The Economics of Contracts: Theories and Applications

By Eric Brousseau; Jean-Michel Glachant | Go to book overview

13
Complexity and contract
W. Bentley MacLeod

“The time is not here yet, but I hope it is coming when judges realize that the people who draft… contracts cannot envisage all the things that the future will bring. ” 1


1 Introduction

Building upon the work of Simon (1957), Williamson (1975) observes that a fundamental reason for transaction costs is the impossibility of planning for all future contingencies in a relationship. 2 The purpose of this chapter is to explore the conditions under which such complexity can constrain the set of feasible contracts, and help us better understand the contracts observed in practice. Specifically, a situation where agents are asked to make decisions when unforeseen events occur, but cannot renegotiate the contract is one I call expost hold-up. In these cases, complexity can have an important impact upon the form of the optimal contract. The chapter begins by comparing the structure of the expost hold-up problem to other contracting problems in the literature and suggests that a key ingredient in understanding the form of the optimal contract is the timing of information and actions in a relationship. Secondly, a way to measure contract complexity is suggested that has empirical implications. Finally, the optimal governance of contracts facing expost hold-up when complexity is high depends upon the degree of correlation in subjective beliefs between the contracting parties.

Beginning with Simon (1951), there is a large literature that takes as given contract incompleteness due to transaction costs and then explores its implications for efficient governance. Simon argues that giving one agent authority over another economizes on transaction costs by allowing one to delay decision-making until after uncertainty has been resolved. In a similar vein, the property-rights literature, beginning with Grossman and Hart (1986), argues that problems of contract incompleteness are resolved by an appropriate reallocation of bargaining power in a relationship through ownership rights. Agency theory, beginning with

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