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Contractual Incompleteness and the Nature of Market Interactions

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  • Martin Brown
  • Armin Falk
  • Ernst Fehr

Abstract

We provide experimental evidence that contractual incompleteness, i.e., 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 labor market that are based on the idea that unemployment is a worker discipline device.

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Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 038.

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Handle: RePEc:zur:iewwpx:038

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Keywords: Market Interaction; Contract Enforcement; Incomplete Contract; Involuntary Unemployment; Repeated Transaction; Fairness Preferences;

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Cited by:
  1. William Fuchs, 2005. "Contracting with Repeated Moral Hazard and Private Evaluations," Game Theory and Information 0511007, EconWPA.
  2. Brandts, Jordi & Riedl, Arno & van Winden, Frans, 2005. "Competition and Well-Being," IZA Discussion Papers 1769, Institute for the Study of Labor (IZA).
  3. Renner, Elke & Tyran, Jean-Robert, 2004. "Price rigidity in customer markets," Journal of Economic Behavior & Organization, Elsevier, vol. 55(4), pages 575-593, December.
  4. Michael Kosfeld, . "Network Experiments," IEW - Working Papers 152, Institute for Empirical Research in Economics - University of Zurich.
  5. 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.
  6. Truman F. Bewley, 2002. "Fairness, Reciprocity, and Wage Rigidity," Cowles Foundation Discussion Papers 1383, Cowles Foundation for Research in Economics, Yale University.
  7. 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).
  8. Bewley, Truman, 2004. "Fairness, Reciprocity, and Wage Rigidity," IZA Discussion Papers 1137, Institute for the Study of Labor (IZA).
  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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