incomplete contracts
In contract law, an incomplete contract is one that is defective or uncertain in a material respect. In economic theory, an incomplete contract (as opposed to a complete contract) is one that provides for the rights, obligations and remedies of the parties in every possible state of the world.{{Citation |last=Eisenberg |first=Melvin A. |title=Incomplete Contracts |date=2018 |url=https://oxford.universitypressscholarship.com/10.1093/oso/9780199731404.001.0001/oso-9780199731404-chapter-36 |work=Foundational Principles of Contract Law |place=New York |publisher=Oxford University Press |doi=10.1093/oso/9780199731404.003.0036 |isbn=978-0-19-973140-4 |access-date=2022-04-25|url-access=subscription }}
Since the human mind is a scarce resource and the mind cannot collect, process, and understand an infinite amount of information, economic actors are limited in their rationality (the limitations of the human mind in understanding and solving complex problems) and one cannot anticipate all possible contingencies.{{Cite journal |last=Karen Eggleston, Eric A Posner and Richard Zeckhauser |date=2000 |title=The Design and Interpretation of Contracts: Why Complexity Matters |journal=95 Northwestern University Law Review 91.}}{{Cite journal |last1=Aghion |first1=Philippe |last2=Holden |first2=Richard |date=2011-05-01 |title=Incomplete Contracts and the Theory of the Firm: What Have We Learned over the Past 25 Years? |journal=Journal of Economic Perspectives |language=en |volume=25 |issue=2 |pages=181–197 |doi=10.1257/jep.25.2.181 |issn=0895-3309|doi-access=free }} Or perhaps because it is too expensive to write a complete contract, the parties will opt for a "sufficiently complete" contract.{{Cite journal |last=Sanga |first=Sarath |date=2018-11-01 |title=Incomplete Contracts: An Empirical Approach |journal=The Journal of Law, Economics, and Organization |volume=34 |issue=4 |pages=650–679 |doi=10.1093/jleo/ewy012 |issn=8756-6222|doi-access=free }} In short, in practice, every contract is incomplete for a variety of reasons and limitations. The incompleteness of a contract also means that the protection it provides may be inadequate.{{Cite web |title=Keay, Andrew; Zhang, Hao --- "Incomplete Contracts, Contingent Fiduciaries and a Director's Duty to Creditors" [2008] MelbULawRw 5; (2008) 32(1) Melbourne University Law Review 141 |url=http://www5.austlii.edu.au/au/journals/MelbULawRw/2008/5.html |access-date=2022-04-25 |website=www5.austlii.edu.au}} Even if a contract is incomplete, the legal validity of the contract cannot be denied, and an incomplete contract does not mean that it is unenforceable. The terms and provisions of the contract still have influence and are binding on the parties to the contract. As for contractual incompleteness, the law is concerned with when and how a court should fill gaps in a contract when there are too many or too uncertain to be enforceable, and when it is obliged to negotiate to make an incomplete contract fully complete or to achieve the desired final contract.
The incomplete contracting paradigm was pioneered by Sanford J. Grossman, Oliver D. Hart, and John H. Moore. In their seminal contributions, Grossman and Hart (1986), Hart and Moore (1990), and Hart (1995) argue that in practice, contracts cannot specify what is to be done in every possible contingency.{{Cite journal|url = http://nrs.harvard.edu/urn-3:HUL.InstRepos:3450060|title = The costs and benefits of ownership: A theory of vertical and lateral integration|last1 = Grossman|first1 = Sanford J.|date = 1986|journal = Journal of Political Economy|doi = 10.1086/261404|last2 = Hart|first2 = Oliver D.|pages = 691–719|volume = 94|issue = 4|hdl = 1721.1/63378|hdl-access = free}}{{Cite journal|title = Property Rights and the Nature of the Firm|last1 = Hart|first1 = Oliver D.