Ebook Incomplete Contract Theory and Contracts Between Firms: A Preliminary Empirical Study
Since the late 1980s (Grossman & Hart, 1986; Hart & Moore 1989), there has been a considerable growth in the literature known as incomplete contract theory (ICT). This literature sets about formalising and extending some of the insights from transaction cost theory (Williamson, 1975, 1985; Klein et al 1978). These include the ideas: that parties to trade fear opportunistic behaviour in the presence of specific investment; that insufficient contractual safeguards can result in inefficient levels of such investment; and that the avoidance of such inefficiencies provides a key element in the theory of the boundaries of the firm. Two assumptions are axiomatic of ICT. The first closely follows transaction cost theory (TCT) in that many important investments are observable ex post by economic agents close to a trade, but they are not verifiable in a court of law. In the jargon, they are not contractible. In particular, a contract cannot condition prices (or anything else) on ex post investments. The second is that parties to a contract cannot prevent themselves from renegotiating the terms if it is mutually beneficial to do so (Hart & Moore, 1988). Anticipating this, the parties use the contract in the context of an effective legal system to frame these renegotiations.
The name, incomplete contract theory suggests that the theory's main concern is to consider the limitations of contracts that fail to specify not only investment levels, but also many of the other contingencies that a complete contract might wish to include in an Arrow-Debreu world. The reason for this failure might be due to bounded rationality such that some contingencies cannot be imagined, or to the cost of writing complex contracts. The theory might then ask, for example: how efficient are simple contracts that can specify, at most, only one price, one product specification and one quantity? An efficient contract is one that gives the optimal incentives for both investment and trade. This characterisation of the approach suggests a fairly ad hoc limit on the ability of rational agents to write contracts. However, in practice, much of the literature has avoided this potential criticism (or aspect of reality, depending on your point of view) by adopting one of two directions that finesse the need to specify arbitrary restrictions on the content of contracts.
The first direction asks: what is the minimum that must be written into a contract that would allow it to achieve efficiency in a particular, well specified game, defined according to the types of investment, nature of uncertainty, ex post bargaining procedures, etc? If the answer is that a very simple contract can achieve efficiency, then one efficient contract has been identified. There may be a multitude of other equally efficient contracts, but the one identified by the modeller typically has the added virtue of simplicity. Since it is efficient, it might be thought to be a misnomer to call such a contract 'incomplete'.
The alternative direction asks: why can no contract achieve efficiency in a particular situation? In essence, there is little to distinguish this approach formally from the more traditional complete contract agency theory, except ICT puts great stress on the constraints that renegotiation places on what can and cannot be written into a contract.
What sort of empirical predictions emerge from these two directions taken by ICT modellers? The second suggests situations in which market contracts may fail, and so which encourage some alternative form of governance. The main organisational alternative is an integrated firm. Integration may not itself be fully efficient, and the degree of inefficiency may differ according to who has residual rights of control over physical capital. Nevertheless, it is possible to find at least a second best form of organisation characterised by a contract that allocates only ownership rights (Grossman & Hart, 1986). Although intra-firm organisation and the integration decision are beyond the direct scope of this paper, there is an important link because the ICT theory of the firm necessarily has the theory of market contracts as the counterweight against which intra-firm contracting compared. If the market side of the story is inappropriate, then so too must be the theory of the firm (at least with respect to the integration decision).
Our direct concern is with the light that ICT can shed on the nature of contractual relations between firms, given that they have chosen not to integrate. In the next section, we review the theoretical literature with a view to identifying both the empirical assumptions of ICT, and its predictions as to the content of actual contracts between independent firms. Possibly surprisingly, there has been almost no empirical work on this. ICT theorists frequently motivate their work by reference to a 'preliminary' study of non-contractual relations written by a sociologist nearly 40 years ago (Macauley, 1963), and to a more recent case study of a regulated industry (Joskow, 1987). However, neither study is in any way fine tuned to the contribution of ICT.7 Of course, more widely, transaction cost theory has developed in a much more interactive way with empirical evidence, so there is now a considerable body of econometric evidence on contracts that is of some relevance. However, the aim of such empirical work has typically been to investigate much simpler and broader issues, which do not pick up the more subtle additional contribution of ICT.
In section 3 of this paper, we revisit some survey data, originally collected to investigate some of the broader TCT issues in inter-firm contracting, to see what evidence this provides to support some of the more particular concerns of ICT.
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