Wednesday, April 13, 2005
In a great many contractual situations, one party has a substantial amount of discretion over its own performance. A law school, for example, has a contract with its students, but the school will unilaterally decide what classes are offered, who will teach them, what time they'll be taught, what hours the library will be open, who'll be licensed to provide beverages in the building, and so on. MIT economist Birger Wernerfelt views these as incomplete contracts where subsequent term-making has been delegated to one party. In Incomplete Contracts and Renegotiation, he tries to model such situations:
The parties to a contract typically make a lot of decisions during the time it is in force, and the paper is based on the premise that it takes time to be involved in any one of these decisions. Attempts to economize on decision-making time then imply that the parties may write a contract in which each cedes some decision rights to the other. The cost of the arrangement is that the information and preferences of the uninvolved party are neglected. We find that decisions are more likely to be left out of contracts if only one player attaches significant weight to them and simultaneously is well informed. While the direct effect of this may be small, it is dramatically amplified if the decision-maker can be disciplined by the threat of renegotiation. We identify a set of conditions under which the possibility of renegotiation allows the parties to leave all non-price decisions out of the contract. By thus arguing that the threat of renegotiation allows contractual incompleteness, the paper reverses the direction of causality stressed by the literature.