|date = 1990|journal = Journal of Political Economy|doi = 10.1086/261729|last2 = Moore|first2 = John|pages = 1119–58|volume = 98|issue = 6|citeseerx = 10.1.1.472.9089}}{{Cite book|title = Firms, Contracts, and Financial Structure|last = Hart|first = Oliver|publisher = Oxford University Press|year = 1995}} At the time of contracting, future contingencies may not even be describable. Moreover, parties cannot commit themselves never to engage in mutually beneficial renegotiation later on in their relationship. Thus, an immediate consequence of the incomplete contracting approach is the so-called hold-up problem.{{Cite journal|title = The Hold-Up Problem and Incomplete Contracts: A Survey of Recent Topics in Contract Theory|journal = Bulletin of Economic Research|date = 2001|issn = 1467-8586|pages = 1–17|volume = 53|issue = 1|doi = 10.1111/1467-8586.00114|first = Patrick W.|last = Schmitz|url = https://mpra.ub.uni-muenchen.de/12562/2/MPRA_paper_12562.pdf}} Since at least in some states of the world the parties will renegotiate their contractual arrangements later on, they have insufficient incentives to make relationship-specific investments (since a party's investment returns will partially go to the other party in the renegotiations). Oliver Hart and his co-authors argue that the hold-up problem may be mitigated by choosing a suitable ownership structure ex-ante (according to the incomplete contracting paradigm, more complex contractual arrangements are ruled out). Hence, the property rights approach to the theory of the firm can explain the pros and cons of vertical integration, thus providing a formal answer to important questions regarding the boundaries of the firm that were first raised by Ronald Coase (1937).{{Cite journal|title = The Nature of the Firm|journal = Economica|date = 1937|issn = 1468-0335|pages = 386–405|volume = 4|issue = 16|doi = 10.1111/j.1468-0335.1937.tb00002.x|first = R. H.|last = Coase}}
The incomplete contracting approach has been subject of a still ongoing discussion in contract theory. In particular, some authors such as Maskin and Tirole (1999) argue that rational parties should be able to solve the hold-up problem with complex contracts, while Hart and Moore (1999) point out that these contractual solutions do not work if renegotiation cannot be ruled out.{{Cite journal|title = Unforeseen Contingencies and Incomplete Contracts|journal = The Review of Economic Studies|date = 1999|issn = 0034-6527|pages = 83–114|volume = 66|issue = 1|doi = 10.1111/1467-937X.00079|first1 = Eric|last1 = Maskin|first2 = Jean|last2 = Tirole}}{{Cite journal|title = Foundations of Incomplete Contracts|journal = The Review of Economic Studies|date = 1999|issn = 0034-6527|pages = 115–138|volume = 66|issue = 1|doi = 10.1111/1467-937X.00080|first1 = Oliver|last1 = Hart|first2 = John|last2 = Moore| url=http://eprints.lse.ac.uk/19354/1/Foundations_of_Incomplete_Contracts.pdf }}{{Cite journal|title = Incomplete Contracts: Where do We Stand?|journal = Econometrica|date = 1999|issn = 1468-0262|pages = 741–781|volume = 67|issue = 4|doi = 10.1111/1468-0262.00052|first = Jean|last = Tirole|citeseerx = 10.1.1.465.9450}} Some authors have argued that the pros and cons of vertical integration can sometimes also be explained in complete contracting models.{{Cite journal|jstor = 4135244|title = Allocating Control in Agency Problems with Limited Liability and Sequential Hidden Actions|last = Schmitz|first = Patrick W.|date = 2005|journal = RAND Journal of Economics|volume = 36|issue = 2|pages = 318–336}} The property rights approach based on incomplete contracting has been criticized by Williamson (2000) because it is focused on ex-ante investment incentives, while it neglects ex-post inefficiencies.{{Cite journal|title = The New Institutional Economics: Taking Stock, Looking Ahead|journal = Journal of Economic Literature|date = 2000|issn = 0022-0515|pages = 595–613|volume = 38|issue = 3|doi = 10.1257/jel.38.3.595|first = Oliver E|last = Williamson|citeseerx = 10.1.1.128.7824}} It has been pointed out by Schmitz (2006) that the property rights approach can be extended to the case of asymmetric information, which may explain ex-post inefficiencies.