Incomplete Contracts, Reference Points, and Firms

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

This award funds work in contract theory. The PI continues his research in the economic theory of contracts. Lawyers and economists have traditionally thought of a contract as providing parties with rights and obligations. The PI is developing a complementary idea: contracts provide reference points that create a sense of entitlement in each of the contracting parties. A flexible contract is good in that it allows parties to adjust to an observable but unverifiable state of the world. However, a flexible contract is bad because it may create argument about what outcome has occurred. Argument leads to aggrievement, which causes parties to shirk on non-contractible effort, leading to a loss of efficiency. The PI has already used this approach to analyze the employment relationship and the costs and benefits of vertical organization. This approach also yields new and more general insight into internal organization of firms. This research can help to explain why much negotiation inside an organization focuses on working conditions rather than wages. It also provides new perspectives on the motives for corporate merges and sheds light on the rules that courts should use to interpret contracts that are deliberately left incomplete by the contracting parties.