A Theory of Self-Enforcing Indefinite Agreements

Abstract

All contracts are incomplete. But incomplete contracts differ along several key dimensions. Many contracts are incomplete because parties decline to condition performance on future states that they cannot observe or verify to courts. In these cases, the incompleteness is exogenous to the contract. Other agreements, however, appear to be "deliberately" incomplete in the sense that parties decline to condition performance on available, verifiable measures that could be specified in the contract at relatively low cost. Thus, incompleteness is endogenous to these agreements suggesting that the parties had other reasons for leaving the terms in question unspecified.

Traditional contract law doctrine appears to track this distinction. One of the core principles of contact law is the requirement of definiteness. An agreement will not be enforced as a contract if it is uncertain and indefinite in its material terms. It is widely believed, however, that the indefiniteness doctrine is largely ignored by contemporary courts. But a study of the contemporary case law on indefinite contracts reveals some striking facts. In literally dozens of cases, American courts dismiss claims for breach of contract on the grounds of indefiniteness, often without granting any relief to the disappointed promisee. This evidence raises a fundamental question: Why do parties write deliberately incomplete agreements in the shadow of a robust indefiniteness doctrine?

One hypothesis is that these agreements may be self-enforcing. But most of the recently litigated cases do not appear to be self-enforcing in the traditional sense. Rather, most are isolated transactions between strangers trading at arms length. Recent work in experimental economics suggests, however, that the domain of self-enforcing contracts may be considerably larger than has been conventionally understood. A robust result of these experiments is that a significant fraction of individuals behave as if reciprocity were an important motivation (even in isolated interactions with strangers) while a comparable fraction react as if motivated entirely by self interest. These experiments support a theory that predicts that deliberately incomplete contracts that rely on self-enforcement through reciprocal fairness are more efficient than the alternative of more complete, legally enforceable agreements. The potency of reciprocal fairness as a method of self-enforcement explains (and justifies) the resiliency of the common law indefiniteness doctrine in the face of a contemporary academic consensus in favor of expanding the scope of legal regulation.

JEL Classification: D82, K12