{{Cite journal|title = Information Gathering, Transaction Costs, and the Property Rights Approach|journal = American Economic Review|date = 2006|issn = 0002-8282|pages = 422–434|volume = 96|issue = 1|doi = 10.1257/000282806776157722|first = Patrick W|last = Schmitz}} The property rights approach has also been extended by Chiu (1998) and DeMeza and Lockwood (1998), who allow for different ways to model the renegotiations.{{Cite journal|jstor = 117010|title = Noncooperative Bargaining, Hostages, and Optimal Asset Ownership|last = Chiu|first = Y. Stephen|date = 1998|journal = American Economic Review|pages = 882–901|volume = 88|issue = 4}}{{Cite journal|title = Does Asset Ownership Always Motivate Managers? Outside Options and the Property Rights Theory of the Firm|journal = The Quarterly Journal of Economics|date = 1998|issn = 0033-5533|pages = 361–386|volume = 113|issue = 2|doi = 10.1162/003355398555621|first1 = David de|last1 = Meza|first2 = Ben|last2 = Lockwood}} In a more recent extension, Hart and Moore (2008) have argued that contracts may serve as reference points.{{Cite journal|jstor = 25098893|title = Contracts as Reference Points|last1 = Hart|first1 = Oliver|date = 2008|journal = Quarterly Journal of Economics|doi = 10.1162/qjec.2008.123.1.1|volume = 123|issue = 1|pages = 1–48|last2 = Moore|first2 = John|citeseerx = 10.1.1.486.3894}} The theory of incomplete contracts has been successfully applied in various contexts, including privatization,{{Cite journal|title = The Proper Scope of Government: Theory and an Application to Prisons|journal = The Quarterly Journal of Economics|date = 1997|issn = 0033-5533|pages = 1127–1161|volume = 112|issue = 4|doi = 10.1162/003355300555448|first1 = Oliver|last1 = Hart|first2 = Andrei|last2 = Shleifer|first3 = Robert W.|last3 = Vishny| url=http://nrs.harvard.edu/urn-3:HUL.InstRepos:30727607 }}{{Cite journal|title = Public versus private ownership: Quantity contracts and the allocation of investment tasks|journal = Journal of Public Economics|date = 2010|pages = 258–268|volume = 94|issue = 3–4|doi = 10.1016/j.jpubeco.2009.11.009|first1 = Eva I.|last1 = Hoppe|first2 = Patrick W.|last2 = Schmitz}} international trade,{{Cite journal|title = Offshoring and the Role of Trade Agreements|journal = American Economic Review|date = 2012|issn = 0002-8282|pages = 3140–3183|volume = 102|issue = 7|doi = 10.1257/aer.102.7.3140|first1 = Pol|last1 = Antràs|first2 = Robert W|last2 = Staiger|url = http://nrs.harvard.edu/urn-3:HUL.InstRepos:3374525}}{{Cite journal|title = Protection and International Sourcing*|journal = The Economic Journal|date = 2012|issn = 1468-0297|pages = 26–63|volume = 122|issue = 559|doi = 10.1111/j.1468-0297.2011.02462.x|first1 = Emanuel|last1 = Ornelas|first2 = John L.|last2 = Turner|url = http://eprints.lse.ac.uk/28511/1/dp0900.pdf}} management of research & development,{{Cite journal|title = The Management of Innovation|journal = The Quarterly Journal of Economics|date = 1994|issn = 0033-5533|pages = 1185–1209|volume = 109|issue = 4|doi = 10.2307/2118360|first1 = Philippe|last1 = Aghion|first2 = Jean|last2 = Tirole|jstor = 2118360}}{{Cite journal|title = Optimal allocation of ownership rights in dynamic R&D alliances|journal = Games and Economic Behavior|date = 2003|pages = 153–173|volume = 43|issue = 1|doi = 10.1016/S0899-8256(02)00553-5|first1 = Stephanie|last1 = Rosenkranz|first2 = Patrick W.|last2 = Schmitz}} allocation of formal and real authority,{{Cite journal|title = Formal and Real Authority in Organizations|journal = Journal of Political Economy|date = 1997|issn = 0022-3808|pages = 1–29|volume = 105|issue = 1|doi = 10.1086/262063|first1 = Philippe|last1 = Aghion|first2 = Jean|last2 = Tirole|citeseerx = 10.1.1.558.3199}} advocacy,{{Cite journal|title = Advocates|jstor = 10.1086/250049|journal = Journal of Political Economy|volume = 107|issue = 1|doi = 10.1086/250049|first1 = Mathias|last1 = Dewatripont|first2 = Jean|last2 = Tirole|pages = 1–39|date = 1999}} and many others.
