Institutional and contractual solutions for incomplete contracts
Several solutions have been investigated in order to minimize the risk of holdup in incomplete contracts. Some may be jointly and autonomously implemented by economic agents; others rely on the emergence of an institutional setting which induces parties to actively cooperate by means of sanctions and enforcement devices based on reputation, social norms and private orderings.
Investments partitioning
A first solution for implementing specific investments in an incomplete contract framework is to split the expected specific investments into small and verifiable subinvestments (Pitchford and Snyder, 2004). In this case, the original contract is replaced by a series of smaller contracts, each governing the exchange of a portion of the original investment. At each stage the decision to continue to invest in the future depends on the previously observed behaviour of the counterpart. If both parties fulfil their contractual obligations at each stage then the contract is endogenously enforced. As long as the relationship continues, each party becomes more and more specific to the other, thus also raising the opportunity costs of breaching the contract. However, investment partitioning might be implemented as a solution only when the nature of investments makes it possible. Unfortunately, most specific investments often imply one-shot large-scale investments and thus some alternative enforcement device is required to optimally align parties’ incentives to invest.
Vertical integration
Vertical integration is another solution for incomplete contracts. This refers to the idea of generating appropriate incentives to invest in specific assets by assigning to the investing party the right to be a residual claimant on the surplus generated. This could be done by transferring to the investing party the property rights on assets involved in the contract.
With reference to the above example of Fisher Body and General Motors, Klein et al. (1978) have concluded that GM’s decision to acquire the total amount of Fisher Body’s shares in 1926 represented a way of overcoming - by vertical integration - Fisher Body’s hold-up.7 Vertical integration thus induces optimal incentives to invest by assigning to the investing party the right to the residual income generated, once other factors of production have been accounted for. This explanation has also provided an incomplete contract-based theory of the firm along the original intuition of Coase (1937): when the ex post transaction costs involved in incomplete contracts make it convenient to internalize market transactions into an integrated governance structure, a second-best solution to incomplete contracts is provided by vertical integration within a single firm (Williamson, 1985). Firms thus emerge as institutions of private orderings governing incomplete contracts characterized by specific investments.Authority and residual control rights
Vertical integration is based on the idea that assigning residual income to the investing party is a viable way to induce efficient levels of investments. However, as Hart (1995) pointed out, in many contexts ‘residual income is not well defined’. For instance, in profit-sharing contracts each party is a residual claimant, but this does not imply that parties maintain appropriate incentives to invest. Moreover, the notion of residual income outlines only one of the features characterizing a property right. As a consequence, in order to understand the role played by vertical integration in enforcing incomplete contracts, it is necessary to investigate the functions performed by a property right. As Furubotn and Richter (1997) outlined, a property right embodies the right to use the asset (usus), the right to appropriate return from the asset (usus fructus) and the right to change its form, substance and location (abusus)* The reason why property rights assignment matters in a world of incomplete contracts is thus provided by the fact the property right gives the assets’ owner the residual control rights over that asset, that is, with ‘the right to decide all usages of the assets in any way’ (Hart, 1995).
This is why, in an incomplete contract world, ‘ownership is a source of power’ (p. 23).Having residual control rights confers on the owner the power to take care of unspecified contingencies and to organize the production process involving own assets. This power is also defined as authority. The authority relationship from one side reduces the degree of contractual incompleteness by assigning to him/her the power to decide what to do when unforeseen contingencies arise; from the other, it induces efficient levels of investment from the owner’s side, by assigning to the owner all the bargaining power in the ex post renegotiation stage. Residual control rights thus represent a powerful way of tackling the tradeoff between opportunism and adaptation in incomplete contracts. As the Grossman-Hart-Moore (GHM) theories provided by Grossman and Hart (1986) and Hart and Moore (1990) pointed out, the efficient assignment of residual control rights depends strictly on the nature of investments and on the degree of substitutability or complementarity among the agents involved in a given transaction. Given that property rights induce owners’ optimal incentives to invest, while minimizing non-owners’ incentives to invest, the (second-best) efficient assignment of property rights should be decided according to agents’ ability to maximize social surplus.9 Under this setting, when assets are independent, vertical integration will not help to increase parties’ incentives to invest in specific assets, whereas when assets are strictly complementary they should be owned jointly.
Simple contracts on ex post bargaining
The assignment of property right is only one way - possibly the most convenient in terms of transaction cost minimization - to attribute authority to one party in a contract. Since authority is associated with the attribution of bargaining power at the renegotiation stage, it is also possible to imagine that parties may assign authority by contract.
A recent field of research on incomplete contracts focuses on the emergence of first-best investment choices in ‘simple contracts’ characterized by some exogenous bargaining rule at the renegotiation stage (Aghion et al., 1994; Noldeke and Schmidt, 1995; Edlin and Reichelstein, 1996). The basic intuition is that of defining a ‘procedural verifiability’ in a renegotiation game according to which the ex post bargaining can be designed ex ante (for a survey, see Schmitz, 2001). In this case it is sufficient to give one party with all the ex post bargaining power (which corresponds to the previous case of assigning residual rights to control). When there are positive gains from trade, the party which has all the ex post bargaining power will make a take-it-or-leave-it offer to the counterpart, and the first best will be achieved (Schmitz, 2001). Aghion et al. (1994) imagine the case in which parties may write a contract which specifies the nature of the investments in the presence of uncertainty on future contingencies that may affect the number of widgets exchanged within parties. They assume that parties may write specific performance contracts which determine a new ex post default point in the renegotiation stage. Parties defining the ex post default point so as to induce one party to efficiently invest, thus giving the other counterpart all the bargaining power at the renegotiation stage, will induce efficient bilateral investments. The Aghion et al. model implements a first-best contract, thanks to some restrictive assumptions (Hart, 1995) such as that parties sustain no transaction costs in writing and enforcing simple contracts.Corporate culture, reputation and trust in implicit contracts
As Bowles and Gintis (1993) pointed out: ‘the Walrasian general equilibrium model is based on an artificially truncated concept of self-interested behavior, depicting a charming but utopian world in which conflicts abound but a promise is a promise’. The idea that moral commitment may act as an enforcement device in incomplete contract has been studied, among others, by Kreps (1990), Cremer (1993), Lazear (1995) and Hodgson (1996), who emphasized the role played by reputation in favouring implicit and selfenforcing cooperation in repeated interactions.
In many situations, the endogenous enforcement devices represented by trigger strategies and optimal penal codes in infinitely repeated prisoner dilemmas might even be cheaper than devising detailed and complicated contracts. Given that with trigger strategies players’ deviations from cooperating are punished by other players refusing to cooperate in the future, a ‘good reputation’ represents a powerful tool to minimize transaction costs in incomplete contracts (Hermalin, 1999) and to enhance trust of other counterparts. In this respect, firms should be interpreted as repeated players who may develop an internal system of contractual enforcement based on reputation and ‘corporate culture’, that is, on a dominant set of norms which guides the way in which work is accomplished within the organization.