Definition
According to the standard literature (Hart and Holmstrom, 1987; Milgrom and Roberts, 1990; Hart, 1995; Tirole, 1999), an incomplete contract is defined as an agreement whose contractual obligations are observable to contractual parties but not verifiable ex post by third parties, typically a judge or an arbitrator2 to whom parties might eventually refer when controversies arise.
The emergence of (a degree of) unverifiability on contractual terms might be generated by several circumstances, such as: parties’ bounded rationality and uncertainty concerning future events; high transaction costs incurred in writing and accurately describing any contractual feature (also called ‘ink costs’), or going to court; and so on.Starting from this standard definition of incomplete contracts, at least two approaches have been developed (Brousseau and Glachant, 2002): first, concerning the compared analysis of institutional arrangements designed to mitigate the effects of incompleteness on parties’ incentives to perform; and second, a more recent approach focused on the analysis of the foundations of contractual incompleteness.3
Whatever is believed to be the origin of unverifiability, the economic reason why contractual incompleteness matters is that it may constitute a source of inefficiency when it inhibits Pareto-relevant exchanges. According to Williamson (1985), this inefficient outcome might emerge only when two other conditions are jointly satisfied: (i) the incomplete contract has to perform investments in specific assets; and (ii) at least one agent in the contract is opportunistic.4
The degree of asset specificity has been defined as ‘the degree to which an asset cannot be redeployed to alternative uses and by alternative users without sacrifice of productive value’ (Williamson, 1996: 59). Asset specificity thus creates a sort of lock-in effect which exposes the owners of specific assets to counterparts’ economic dependency.
Thus the sacrifice of economic value due to redeployment in alternative uses represents a measure of the parties’ exit costs and the opportunity cost to dissipate contractual quasi-rents.When specific assets are involved in incomplete contracts, the owner of the assets is locked in by the fact that the degree of asset specificity acts as a ‘fundamental transformation’ which reduces ex post the value of employing the assets in alternative uses (Williamson, 1985). This lock-in effect in turn generates the risk of opportunistic behaviour by contractual counterparts who may want to renegotiate terms in order to extract additional rents with respect to those contracted ex ante (the so-called ‘hold-up problem’). The main consequence of linking together incomplete contracts, opportunism and asset specificity is that, under this framework, contractual parties maintain strong incentives to underinvest in asset specificity. As a consequence, the risk of a counterpart’s opportunistic behaviour implies an unwillingness to generate potential quasi-rents.
The relevance of the analysis of incomplete contracts in law and economics stems from the selection of the legal and economic rules and institutions which might reduce the risk of post-contractual opportunism by optimally aligning parties’ incentives to generate the highest level of specific investment (second-best outcome). In this respect, ‘transaction cost economics’ (Williamson, 1985), in particular, outlines a theory of private orderings (such
as contracts and economic organizations) as institutions performing alternative transaction costs to ensure the enforcement of incomplete contracts.