Thursday, August 1, 2013

The Completeness of Contracts

Imagine for a moment that you and I are about to make a deal. I need $10,000 today in order to secure a fantastic bargain on a piece of machinery that will greatly improve my production capabilities. In return I promise to repay you $1000 a month every month for one year. We shake hands, you give me the money, the machine is purchased and everyone is happy. But... what if?

What if the machine breaks, I return it and receive the money back? Can I just return the $10,000 to you the next day?

What if my company goes bankrupt? How are you going to recoup your losses?

What if the value of the dollar collapses and the real purchasing power of your compensation amounts to far less than the original $10,000?

What if the machine exceeds all expectations and I earn incredible surpluses? Are you entitled to any additional gains?

What if I find myself with excess funds at some point during the year? Can I pay you off early and if so must I pay the full $12,000 or can I pay a prorated amount based upon how much of the year has passed?

These are only a few of the contingencies that could easily be written into our original contract.  However, the question of whether we should bother is surprisingly difficult to answer.

In contract theory there exists a spectrum of contract completeness ranging from complete to incomplete. A complete contract would cover every possible eventuality.  In practical terms such a contract is impossible as negotiating every conceivable event would be cost prohibitive.  On the other end of the spectrum an incomplete contract tends more towards a "You take care of me, I'll take care of you." sort of arrangement. In reality, nearly all contracts fall somewhere in between with important details being clearly spelled out while many possible contingencies are ignored.  A good example to illustrate the difference between the two ends of the spectrum is the difference between marriage and a prenuptial agreement. Marriage is generally a very loosely defined agreement between two people that they will live together and attempt to improve each others lives. There's not very much provided in the way of specifics beyond social norms such as monogamy. A prenuptial agreement on the other hand usually is very specific. It details exactly what each party will come out of a marriage with in the event of separation. Thus, in general a prenuptial agreement is a far more complete contract than a marriage agreement.

The question is then, are more complete contracts better?  Surprisingly, the answer very often seems to be no.  Every contingency built into a contract has an associated negotiation cost. Attempting to account for every possible eventuality piles on negotiation costs for events which are unlikely to ever occur.  Further, contingencies can often signal inaccurate or misleading information between parties.

For example, suppose you needed to contract a babysitter. You both agree that she will watch your children five nights a week (Monday to Friday) from 4 pm until 8 pm. She'll be paid $10 an hour which amounts to $200 per week.  Now suppose you add a stipulation that if you're running late she's expected to stay until 10 pm. The additional hours from 8 until 10 will be compensated at a rate of $12 per hour. How might this one contingency influence her view of the contract?

Most obviously such a contingency signals to her that it's likely you'll occasionally run late.  Whether her belief is accurate or not is irrelevant. The addition of this stipulation makes your tardiness appear to be likely to her. Given that you felt a need to cover the eventuality, as well as the correspondingly low additional compensation, it would seem as if you intend to be late fairly regularly. Contrast this contract with one wherein her compensation rises to $25 per hour after 8 pm.  Such a contract sends a far different message via it's much higher compensation.

An incomplete contract would neglect to specify this eventuality entirely and the involved parties would renegotiate or resolve the issue later when it arose, resulting in no signaling during contract creation.  If the two parties beliefs regarding appropriate compensation were similar there would be little in the way of losses and an incomplete contract (in this case) would end up being superior. Contrarily, if beliefs regarding compensation were very different there would be a difficult negotiation process and the more complete contract would have been better.

An extension of this signaling concept is the introduction of reference points. Suppose you require your babysitter to work a weekend a month from now. What is the appropriate compensation for weekend work? In the case of an incomplete contract you and the babysitter would come together to negotiate an appropriate price.  Again, if beliefs were similar in regards to what was appropriate the negotiation process would be smooth and little in the way of losses incurred. However, if beliefs were widely separated negotiation costs would quickly rise.

In the case of a more complete contract existing stipulation often provide reference points for negotiating parties. Returning to the previous example of late night hours, how might the different levels of compensation ($12 vs $25) influence how much the sitter expects for weekend work?  It would seem that weekend hours are similar to late night hours in that both are beyond the "normal" scope of the original contract. Thus the sitter will likely expect to receive compensation similar to whichever late night penalty rate is used. This contingency in a complete contract can thus have far reaching implications for future negotiations.

In general incomplete contracts seem to be better when parties have reason to trust each other and the balance of power is relatively even.  Complete contracts generally are superior when one party requires protection from the other (an uneven balance of power) or there is reason for mistrust.  A landlord for example holds a great deal of power over their tenants and thus a more complete contract is appropriate. Meanwhile a "Mow my lawn and I'll take you to dinner." deal is far more appropriate between neighbors.

The prevailing theme is that more specificity is not always better. At times, under the right conditions it's far more efficient to simply trust and deal with issues as they arise.  In fact, far more of our society relies on implied incomplete contracts than complete contracts. Every time someone pays for gas they didn't prepay for an incomplete contract is fulfilled.  Every birthday present, returned favor, IOU repaid, or split lunch check is an incomplete contract fulfilled. Most of them go unspoken and unrecognized, but incomplete contracts are the currency of our day to day interactions.

As always more economics next week. Until then stay safe and rational.

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