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文/Scott E. Masten

 CONTRACTUAL CHOICE

Abstract

 

This chapter discusses alternative theories of contract choice and design with

special emphasis on (i) the interaction between contract design and contract

enforcement and (ii) the explanatory power of alternative theories. After

discussing the primary functions of contract, the entry reviews the assumptions

and implications for contract design of the three dominant approaches to

contracting in economics. An overview of the empirical literature on

contracting and contractual choice identifies the main empirical regularities

and their relation to the theory. A final section addresses implications for

contract law and enforcement and directions for future research.

JEL classification: D23, K12, D82

Keywords: Contracting, Contract Enforcement, Incentives, Transaction Costs

 

1. Introduction

 

A contract, at its most basic level, is a legally enforceable agreement. Although

economists - and occasionally lawyers - have used the term more expansively

to describe essentially any transaction, the term contract as used in this chapter

is reserved for formal, legal commitments to which each party gives express

(though not necessarily written) approval and to which a particular body of law

applies. ‘Breaching a contract’ differs from ‘canceling an order’, to use Stewart

Macaulay’s (1963, p. 61) dichotomy. Ultimately, what distinguishes a contract

from a mere transaction is the opportunity contracts afford transactors to invoke

the formal dispute resolution machinery and coercive power of the state to

enforce promises.

 

Besides distinguishing true contracts from ‘implicit contracts’ or

self-enforcing agreements, this definition of contract highlights the

fundamental link between contract design, on the one hand, and contract

enforcement, on the other: the choice of contract terms will depend in part on

the legal rules and enforcement policies transactors expect courts to follow

while, at the same time, the enforcement practices of efficiency-minded courts

will depend on what courts perceive as the purpose and impediments to

contracting. In short, the analysis of contract law and enforcement presupposes

a theory of contracting behavior, and vice versa.

 

Despite this interdependence, the literatures on contract design and contract

enforcement have largely developed independently of one another. Economic

theories of contracting, for the most part, give little explicit attention to

enforcement issues, the presumption being that courts will see to it (subject only

to verifiability constraints) that whatever terms contracting parties arrive at are

fulfilled. Indeed, enforcing contracts as written is the court’s only function in

mainstream contract theory (see, for example, Tirole, 1994). This judicial

deference to contracts in economic theory contrasts with the far more intrusive

role of courts in economic analyses of contract law, in which courts are called

on to adjudicate disputes, fill gaps, and devise and implement default rules.

 

Perspectives on contracting can be divided into three broad categories. The

first consists of formal models associated with the principal-agent and

asymmetric information literature, including theories of both complete and

incomplete contracting; the second covers perspectives on contracting implicit

in the law and economics literature on contract law and enforcement; while the

third consists of what has come to be known as relational contracting theory,

an approach often associated with transaction cost economics. Dimensions

along which the theories differ include the functions of contracting, the

impediments to contracting, and the role of courts and their implications for

legal rules and contract enforcement. Last but not least, the theories differ in

their ability to explain and predict actual contracting behavior.

 

2. Why Contract?

 

As the definition in the introduction suggests, the essence of contract is

commitment. Without some form of assurance that others will, when the time

comes, uphold their end of a bargain, individuals will be justifiably reluctant

to make investments, forego opportunities, or take other actions necessary to

realize the full value of exchange. To be sure, reputation considerations - the

prospect that trading partners will withhold future cooperation - often provide

that assurance (Telser, 1980), especially in business transactions (Macaulay,

1963). But where the size or credibility of nonlegal sanctions is insufficient to

constrain opportunism, contracting offers an additional recourse: by

contracting, transactors expose themselves to legal sanctions for failing to

honor their commitments.

 

Beyond this basic commitment-enhancing function, contract theorists

generally associate three broad motives with contracting: risk transfer,

incentive alignment, and transaction cost economizing. In pure insurance or

risk-transfer transactions, the objective is to shift risk to the less risk-averse

transactor or ‘low-cost risk bearer’ (Cheung, 1969; Stiglitz, 1974). In incentive

contracts, the aim is to align the parties’ (commonly, a principal and agent)

individual incentives to take actions or reveal private information with their

joint-surplus maximizing interests (for example, Hart and Holmstrom, 1987).

