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More is Less: Why Parties May Deliberately Write Incomplete Contracts

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  • Maija Halonen-Akatwijuka
  • Oliver D. Hart

Abstract

Why are contracts incomplete? Transaction costs and bounded rationality cannot be a total explanation since states of the world are often describable, foreseeable, and yet are not mentioned in a contract. Asymmetric information theories also have limitations. We offer an explanation based on "contracts as reference points". Including a contingency of the form, "The buyer will require a good in event E", has a benefit and a cost. The benefit is that if E occurs there is less to argue about; the cost is that the additional reference point provided by the outcome in E can hinder (re)negotiation in states outside E. We show that if parties agree about a reasonable division of surplus, an incomplete contract can be strictly superior to a contingent contract.

Suggested Citation

  • Maija Halonen-Akatwijuka & Oliver D. Hart, 2013. "More is Less: Why Parties May Deliberately Write Incomplete Contracts," NBER Working Papers 19001, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:19001
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    References listed on IDEAS

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    1. Bajari, Patrick & Tadelis, Steven, 2001. "Incentives versus Transaction Costs: A Theory of Procurement Contracts," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 387-407, Autumn.
    2. Oliver Hart & John Moore, 2008. "Contracts as Reference Points," The Quarterly Journal of Economics, Oxford University Press, vol. 123(1), pages 1-48.
    3. Kathryn E. Spier, 1992. "Incomplete Contracts and Signalling," RAND Journal of Economics, The RAND Corporation, vol. 23(3), pages 432-443, Autumn.
    4. Herold, Florian, 2010. "Contractual incompleteness as a signal of trust," Games and Economic Behavior, Elsevier, vol. 68(1), pages 180-191, January.
    5. Card, David, 1986. "An Empirical Model of Wage Indexation Provisions in Union Contracts," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 144-175, June.
    6. Fabian Herweg & Klaus Schmidt, 2012. "Loss Aversion and Ex Post Inefficient Renegotiation," CESifo Working Paper Series 4031, CESifo Group Munich.
    7. Ernst Fehr & Oliver Hart & Christian Zehnder, 2011. "Contracts as Reference Points--Experimental Evidence," American Economic Review, American Economic Association, vol. 101(2), pages 493-525, April.
    8. Paul Oyer, 2004. "Why Do Firms Use Incentives That Have No Incentive Effects?," Journal of Finance, American Finance Association, vol. 59(4), pages 1619-1650, August.
    9. Ernst Fehr & Oliver Hart & Christian Zehnder, 2008. "Contracts as reference points � experimental evidence," IEW - Working Papers 393, Institute for Empirical Research in Economics - University of Zurich.
    10. Steven Shavell, 1980. "Damage Measures for Breach of Contract," Bell Journal of Economics, The RAND Corporation, vol. 11(2), pages 466-490, Autumn.
    11. Aghion, Philippe & Bolton, Patrick, 1987. "Contracts as a Barrier to Entry," American Economic Review, American Economic Association, vol. 77(3), pages 388-401, June.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Incomplete contracts can be optimal
      by Economic Logician in Economic Logic on 2013-05-24 20:08:00

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    Cited by:

    1. repec:spr:epolin:v:45:y:2018:i:1:d:10.1007_s40812-017-0087-4 is not listed on IDEAS
    2. Oliver Hart, 2013. "Noncontractible Investments and Reference Points," Games, MDPI, Open Access Journal, vol. 4(3), pages 1-20, August.
    3. Iossa, Elisabetta & Martimort, David, 2016. "Corruption in PPPs, incentives and contract incompleteness," International Journal of Industrial Organization, Elsevier, vol. 44(C), pages 85-100.
    4. Schmitz, Patrick W., 2015. "Government versus private ownership of public goods: The role of bargaining frictions," Journal of Public Economics, Elsevier, vol. 132(C), pages 23-31.
    5. Fabian Herweg & Heiko Karle & Daniel Müller, 2014. "Incomplete Contracting, Renegotiation, and Expectation-Based Loss Aversion," CESifo Working Paper Series 4687, CESifo Group Munich.
    6. repec:eee:jeborg:v:145:y:2018:i:c:p:176-201 is not listed on IDEAS
    7. Charles T. Carlstrom & Timothy S. Fuerst & Matthias Paustian, 2016. "Optimal Contracts, Aggregate Risk, and the Financial Accelerator," American Economic Journal: Macroeconomics, American Economic Association, vol. 8(1), pages 119-147, January.
    8. repec:eee:corfin:v:44:y:2017:i:c:p:331-352 is not listed on IDEAS
    9. Maija Halonen-Akatwijuka & Oliver Hart, 2015. "Short-term, Long-term, and Continuing Contracts," NBER Working Papers 21005, National Bureau of Economic Research, Inc.
    10. repec:bri:cmpowp:13/325 is not listed on IDEAS
    11. Fabian Herweg & Klaus M. Schmidt, 2015. "Loss Aversion and Inefficient Renegotiation," Review of Economic Studies, Oxford University Press, vol. 82(1), pages 297-332.
    12. Björn Bartling & Klaus M. Schmidt, 2015. "Reference Points, Social Norms, And Fairness In Contract Renegotiations," Journal of the European Economic Association, European Economic Association, vol. 13(1), pages 98-129, February.
    13. Maija Halonen-Akatwijuka & Oliver Hart, 2015. "Continuing Contracts," Bristol Economics Discussion Papers 15/665, Department of Economics, University of Bristol, UK, revised 12 Oct 2016.

    More about this item

    JEL classification:

    • D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law

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