Incomplete Contracts and Corporate Ethics: A Game Theoretical Model Under Fuzzy Information
University of Siena Working Paper
49 Pages Posted: 25 Jun 2003
Corporations allocate to their corporate governance structures authority over a large part of the transactions they carry out, both regulated by (incomplete) labour contracts or by (incomplete) arm's length contracts. These contracts, as the eventuality of unforeseen contingencies is anticipated, are completed by residual rights of control allocating discretion upon ex ante non-contractible decisions to one party in the contract. Ownership and control structures respond to a need of minimising some transaction costs, but also admit the risk of abuse of authority. Both empirical investigation and theoretical deduction from the theory of firm suggest that corporations need systems of self-regulatory norms of behaviour like codes of ethics exactly because of the 'abuse of authority' problem. One requirement that a code of ethics must satisfy is to answer the question of how who holds authority in the firm may undertake commitments over events and situations that cannot be ex ante contractible nor describable. This paper suggests a first modelling of unforeseen contingencies in terms of fuzzy sets theory. Incomplete knowledge about unforeseen contingencies is captured by defining some events as fuzzy sub-sets of the set of unforeseen states of the world. Such events correspond to terms of the ex ante language used to define the domain of general abstract principles. The cost of their all-encompassing nature is vagueness. This opens the route to define domains of abstract principles as fuzzy sets of unforeseen states of the world. Then players' inferences are understood according to the logic of default reasoning. The intuition is that, given our limited knowledge, we extend our belief that the 'normal course' does in fact hold also to the unforeseen situations. As a consequence commitments are defined that a player conforming to the code is expected to carry out. This allows replicating within the new context some well-known results in the theory of reputation games.
Keywords: Incomplete contract, Authority, Ethics, Reputation, Fuzzy logic
JEL Classification: C72, D23, L14, M14
Suggested Citation: Suggested Citation