The 2016 Nobel Prize in Economics was awarded to Oliver D. Hart and Bengt Holmström for their contribution to contract theory, including incomplete contracts.{{Cite web | url=https://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2016/press.html | title=The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2016}}
In economic theory
In 1986, Grossman and Hart (1986) used incomplete contract theory in their seminal paper on the costs and benefits of vertical integration to answer the question "What is a firm and what determines its boundaries?". The Grossman-Hart theory of property rights is the first to explain{{Citation needed|date=May 2022}} in a straightforward manner why markets are so important in the context of organizational choice. The advantage of non-integrated markets is that the owners (entrepreneurs) can exercise their control, while the advantage of market transactions also stems from the power of restraint conferred by ownership.{{Cite journal |last1=Moore |first1=John |last2=Hart |first2=Oliver |date=2007 |title=Incomplete Contracts and Ownership: Some New Thoughts |url=https://www.research.ed.ac.uk/en/publications/incomplete-contracts-and-ownership-some-new-thoughts |journal=American Economic Review |language=English |volume=97 |issue=2 |pages=182–186|doi=10.1257/aer.97.2.182 }} The fact that economic actors are only finitely rational and cannot foresee all possible contingencies is perhaps at the heart of the problem.{{Citation |last=Moore |first=John |editor-first1=Philippe |editor-first2=Mathias |editor-first3=Patrick |editor-first4=Luigi |editor-last1=Aghion |editor-last2=Dewatripont |editor-last3=Legros |editor-last4=Zingales |title=Introductory Remarks on Grossman and Hart (1986) |date=2016 |url=https://oxford.universitypressscholarship.com/10.1093/acprof:oso/9780199826223.001.0001/acprof-9780199826223-chapter-1 |work=The Impact of Incomplete Contracts on Economics |place=New York |publisher=Oxford University Press |doi=10.1093/acprof:oso/9780199826223.001.0001 |isbn=978-0-19-982622-3 |access-date=2022-04-27|url-access=subscription }} However, as this uncertain state of nature or behavior cannot be written into an enforceable contract, when the contract is incomplete, not all uses of the asset can be specified in advance and any contract negotiated in advance must leave some discretion as to the use of the asset, with the 'owner' of the company being the party to whom residual control is allocated at the contract stage. Grossman and Hart claim that the essence of the firm lies in the decision-making power conferred by the ownership of its assets. In a world of incomplete contracts, decision-making power plays a key role in determining the incentives of owners.{{Citation |last=Holmström |first=Bengt |editor-first1=Philippe |editor-first2=Mathias |editor-first3=Patrick |editor-first4=Luigi |editor-last1=Aghion |editor-last2=Dewatripont |editor-last3=Legros |editor-last4=Zingales |title=Grossman-Hart (1986) as a Theory of Markets |date=2016 |url=https://oxford.universitypressscholarship.com/10.1093/acprof:oso/9780199826223.001.0001/acprof-9780199826223-chapter-2 |work=The Impact of Incomplete Contracts on Economics |place=New York |publisher=Oxford University Press |doi=10.1093/acprof:oso/9780199826223.001.0001 |isbn=978-0-19-982622-3 |access-date=2022-04-26|url-access=subscription }} Grossman and Hart believe that the optimal allocation or governance structure of property rights is the allocation that minimizes efficiency losses. Therefore, where Party A's investment is more important than Party B's, it is preferable to allocate title to the asset to Party A, even if this discourages Party B's investment.{{Cite journal |last=Hart |first=Oliver |date=2017 |title=Incomplete Contracts and Control |url=https://www.aeaweb.org/articles?id=10.1257/aer.107.7.1731 |journal=American Economic Review |language=en |volume=107 |issue=7 |pages=1731–1752 |doi=10.1257/aer.107.7.1731 |issn=0002-8282|url-access=subscription }} Incomplete contractual/property rights approach gives rise to theories of ownership and vertical integration, and it also directly addresses the question of what constitutes a firm. Both Grossman and Hart consider the firm to be a collection of assets over which the owners have residual control.
In 1990, Oliver Hart and John Moore published another article, "Property Rights and the Nature of the Firm", which provided a framework for addressing when transactions should take place within the firm and when they should take place through the market.{{Cite journal |last1=Hart |first1=Oliver |last2=Moore |first2=John |date=1990 |title=Property Rights and the Nature of the Firm |url=https://www.jstor.org/stable/2937753 |journal=Journal of Political Economy |volume=98 |issue=6 |pages=1119–1158 |doi=10.1086/261729 |jstor=2937753 |issn=0022-3808|hdl=1721.1/64099 |hdl-access=free }} The essence of the 1986 Grossman-Hart model is about the optimal allocation of the constraining forces conferred by ownership, and its model of property rights is about the allocation of assets between individuals (entrepreneurs) rather than firms. Whereas the Hart-Moore model of 1990 extends this optimal allocation of traction, property rights theory clarifies the content of the asset allocation assumptions between firms and identifies a firm with the assets that its owners control.{{Cite journal |last1=Hart |first1=Oliver |last2=Moore |first2=John |date=1990-12-01 |title=Property Rights and the Nature of the Firm |url=https://www.journals.uchicago.edu/doi/10.1086/261729 |journal=Journal of Political Economy |volume=98 |issue=6 |pages=1119–1158 |doi=10.1086/261729 |issn=0022-3808|hdl=1721.1/64099 |hdl-access=free }} One of Hart-Moore's key findings suggests an explanation for why firms, rather than workers, tend to own most of the non-human assets used to produce goods and services: complementary assets should be owned by one person.