Finally, transaction cost economists emphasize the use of contracts to reduce

various costs of transacting, especially, ex post bargaining and ‘hold-up’ costs

in transactions supported by relationship-specific investments (Williamson,

1975, 1979; Klein, Crawford, and Alchian, 1978) and ex ante sorting and

search costs in contexts where additional information serves merely to

redistribute rather than expand the available surplus (Kenny and Klein, 1983;

Goldberg, 1985). While the essence of contracting is commitment, the design

and interpretation of contractual agreements will depend on which of these

three motives dominates.

 

3. Formal Economic Theories of Contractual Choice

 

The search for contract terms that yield efficient outcomes is the subject of a

prodigious theoretical literature in economics. The customary starting point for

that inquiry is the complete contingent claims contract associated with the work

of Arrow and Debreu (see, for example, Hart and Holmstrom, 1987). Although

originally conceived as an analytical tool for modeling competitive equilibrium

rather than as a theory of contracting per se (see Guesnerie, 1992), the

efficiency properties associated with contingent trade in the Arrow-Debreu

framework made complete contingent claims contracts - contracts specifying

the physical characteristics, date, location, and price of a commodity for every

future state of nature - appealing to contract theorists as an archetype against

which to compare more realistic agreements: Arrow-Debreu complete

contingent claims contracts represent what transactors would write in an ideal

world free from ‘imperfections’.

 

Mainstream contract theories developed specifically to analyze actual

contracting practices fall into two categories depending on the nature and

source of the ‘real world’ imperfections they emphasize. So-called complete

contract theory analyzes the efficiency and contract design implications of the

inability of courts to verify particular events or outcomes. Departures from the

Arrow-Debreu ideal in complete contract theory thus derive from imperfections

or limitations of adjudicators at the contract execution stage. Incomplete

contract theory, in contrast, is concerned with the design and efficiency

consequences of imperfections arising during contract formation, specifically,

the limited capacity of transactors to anticipate, identify and describe optimal

responses to future events.

 

3.1 Complete Contracting

The cornerstone of complete contract theory is the recognition that courts may

not be able to verify some contingencies or outcomes and that contracting

parties, therefore, may not be able to condition performance on every relevant

contingency. The concern posed by nonverifiability is that, with the court no

longer able to determine whether some aspect of promised performance has

occurred, transactors stand to gain by strategically withholding information or

by altering their behavior in ways that yield private benefits but reduce joint

gains. In the standard terminology, the propensity to deviate from joint-surplus

maximizing behavior in the presence of asymmetric information is called moral

hazard when the distortion involves actions or information revelation ex post,

and adverse selection where ex ante private information leads only those

transactors with less desirable characteristics to transact (the so-called ‘lemons’

problem).

 

The problem of contract design in the complete contracting framework

consists of discovering a contingent payment schedule, or sharing rule, that is

incentive compatible, that is, that satisfies the requirement that the contract

leave the party with discretion over the unverifiable action at least as well off

acting in the parties’ joint interests as taking any other feasible action. When

only one party’s actions affect outcomes and that party is risk neutral, a

contract that makes that party the residual claimant (and distributes expected

gains to the other via a fixed payment) will be efficient. Nontrivial design

tradeoffs arise when aligning one party’s incentives results either in inefficient

risk sharing (if that party is also the more risk averse of the two) or in

inefficient incentives for the other party (the case of double-sided moral

hazard). In the latter settings, first-best outcomes will generally not be feasible.

(Reviews of this literature can be found in Hart and Holmstrom, 1987, and

Furubotn and Richter, 1998, among other sources.)

