Incomplete contracts.

• Author: Hart, Oliver D.

Economists have a very well-established theory of market trading, and are on the way to a similarly well-developed theory of contractual transactions. However, the economic analysis of institutions is in a much more rudimentary state. This article discusses a recent literature that tries to provide a framework for thinking about economic institutions such as firms. The basic idea is that firms arise in situations in which people cannot write good contracts, and in which the allocation of power or control is therefore important.(1)

The starting point of this recent literature - which is sometimes called the "incomplete contracting" approach - is that it is prohibitively expensive for parties to write a contract governing their economic relationship that is all-inclusive, that is, that anticipates all the many things that may happen. Instead, parties will write a contract that is incomplete, and that will be revised and renegotiated as the future unfolds. The contract they write can be seen as a backdrop or starting point for such renegotiations, rather than a specification of the final outcome. Thus, the parties look for a contract that will ensure that, whatever happens, each side has some protection, both against opportunistic behavior by the other party and against bad luck.(2)

In a world of incomplete contracts, the ex post allocation of power (or control) matters. Here power refers roughly to the position of each party if the other party does not perform (for example, if the other party behaves opportunistically). These two ideas - contractual incompleteness and power - can be used to understand a number of economic institutions and. arrangements. I discuss some of these in the remainder of this article.

The Meaning of Ownership

Economists have written a great deal about why property rights are important, and in particular why it matters, for example, whether a machine is privately owned or is common property. However, they have been less successful in explaining why it matters who owns a piece of private property. To understand the difficulty, consider a situation in which I want to use a machine that you own. I can buy the machine from you or rent the machine from you. If there are no contracting costs, then we can sign a rental agreement that is as effective as a change in ownership. In particular, the rental contract can specify exactly what I can do with the machine; when I can have access to it; what happens if the machine breaks down; what rights you have to use the machine; and so on. Given this, however, it is unclear why changes in asset ownership ever need to take place.

In a world with contracting costs, though, renting and owning are no longer the same. If contracts are incomplete, not all the uses of the machine will be specified in all possible eventualities. The question then arises; who chooses the unspecified uses? A reasonable view is that the owner of the machine has this right; that is, the owner has residual rights of control over the machine, or residual powers. For example, if the machine breaks down or requires modification and the contract is silent about this, then the owner can decide how and when it is repaired or modified.

Now it is possible to understand why it might make sense for me to buy the machine from you, rather than to rent it. If I own the machine, I will have more power in our economic relationship, since I will have all the residual rights of control. To put it another way, if the machine breaks down or needs to be modified, I can ensure that it is repaired or modified quickly, so that I can continue to use it productively. Knowing this, I will have a greater incentive to look after the machine, to learn to operate it, to acquire other machines that create a synergy with this machine, and so on.

The Boundaries of Firms

A long-standing issue in organization theory concerns the determinants of the boundaries of firms. Why does it matter if a particular transaction is carried out inside a firm, or through the market, or via a long-term contract? To put it another way, given any two firms (A and B), what difference does it make if the firms transact through an arms-length contract, or merge and become a single firm?

It is difficult to answer these questions using standard theory for the same reason that it is hard to explain why asset ownership matters. If there are no contracting costs, then the two firms can write a contract governing their relationship that specifies the obligations of all parties in all eventualities. Since the...