= New ideas =
Incomplete contracts can create scenarios that lead to inefficient investments and market failures, but incompleteness is essentially a feasibility constraint. The 'strategic ambiguity hypothesis' assumes that the optimal formal contract may be deliberately incomplete. Companies use strategic ambiguity to circumvent legal constraints. Invalidate these agreements and make the law insufficient to prevent their formation and performance.
Limitations
Contracts have many restrictions in terms. Incomplete contracts are also limited by them. Contractual terms are the specific details of an agreement, including the rights and obligations of the parties. Contractual terms are broadly divided into two types, express terms and implied terms. Express terms are included in the signed contract, or a caveat that is reasonably noticeable to the other party. Implicit terms include those implied by the court and any relevant legal provisions.{{Cite book |last=Nickolas James |title=BUSINESS LAW 4E |publisher=Wiley |year=2014 |pages=293}}
= Terms implied by the Court =
Courts are often willing to imply a term in a settled contract to "fill in the gaps" as long as it is:
- Reasonable and fair;
- Necessary to make the contract workable;
- So obvious as to be "self-explanatory";
- Able to be expressed clearly and in line with clear terms.
Example:
- The court will imply into the contract terms which the parties are deemed to have known by virtue of the previous transaction.{{Cite book |url=http://dx.doi.org/10.5962/bhl.title.78573 |title=Seed annual 1906 |date=1906 |publisher=D.M. Ferry & Co |location=Detroit, Mich|doi=10.5962/bhl.title.78573 }}
= Statutory implied terms =
Example：
ACL’s (Australian Consumer Law) implied terms in consumer contracts are intended to protect the buyer, and there is an implied term in every contract for the sale of goods. Conditions of ownership by the seller, implies the right to sell these goods to the buyer:{{Cite book |last=Nickolas James |title=BUSINESS LAW 4E |publisher=Wiley |year=2014 |pages=301}}
- Provided that the goods will be as described.
- Provided that the goods will be of merchantable quality.
- Provided that the goods are fit for their purpose.
- Provided that most of the goods will correspond to the sample.
= Unenforceable terms =
- If one of the parties to the contract is a minor or a person lacking mental capacity, that party will not have the legal capacity to contract.{{Citation |title=Valid contracts—contracts which can be enforced against a minor Necessaries |date=2004-01-09 |url=http://dx.doi.org/10.4324/9781843145493-34 |work=Cavendish: Contract Lawcards |pages=123–128 |publisher=Routledge-Cavendish |doi=10.4324/9781843145493-34 |isbn=978-1-84314-549-3 |access-date=2022-04-27|url-access=subscription }} Only if both contract parties have the legal capacity to sign a contract, contracts are only enforceable.
- Some contracts are classified by common law as illegal and unenforceable:
——Contracts to promote corruption in public office{{Citation |title=Parkinson, Frank, (1887–28 Jan. 1946), Chairman: Crompton Parkinson Ltd, British Electric Transformer Co. Ltd, and Derby Cables Ltd |date=2007-12-01 |url=http://dx.doi.org/10.1093/ww/9780199540884.013.u230160 |work=Who Was Who |publisher=Oxford University Press |doi=10.1093/ww/9780199540884.013.u230160 |access-date=2022-04-27|url-access=subscription }}
——Contracts to prevent or delay the administration of justice{{Cite journal |last1=Mcalevey |first1=Lynn |last2=Sibbald |first2=Alexander |last3=Tripe |first3=David |date=2010-08-16 |title=New Zealand Credit Union Mergers |url=http://dx.doi.org/10.1111/j.1467-8292.2010.00414.x |journal=Annals of Public and Cooperative Economics |volume=81 |issue=3 |pages=423–444 |doi=10.1111/j.1467-8292.2010.00414.x |issn=1370-4788|url-access=subscription }}
The effect of a breach of a statutory provision on the validity and enforceability of a contract depends on the wording of the regulation itself.{{Cite book |last=A.) |first=Butler, D. A. (Des |url=http://worldcat.org/oclc/812861789 |title=Contract law : case book |date=7 February 2013 |publisher=OUP Australia & New Zealand |isbn=978-0-19-557847-8 |oclc=812861789}} An agreement may just be illegal because it violates a statutory prohibition.{{Citation |title=Anderson, Janet, (born 6 Dec. 1949), Associate Consultant, Pandic (Political and Industrial Connections) Ltd, since 2012; Director, Pearson-Anderson Communications Ltd, since 2015 |date=2007-12-01 |url=http://dx.doi.org/10.1093/ww/9780199540884.013.u5459 |work=Who's Who |publisher=Oxford University Press |doi=10.1093/ww/9780199540884.013.u5459 |access-date=2022-04-27|url-access=subscription }}
See also
References
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{{Authority control}}