Contracting with Opportunistic Partners: An Incomplete Contracts Approach

40 Pages Posted: 16 Aug 2016

See all articles by Pablo Casas-Arce

Pablo Casas-Arce

Arizona State University (ASU) - W.P. Carey School of Business

Thomas Kittsteiner

RWTH Aachen University

Francisco de Asis Martinez-Jerez

University of Notre Dame - Department of Accountancy

Date Written: April 15, 2016

Abstract

After a contract is signed, contracting partners may engage in opportunistic behavior that circumvents the original intention of the agreement governing their business relationship (i.e. complying with the letter but not the spirit of the contract). We use an incomplete contracts approach to show that the anticipation and observability of such behavior are typically not enough to prevent it when parties can renegotiate contractual outcomes. This is because contractually specified incentives inevitably have conflicting effects: they simultaneously increase the likelihood of welfare-improving investments and welfare-reducing opportunistic behavior. The possibility of opportunism thus limits the effectiveness of contractual incentives and may call for simpler (less complete) rather than more complete contractual solutions. We provide general conditions for the optimality of incomplete contracts, a simple characterization of the second-best contract, and some comparative statics. We also discuss implications for vertical integration and make versus buy decisions.

Keywords: Incomplete contracts; Opportunism; Supply chain

JEL Classification: D23, J41, K12, L20

Suggested Citation

Casas-Arce, Pablo and Kittsteiner, Thomas and Martinez-Jerez, Francisco de Asis, Contracting with Opportunistic Partners: An Incomplete Contracts Approach (April 15, 2016). AAA 2017 Management Accounting Section (MAS) Meeting. Available at SSRN: https://ssrn.com/abstract=2823799 or http://dx.doi.org/10.2139/ssrn.2823799

Pablo Casas-Arce

Arizona State University (ASU) - W.P. Carey School of Business ( email )

Tempe, AZ 85287-3706
United States

Thomas Kittsteiner

RWTH Aachen University ( email )

Templergraben 55
52056 Aachen, 52056
Germany

Francisco de Asis Martinez-Jerez (Contact Author)

University of Notre Dame - Department of Accountancy ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States

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