The tradeoff between opportunism and adaptation
One way of clarifying some essential features of incomplete contracts is to distinguish between exogenous and endogenous incompleteness. Roughly speaking, exogenous incomplete contracts refer to a dimension of contractual unverifiability which is independent of parties’ actions.
On the contrary, endogenous incomplete contracts refer to the idea that the degree of (un)verifiability in a contract could also be determined explicitly by contractual parties who may deliberately decide to leave unspecified some essential contractual term in the presence of uncertainty. This distinction is important since it outlines two opposite, and somehow contradictory effects of contractual incompleteness regarding parties’ attitude to perform contractual obligations:1. when the degree of unverifiability is exogenous, it weakens the probability that parties will achieve a contractual agreement in the first instance, given that at least one party could be exposed to a counterpart’s post- contractual opportunism at the renegotiation stage (opportunism); and
2. when the degree of unverifiability is explicitly agreed upon by parties it may support contract formation and encourage parties’ performance (adaptation).
As Coase (1937) outlines, there are economic contexts in which a contract, far from being detailed in every part, ‘should only state the limits to the power’ of one party on the other. This might be due to the fact that:
[If] one contract is made for a longer period instead of several shorter ones, then certain costs of making each contract will be avoided... [especially when] owing to the difficulty of forecasting, the longer the period of the contract. the less desirable it is for the person purchasing to specify what the other contracting party is expected to do. All that is stated in the contract is the limits to what the person supplying the commodity or service is expected to do.
The details of what the supplier is expected to do are not stated in the contract but are decided later by purchaser. (Coase, 1988, pp. 39-40)The apparent contradiction between the relative efficiency of having a very detailed contract rather than a broader one relies upon the tradeoff between opportunism and adaptation in incomplete contracts. A very detailed contract, when feasible, might reduce the uncertainty on the degree of ex post verifiability, also inhibiting, however, any future efficiency-enhancing renegotiation of contractual terms. On the other hand, a broader and general contract might favour ex post efficient adaptation of contractual terms after an uncertain contingency is realized, while at the same time increasing the risk of opportunistic behaviour.
The literature on incomplete contracts has mainly been concerned with the problem of opportunism, while only recently have the virtues of adaptation been pointed out, with particular reference to the compared efficiency of economic organization, such as firms, to deal with incomplete contract relationships (Williamson, 1996: pp. 228-9).
The following discussion outlines the economic context that characterizes, respectively, opportunism and adaptation, and it also illustrates some possible institutional solutions for mitigating the inefficiency of contractual incompleteness.