Incomplete Contract

Published Apr 29, 2024

Definition of Incomplete Contract

An incomplete contract is a contract that lacks specific terms and conditions, fails to address certain eventualities, or leaves significant decisions unmade, thereby requiring further negotiation and agreement between the parties involved. In the field of economics and law, an incomplete contract is seen as an inevitability due to the impossibility of foreseeing all future contingencies and the high costs of specifying every possible outcome in a contract.

Example

Consider a contract between a book author and a publisher. The contract may specify the deadline for manuscript submission and the initial payment amount. However, it might not detail the marketing plan, how additional profits are to be shared if the book becomes a bestseller, or revisions protocols if the book needs substantial changes after the first draft is submitted. These omissions necessitate further agreement and can lead to disputes if the parties have different expectations.

Another example could involve a long-term lease agreement for commercial property. The contract may cover the rent and basic terms but might not specify conditions for renovations or what happens if the property is significantly damaged through no fault of the lessee. Such situations require additional negotiation, which can lead to disagreements.

Why Incomplete Contracts Matter

The existence of incomplete contracts is crucial for two main reasons. First, it highlights the complexities and uncertainties in drafting comprehensive contracts that can account for every possible future scenario. This understanding is essential in business and legal practices, as it emphasizes the importance of flexibility, negotiation, and the need for mechanisms to resolve unforeseen issues.
Second, the theory of incomplete contracts influences organizational structure and governance. It affects decisions about whether to outsource or integrate operations, determine the boundaries of firms, and the design of contracts to align incentives.
In essence, recognizing and managing the limitations of contract completeness are foundational to effective economic and legal arrangements, helping parties navigate uncertainties and maintain cooperative relationships despite incomplete information.

Frequently Asked Questions (FAQ)

How do parties usually resolve issues arising from incomplete contracts?

Parties typically resolve issues through negotiation, mediation, or arbitration. They may refer to existing laws and regulations when the contract’s terms are unclear or incomplete. In some cases, principles such as good faith and fair dealing are invoked to fill gaps and resolve disputes. Tools like contingent contracts, where specific actions depend on future events, can also be used to address potential incompleteness.

Can incomplete contracts be beneficial?

Yes, in some contexts, incomplete contracts can be beneficial. They provide flexibility, allowing parties to adapt to unforeseen circumstances without the need for constant renegotiation of the contract terms. This adaptability can save costs and time, fostering long-term relationships and cooperation. The freedom to negotiate terms as situations evolve can also lead to more innovative and mutually beneficial solutions.

What role does trust play in incomplete contracts?

Trust plays a pivotal role in the management of incomplete contracts. Given the impossibility of specifying every detail and contingency, parties must rely on a mutual understanding and trust that they will deal with unforeseen circumstances fairly. Strong relationships and trust can reduce the need for detailed contracts, lower negotiation and enforcement costs, and facilitate more efficient dispute resolution.

How do economic theories view incomplete contracts?

Economic theories, particularly those related to contract theory and organizational economics, view incomplete contracts as both a challenge and a necessity. They examine how contract incompleteness affects the allocation of control rights, the design of incentives, and the governance structure of organizations. The Nobel Prize in Economic Sciences 2016 was awarded to Oliver Hart and Bengt Holmström for their contributions to contract theory, which includes foundational work on incomplete contracts and their implications for firm boundaries, ownership, and control rights.

By understanding the nature and implications of incomplete contracts, parties can better prepare for the uncertainties of business and legal relationships, ensuring more robust and adaptable arrangements that withstand the test of time and unforeseen circumstances.