Incomplete contracts and market dynamics
Fisher Body v. General Motors and Essex v. Alcoa have shown the relevance of market dynamics in affecting parties’ incentives to either fulfil or renegotiate incomplete contracts.
Notwithstanding the relevance of market dynamics in incomplete contracts, most of the theories outlined above are generally based on the assumption that agents’ outside options are exogenous, focusing mainly on bilateral relationships.10 The analysis of incomplete contracts characterized by specific investments has thus been confined to the Williamsonian ‘fundamental transformation’ (Williamson, 1985), for which an ex ante competitive transaction is ex post transformed into a bilateral monopoly. According to this perspective, the level of ex ante parties’ outside options acts as a default point in the ex ante contracting game and as a threat point in the ex post bargaining over the joint surplus. The ‘market’ is implicitly assumed to be an equilibrium market and hence for contractual parties it is not possible to affect (and to be affected by) competitors’ strategies.One way of analysing how market dynamics affects incomplete contract theories is to shift from a bilateral contract to a complex transaction in which contract and market dynamics are interdependent, according to the original intuition outlined by Commons (1924, 1934, 1970; see also Nicita, 2001). As Commons (1970) has emphasized:
[W]hen we reduce all prospective buyers and sellers upon a given market to those who participate in one bargaining transaction as our smallest unit of investigation, then they are the ‘best’ two buyers and the ‘best’ two sellers, meaning the two buyers who offer the highest prices and the two sellers who offer to accept the lowest prices, in consideration of transfers of ownership11... The best two sellers are those able to sell at the lowest price.
They compete for choice of alternatives offered by the best two buyers, those able to buy at the highest prices, while, in turn, the best two buyers are competing for choice of alternatives offered by the best two sellers.As a consequence, under a transaction, ‘instead of the “exchange” of physical things between two parties, as contemplated in the former physical economics, there are five parties, all of whom are “potential” and then they are successively “actual” participants in the lawful alienation and acquisition of ownership’. These five parties are four competitors (two buyers and two sellers) and the ‘enforcer’ or judge who is ‘ready to issue commands to any of the buyers and sellers in the name of sovereignty, if any dispute arises’.
The above framework is very useful for analysing incomplete contracts since it shows that when contracts are incomplete a ‘five parties transaction’ does not necessarily collapse into a bilateral relationship, as in Williamson (1985), but it still involves four agents (contractual parties and their respective competitors). In other words, the notion of transaction outlined by Commons always maintains a market dimension within the framework of incomplete contracts. In this setting, parties’ decisions are made considering not only the impact of investment decisions on contractual counterparts but also the impact exerted on the outside market. This has several important consequences. For instance, with endogenous outside options, parties may have strong incentives to overinvest in asset specificity when investments increase own outside options and reduce the counterparts’ outside options (Nicita, 2001). Moreover, endogenous outside options may reverse some of the main conclusions of the GHM models. De Meza and Lockwood (1998) show that in some cases an agent with an important investment decision should not own the assets he/she works with; in other cases independent assets should be owned jointly whereas strictly complementary assets should be owned separately. The analysis of market-contract dynamics thus constitutes an interesting field for future research on incomplete contracts.