 

Although contracts designed to elicit voluntary performance of unverifiable

actions depart from the Arrow-Debreu ideal in leaving gains from trade

potentially unrealized relative to the cooperative (nonstrategic) outcome,

economists generally regard contracts optimally designed to deal with

information asymmetries as complete in the sense that such agreements (i) still

fully specify each party’s performance obligations for every possible

contingency, and (ii) yield the best possible outcome given the information

available to the courts at the time the agreement is carried out and thus ‘never

need to be revised or complemented’ (Holmstrom and Tirole, 1989, p. 68).

 

Despite the variety of settings in which risk sharing, moral hazard and

adverse selection are potentially important (see below), complete contract

theory’s performance as a positive theory has been disappointing. Aside from

the broad prediction that efficient sharing rules will balance incentives for one

party against inefficient risk bearing by that party or the incentives of trading

partners, asymmetric information models yield few testable hypotheses. One

reason for this is the ‘extreme sensitivity’ of optimal incentive schemes to slight

changes in the relation between actual performance and verifiable information

(Hart and Holmstrom, 1987, p. 105). Complete contract theory also fails to

account for the observed simplicity of sharing rules in most real world

contracts. Whereas the theory admits potentially detailed and complex payment

rules specifying each party’s performance obligations for every possible

contingency (in the case of discrete contingencies) and elaborate nonlinear

pricing rules (in the continuous case), actual contracts incorporate few if any

explicit contingencies and generally use simple, typically linear, pricing

schemes (Holmstrom and Hart, 1987; Bhattacharyya and Lafontaine, 1995).

Complete contract theory has also been faulted for its inability to distinguish

between, and therefore account for the choice between, contracting and other

institutional and organizational forms such as property rights and the firm.

 

3.2 Incomplete Contracting

Contract theorists consider a contract incomplete, or to contain a ‘gap,’ if

performance of the actual terms of the agreement would leave gains from trade

unrealized given the information available to the parties and the courts at the

time performance takes place (see, for example, Holmstrom and Tirole, 1989,

p. 68; Tirole, 1994, p. 18). Under the assumption that transactors possess

unlimited foresight and cognition, such an omission could never occur.

Incomplete contract theory relaxes the extreme rationality assumption of

complete contract theory and assumes that the limits on rationality that make

courts less than fully omniscient apply to contracting parties as well:

sophisticated but boundedly rational transactors will omit contingencies when

the costs of anticipating, devising optimal responses to, and drafting provisions

for improbable events outweigh the expected gains in efficiency from doing so.

Departures from the Arrow-Debreu ideal may thus arise in incomplete contract

theory from failures of the contracting parties to foresee and provide for

contingencies in formulating their agreement, instead of or in addition to the

inability of courts to verify performance.

 

The prospect that contracts might leave gains unrealized raises an issue for

the analysis of incomplete contracting that is not germane to complete

contracting, namely, how, if at all, contracting parties respond to opportunities

for mutually advantageous ex post adjustment. Two types of models can be

distinguished: those that permit renegotiation ex post, and those that do not.

 

(a) Models without Renegotiation Although linearity restrictions on sharing

rules have often been imposed by complete contract theorists for tractability

rather than theoretical or empirical reasons, exogenous restrictions on feasible

contracts will, except under special conditions, lead to ex post inefficiencies.

Accordingly, linear principal-agent contracts will in general be incomplete.

(Not surprisingly, therefore, considerable effort has been applied to identifying

the conditions under which linear contracts are sufficient for efficient

outcomes; see, for example, Holmstrom and Milgrom, 1987; Bhattacharyya and

Lafontaine, 1995.) Early principal-agent models mainly dealt with

opportunities for mutually advantageous adjustment within linear contracts by

ignoring them; contract terms were presumed to be definitive and immune to

ex post bargaining, and any ‘residual loss’ from imperfect adjustment to

changing events considered a component of ‘agency costs’ (Jensen and

Meckling, 1976, p. 308; see also Matthewson and Winter, 1985; Allen and

Lueck, 1992, 1993.)

