The paper takes stock of the advances and directions for research on the incomplete contracting front. It first illustrates some of the main ideas of the incomplete contract literature through an example. It then offers methodological insights on the standard approach to modeling incomplete contracts; in particular it discusses a tension between two assumptions made in the literature, namely rationality and the existence of transaction costs. Last, it argues that, contrary to what is commonly argued, the complete contract methodology need not be unable to account for standard institutions such as authority and ownership; and it concludes with a discussion of the research agenda.

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Incomplete contracts: Where do we stand?

In most developing and industrial countries, infrastructure services have traditionally been provided by government enterprises, but in developing countries at least, these enterprises have often proven to be inefficient, unable to provide much-needed investments, and manipulated to achieve political objectives. By contrast, many studies have shown that over the past 30 years, private (or privatized) enterprises in developing countries have, on average, delivered superior performance and needed investments. Explanations differ on why this discrepancy exists. Private enterprises are driven by a desire for profits and may have more professional know-how in management, operating procedures, and use of appropriate technology. But perhaps the most important reason for their stronger performance is that privatization makes intervening in enterprise operations difficult for governments and politicians, so government manipulation is less likely. However, the issue, in general, has been how to ensure that the improved performance and efficiency gains are passed through to the users through lower tariffs and increased coverage, while allowing firms to earn a fair rate of return on their investments.

Granting and Renegotiating Infrastructure Concessions: Doing it Right

We present a new methodology for studying the problem of intra-firm bargaining, based on the notion that contracts cannot commit the firm and its agents to wages and employment. We develop and analyse a general non-cooperative multilateral bargaining framework between the firm and its employees and consider outcomes which are immune to renegotiations by any party. Equilibrium firm profits are characterizable as both a weighted average of a neo-classical (non-bargaining) firm's profits and a generalization of Shapley value for a corresponding cooperative game. Furthermore, the resulting payoffs induce economically significant distortions in the firm's input and organizational-design decisions.

Intra-firm Bargaining under Non-binding Contracts

This paper considers a buyer-seller relationship with observable but unverifiable investments and/or random utility parameters. In such situations, it is known that contract renegotiation may prevent the implementation of first-best outcomes. In this paper, we show however that efficient investments and optimal risk-sharing can typically be achieved provided the initial contract is able to monitor the ex post renegotiation process. Specifically, we focus on the following two features of renegotiation design. First, default options in case renegotiation breaks down; second, the allocation of all bargaining power to either contracting party. Moreover, we show that these two features can be obtained in standard Rubinstein bargaining games through contractual provisions, such as specific-performance clauses and penalties for delay (or, equivalently, financial "hostages" refundable without interest).

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Renegotiation design with unverifiable information

Recent articles have shown that contracts can support the efficient outcome for bilateral trade even in the face of specific investments and incomplete contracting. These studies typically considered 'selfish' investments that benefit the investor (e.g., the seller's investment reduces her production costs). The authors find very different results for 'cooperative' investments that directly benefit the investor's partner (e.g., the seller's investment improves the buyer's value of the good). Most importantly, if committing not to renegotiate the contract is impossible, then contracting has no value, i.e., the parties cannot do better than to abandon contracting altogether in favor of ex post negotiation.

Cooperative Investments and the Value of Contracting

An optimal contract design problem is considered. Contracts which are incomplete and simple are used to investigate the extent to which constrained revisions can mitigate inefficiencies resulting from contractual incompleteness. An optimal contract is characterized in two cases. First, when a contract is being used to facilitate trade between two risk-neutral parties who must make relationship-specific investments, it is possible to implement the first-best by a simple contract. Second, when a contract is being used to share risk, it is generally not possible to implement the first-best. When one party is risk neutral, however, it is possible to implement the first-best by assigning all the ex post decision rights to that party.

Incomplete Contracts, Specific Investments, and Risk Sharing

The objective of this article is to investigate contests in which efforts are productive. Tul- lock's standard rent-seeking model is extended by making the rent itself increase with the aggregate efforts. A positive externality is thereby introduced into the contest, because a contender's private effort in quest of the rent generates a benefit for other contenders. Coupled with a negative exter- nality presented in the standard rent-seeking model, the net effect on the social efficiency of the contest is a priori ambiguous. It is shown that the extended contest generates socially wasteful, ex- cessive aggregate efforts.

Rent-seeking contest when the prize increases with aggregate

The objective of this article is to investigate contests in which efforts are productive. Tullock's standard rent-seeking model is extended by making the rent itself increase with the aggregate efforts. A positive externality is thereby introduced into the contest, because a contender's private effort in quest of the rent generates a benefit for other contenders. Coupled with a negative externality presented in the standard rent-seeking model, the net effect on the social efficiency of the contest is a priori ambiguous. It is shown that the extended contest generates socially wasteful, excessive aggregate efforts.

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Rent-seeking contest when the prize increases with aggregate efforts

This paper studies alternative contract damage measures in the presence of specific investments that generate a direct benefit to the investor's trading partner (referred to as "cooperative investments"). We find that, both with and without the possibility of ex post renegotiation, (i) the standard rules of remedy for breach of contracts such as expectation damages perform poorly in the presence of cooperative investments, (ii) the privately stipulated damages can achieve a better, albeit inefficient, outcome, and (iii) the reliance damages rule performs the best, achieving the fully efficient outcome in the presence of ex post renegotiation. These rankings stand in stark contrast to those found in the existing literature but explain such practices as termination for convenience, investment subsidies, and cost-based reimbursement, often employed in government contracts.

Contract Damages and Cooperative Investments

We study alternative breach remedies in the presence of specific investments that generate a direct benefit to the investor's trading partner (referred to as "cooperative investments."). We find that (i) expectation damages perform very poorly, inducing no cooperative investment; (ii) privately stipulated liquidated damages can achieve a better, albeit inefficient, outcome; and (iii) the reliance damages perform the best, achieving the efficient outcome if ex post renegotiation is possible. These rankings stand in contrast to those found in the existing literature, but they explain many observed contracting practices.

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Tai-Yeong Chung

Papers

Incomplete Contracts, Specific Investments, and Risk Sharing

Rent-seeking contest when the prize increases with aggregate

Rent-seeking contest when the prize increases with aggregate efforts

Contract Damages and Cooperative Investments

Contract Damages and Cooperative Investments