Strategic Incomplete Contracts: Theory and Experiments

53 Pages Posted: 30 Dec 2014

See all articles by Nisvan Erkal

Nisvan Erkal

University of Melbourne - Faculty of Business and Economics

Steven Y. Wu

Purdue University - College of Agriculture; IZA Institute of Labor Economics

Brian E. Roe

Ohio State University (OSU) - Department of Agricultural, Environmental & Development Economics

Abstract

We develop a model of strategic contractual incompleteness that identifies conditions under which principals might omit even costlessly verifiable terms. We then use experiments to test comparative statics predictions of the model. While it is well known that verifiability imperfections can limit complete contracting, researchers know less about how the degree of imperfection affects endogenous incompleteness, particularly with repeat trading. In our baseline treatment with perfect verifiability, subjects overwhelmingly used complete contracts to conduct trades, achieving nearly first best outcomes. In our partial verifiability treatment with a reduced set of verifiable performance levels, the results reversed and parties relied heavily on incomplete contracts that omitted even costlessly verifiable terms. However, the efficacy of incomplete contracts in outperforming available complete contracts depends critically on the continuation probability of repeat trading. With a small continuation probability, incomplete contracts did no better than complete contracts while exposing parties to considerable strategic uncertainty.

Keywords: incomplete contract, relational contract, endogenous incompleteness, informal incentives, experimental economics

JEL Classification: C73, C91, D86, J41, L14, L24, M52

Suggested Citation

Erkal, Nisvan and Wu, Steven Y. and Roe, Brian E., Strategic Incomplete Contracts: Theory and Experiments. IZA Discussion Paper No. 8704. Available at SSRN: https://ssrn.com/abstract=2543898

Nisvan Erkal (Contact Author)

University of Melbourne - Faculty of Business and Economics ( email )

Victoria, 3010
Australia
+61 3 8344 3307 (Phone)
+61 3 8344 6899 (Fax)

HOME PAGE: http://www.nisvanerkal.net

Steven Y. Wu

Purdue University - College of Agriculture ( email )

United States

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

Brian E. Roe

Ohio State University (OSU) - Department of Agricultural, Environmental & Development Economics ( email )

2120 Fyffe Rd
Columbus, OH 43210-1067
United States
614-688-5777 (Phone)

HOME PAGE: http://https://aede.osu.edu/our-people/brian-e-roe

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