Complexity Costs and Contract Incompleteness

Princeton University, Princeton NJ

Investigators

Abstract

We develop a framework in which the incompleteness of contracts is modeled 'from the ground up,' as arising endogenously from the costs of writing contracts. The key feature of our approach is to make explicit the language used to write contracts. This language is used to describe a set of constraints on behavior. The framework highlights that contract incompleteness can take two basic forms: excessive discretion, meaning that the contract does not specify the parties' behavior with sufficient precision; and excessive rigidity, meaning that the contract does not discriminate sufficiently between different states of the world. This framework can be applied to examine a variety of important issues, such as: (i) the determinants of rigidity and discretion in contracts; (ii) the implications of writing costs for the dynamics of contracts, and in particular for the tradeoff between contingent and spot contracts; (iii) the tradeoff between formal and informal contracts; (iv) the consequences of rigidity and discretion for ex-ante investments; (v) the role of legal default rules; (vi) the role of authority in relationships.