Contractual Incompleteness and the Nature of Market Interactions

Zurich IEER Working Paper No. 38

61 Pages Posted: 29 Mar 2002

See all articles by Martin Brown

Martin Brown

University of St. Gallen

Armin Falk

briq - Institute on Behavior & Inequality

Ernst Fehr

University of Zurich - Department of Economics

Multiple version iconThere are 2 versions of this paper

Abstract

We provide experimental evidence that contractual incompleteness, i.e., the absence of third party enforcement of workers' effort or the quality of the good traded, causes a fundamental change in the nature of market interactions. If contracts are complete the vast majority of trades are initiated by public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Moreover, the short side of the market attempts to appropriate the whole gains from trade, which causes much disagreement about contract terms. If contracts are incomplete the vast majority of trades are initiated by private offers. The contracting parties form long-term relations and the provision of low effort or bad quality is penalized by the termination of the relationship. The threat of terminating the relation turns out to be an extremely powerful discipline device. Markets with incomplete contracts resemble a collection of bilateral trading islands rather than a competitive market. The short side of the market shares the gains from trade with the long side of the market so that there is little disagreement about contract terms. Our results support theories of the labor market that are based on the idea that unemployment is a worker discipline device.

Keywords: Market Interaction, Contract Enforcement, Incomplete Contract, Involuntary Unemployment, Repeated Transaction, Fairness Preferences

JEL Classification: D2, D4, C7, C9

Suggested Citation

Brown, Martin and Falk, Armin and Fehr, Ernst, Contractual Incompleteness and the Nature of Market Interactions. Zurich IEER Working Paper No. 38. Available at SSRN: https://ssrn.com/abstract=305707 or http://dx.doi.org/10.2139/ssrn.305707

Martin Brown

University of St. Gallen ( email )

Unterer Graben 21
St. Gallen, CH-9000
Switzerland

Armin Falk

briq - Institute on Behavior & Inequality

Schaumburg-Lippe-Straße 5-9
Bonn, 53113
Germany

HOME PAGE: http://www.briq-institute.org/

Ernst Fehr (Contact Author)

University of Zurich - Department of Economics ( email )

Blümlisalpstrasse 10
Zuerich, 8006
Switzerland
+41 1 634 3709 (Phone)
+41 1 634 4907 (Fax)

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