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Contractual Incompleteness and the Nature of Market Interactions

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  • Brown, Martin
  • Falk, Armin
  • Fehr, Ernst

Abstract

We provide experimental evidence that contractual incompleteness, ie, the absence of third party enforcement of workers’ effort or the quality of the good traded causes a fundamental change in the nature of market interactions. If contracts are complete the vast majority of trades are initiated by public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Moreover, the short side of the market attempts to appropriate the whole gains from trade, which causes much disagreement about contract terms. If contracts are incomplete the vast majority of trades are initiated by private offers. The contracting parties form long-term relations and the provision of low effort or bad quality is penalized by the termination of the relationship. The threat of terminating the relation turns out to be an extremely powerful discipline device. Markets with incomplete contracts resemble a collection of bilateral trading islands rather than a competitive market. The short side of the market shares the gains from trade with the long side of the market so that there is little disagreement about contract terms. Our results support theories of the labour market that are based on the idea that unemployment is a worker discipline device.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3272.

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Date of creation: Mar 2002
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Handle: RePEc:cpr:ceprdp:3272

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Keywords: contract enforcement; fairness preferences; incomplete contract; involuntary unemployment; market interaction; repeated transaction;

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Citations

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Cited by:
  1. Bewley, Truman, 2004. "Fairness, Reciprocity, and Wage Rigidity," IZA Discussion Papers 1137, Institute for the Study of Labor (IZA).
  2. Michael Kosfeld, . "Network Experiments," IEW - Working Papers 152, Institute for Empirical Research in Economics - University of Zurich.
  3. William Fuchs, 2005. "Contracting with Repeated Moral Hazard and Private Evaluations," Game Theory and Information 0511007, EconWPA.
  4. Truman F. Bewley, 2002. "Fairness, Reciprocity, and Wage Rigidity," Cowles Foundation Discussion Papers 1383, Cowles Foundation for Research in Economics, Yale University.
  5. Brown, Martin & Falk, Armin & Fehr, Ernst, 2003. "Relational Contracts and the Nature of Market Interactions," IZA Discussion Papers 897, Institute for the Study of Labor (IZA).
  6. Jordi Brandts & Arno Riedl & Frans van Winden, 2004. "Competition and Well-Being," UFAE and IAE Working Papers 608.04, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  7. Jean-Robert Tyran & Elke Renner, 2003. "Price Rigidity in Customer Markets," University of St. Gallen Department of Economics working paper series 2003 2003-16, Department of Economics, University of St. Gallen.
  8. Giovannetti, E. & Neuhoff, K. & Spagnolo, G., 2005. "Agglomeration in Internet Co-operation Peering Agreements," Cambridge Working Papers in Economics 0505, Faculty of Economics, University of Cambridge.
  9. Blonski, Matthias & Spagnolo, Giancarlo, 2002. "Relational Contracts and Property Rights," CEPR Discussion Papers 3460, C.E.P.R. Discussion Papers.

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