Summary of literature on Incomplete Contracts
There are quite a number of schools of thought that constitute NIE. These include transaction cost economics, moral hazards and agency theory, economics of imperfection information, property rights, incomplete theory etc. (Kirsten, et al. 2009). This paper will look at the incomplete contract theory (ICT), focusing on the description of the theory, its justification, problems as well as solutions of incomplete contracts.
2.0 Incomplete Contracts Theory
Since the late 1980’s, there has been a considerable growth in the literature known as Incomplete Contracts Theory. ICT was founded by Oliver Hart, building on the insight from Williamson (Kirsten et al, 2009). This literature sets about formalising and extending some of the insights from the transaction cost theory (Williamson, 1975). Its focuses on the way different organizational structures assign property rights to resolve the issues that arise when contracts are incomplete. Oliver Hart and his coauthors, study the incentive effects of parties' inability to write complete contingent contracts, e.g. concerning relationship-specific investments.
The theory of incomplete contracts is closely related to the theory of firm. If complete contingent contracts could be written, we would not need firms. All transactions that are carried out within firms could be carried out between independent contractors. The firm is an attempt to deal with the problems that arise when contracts are incomplete.
Contracting can be costly when trading partners engage in opportunistic behaviour to circumvent the original purpose of a contract. Opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead or distort. Sometimes, opportunism is difficult to avoid, leading transacting parties to rely on contracts that are incomplete and offer weak incentives. When opportunism becomes very likely, the value of...