Econ Concepts 11: Incomplete Contracts

這是我寫的期末報告的Intro的一部份:

Incomplete contract has slowly become one of the hottest topics in microeconomics. It differs from previous approaches because it looks at a restricted set of contracts, usually much simpler. While previous approaches focus on optimizing over a general set of contracts subject to incentive and participation constraints (such an approach is conveniently called complete contracts), the incomplete approach restricts its search of contracts over an admittedly smaller set of contracts. In the end, the simpler contracts often can only specify property rights and control rights. An example will help distinguish these two approaches, and the different issues it focuses on.

One of the simplest and most researched topics in asymmetric information is CEO compensation. The complete contracts approach calls on us to focus on finding an optimal compensation package, such that under this package, the CEO’s incentives are aligned with the stockholders. As a result, it is in the best interest of the CEO to work ‘hard’ for the stockholders. The incentive package that we find using this method is often complex and seldom seen in the real world. There are also other practical implications that do not seem to abide to the observations in the real world. One of the most obvious is that under complete contracts, the two parties, the CEO and the stockholders, never have to renegotiate the terms of the incentive package. Since after offering the incentive package, the stockholders do not have to worry that the CEO will do something that is ‘not’ in their best interest.

Under the incomplete contracts approach, other factors become important, and these factors are often institution related. Continuing with our CEO compensation example, it is obvious that the stockholder’s decision making procedure or the amount of control the stockholders have over the CEO’s decision are also very important.

As a result, the incomplete contracts approach shifts its focus from compensation and incentive inducing issues to institutional and procedural issues. The change in methodology has spawned a rich body of research in industrial organization, corporate finance, and other areas of economics. It has helped make theories more realistic.

However, questions still remain, if a complete contract can be written, then why would anyone write an incomplete one? Several answers have been provided, but all can be classified into three distinct reasons:

1.
Writing contracts is costly. If under the supervision of a lawyer, a payment must be made to the lawyer for each word the lawyer writes, then both parties may neglect to hire a lawyer, or hire one but write up a simpler contract than one without cost.

2. Sometimes states of the world are too complicated to describe and are unable to be included in the contract simply because we can not foresee future
events.

3. Many aspects of the relationship are observable to both parties but are unverifiable to an impartial third party, such as the court. Under these circumstances, the contract is naturally incomplete, since even if such aspects are included, it wouldn’t help when a dispute arises, because an impartial third party will not be able to determine the truthfulness of their claims. Note that this is different from the traditional moral hazard problem. Previous moral hazard problem treated CEO effort as an unobservable variable, but if it was observed, the stockholders can include effort level in the contract. Incomplete contracts treat this problem differently, even if effort is observed, it can’t be included in the contract because it couldn’t be verified by an impartial third party.