major Analytical Frameworks
Classical Economics
Classical economics typically assumes contracts are complete and unambiguous. This simplification facilitates easier modeling but often fails to capture real-world complexity.
Neoclassical Economics
Neoclassical theory acknowledges that perfect information is often not available, contributing to the formation of incomplete contracts.
Keynesian Economics
Keynesian thought doesn’t typically focus on contract theory, though it emphasizes the complexity and uncertainty of economic systems where incomplete contracts may have substantial relevance.
Marxian Economics
From a Marxian perspective, incomplete contracts could highlight power imbalances in worker-capitalist relationships, with disputes often resolved in a way that favors capital.
Institutional Economics
Institutional economics scrutinizes how institutional settings affect contractual completeness, emphasizing formal legal systems and informal norms that govern contract enforcement.
Behavioral Economics
Behavioral economists explore how cognitive biases and bounded rationality contribute to contractual incompleteness, as people may not foresee all future contingencies.
Post-Keynesian Economics
Post-Keynesian economists stress the role of fundamental uncertainty, asserting that incomplete contracts are inevitable in a world where the future cannot be predicted with accuracy.
Austrian Economics
Austrian economists recognize entrepreneurship involves handling incomplete contracts, with entrepreneurs engaging in adaptive behaviors to manage contractual gaps.
Development Economics
In developing countries, incomplete contracts may be more prevalent due to weaker legal systems and less clarity in enforcement mechanisms.
Monetarism
While monetarism doesn’t often delve directly into contract theory, it acknowledges that policy credibility (or lack thereof) can be seen as a kind of incomplete social contract between governments and citizens.
Comparative Analysis
Incomplete contracts are common across different economic sectors due to their inherent nature of not encompassing all possible future states. This leads to customary practices of relying on negotiations and adaptive mechanisms to resolve emerging disputes.
Case Studies
- Employment Contracts: Issues arise when trying to link compensation directly to efforts, especially in team environments.
- Land Leases in Agrarian Economies: Informal agreements are rife with incompleteness due to seasonal unpredictability and varying enforcement strength.
Suggested Books for Further Studies
- “Firms, Contracts, and Financial Structure” by Oliver Hart
- “The Economics of Contracts: A Primer” by Bernard Salanié
- “Incomplete Contracts and the Theory of the Firm” edited by Gérard Roland
Related Terms with Definitions
- Agency Theory: Explores the problems that arise in the relationship between principals (e.g., shareholders) and agents (e.g., managers), particularly focusing on conflicts of interest and information asymmetry.
- Moral Hazard: A situation in which one party is tempted to take undue risks because the negative consequences are borne by another party.
- Adverse Selection: A scenario where asymmetric information results in high-risk participants being more likely to engage in a transaction, to the detriment of the other party.