 

Because of their greater tractability and more realistic starting assumptions,

linear agency models have been more successful than complete contract

theories at generating predictions and explaining observed contracts. Settings

in which moral hazard and adverse selection are likely to pose problems for

contracting parties are numerous, and many relationships can be cast in

principal-agent terms. Linear principal-agent models have been the primary

framework for analyzing contract terms in franchising (Matthewson and

Winter, 1985; Lal, 1990), agricultural share-cropping (Stiglitz, 1974; Eswaran

and Kotwal, 1985), and product warranties (Priest, 1981; Cooper and Ross,

1985), among other settings. The linear agency model has also recently been

extended to analyze multi-task settings in which agents perform either multiple

activities or a single activity with multiple dimensions (Holmstrom and

Milgrom, 1991).

 

Formal tests of agency model predictions have proved difficult, however.

The optimal sharing parameter that is the primary focus of these models

depends on factors such as the relative risk aversion of the principal and agent

and the relative effects of their actions on joint surplus. Because these factors

are difficult or impossible to measure, acceptance of the model often turns on

accepting the modeler’s risk preference and marginal productivity assumptions

(Stigler and Becker, 1977; Allen and Lueck, 1995). More generally, heavy

reliance by agency theorists on risk aversion to explain observed contracting

practices has been criticized, especially in the context of commercial

transactions, for diverting attention from other potentially more important

considerations (see Williamson, 1985b, pp. 388-389; Goldberg, 1990).

 

(b) Models with Renegotiation More recent models of incomplete contracting

generally assume that transactors can negotiate to take advantage of any ex post

gains on the grounds that (i) unrealized gains from trade create an incentive to

renegotiate, and (ii) contract law generally allows modification of contract

terms by mutual consent. Incorporating renegotiation into the analysis,

however, requires a model of bargaining, a perennial difficulty for economic

theory. The formal literature on incomplete contracting has generally

circumvented that problem by assuming that the parties costlessly negotiate to

the cooperative (Nash) outcome (Grossman and Hart, 1986; Hart and Moore,

1988; Lutz, 1995).

 

The assumption of costless renegotiation assures ex post efficiency and

thereby eliminates any role for contracts in establishing ex post incentives.

Benefits may nevertheless accrue to contracting if either (i) transactors are risk

averse or (ii) efficiency requires unverifiable ex ante investments. Even though

the parties are free to modify their agreements by mutual consent, the ability of

either party to enforce the contract’s original terms establishes the threat points

in any subsequent negotiation. Hence, by contracting, transactors are able to

influence the distribution of ex post surpluses and, thereby, the allocation of

risk and expected return on investments.

 

Incomplete contract theory has permitted formal analysis of alternative

organizational and institutional arrangements, especially the existence and

locus of property rights (for example, Grossman and Hart, 1986; Hart and

Moore, 1990) for which the complete contract framework was unsuitable. In the

eyes of some theorists, however, the gains in analytical scope come at the cost

of generality. While sympathizing with the view that individuals are not

capable of dealing with unlimited complexity, purists complain that, in the

absence of an accepted model of bounded rationality, restrictions on feasible

contract forms are unavoidably arbitrary and ad hoc (for example Tirole, 1994,

pp. 15-17; Hart and Holmstrom, 1987, pp. 133, 148).

 

4. Contracting in Law and Economics

 

In most respects, conceptions of contracting in law and economics conform to

those in economic theory more generally. Like mainstream economics, the law

and economics literature conceives of contracting as a device for

communicating substantive performance objectives. As Goetz and Scott (1985,

p. 265) describe it, contracting parties seek first ‘to negotiate a subjective

understanding about the combination of underlying substantive rights that form

the basis for mutually beneficial trade. What remains is an instrumental

problem, that of formulating contractual terms that mirror the desired

exchange.’ Like incomplete contract theory, law and economics also recognizes

that limitations of language and foresight generally prevent transactors from

drafting all-encompassing agreements, of which Arrow-Debreu contingent

claims contracts are again the archetype (for example, Shavell, 1984; Schwartz,

1992a, 1992b; Ayres and Gertner, 1992, p. 730). As a consequence of these

imperfections, contracts often contain gaps that leave performance under the

contract potentially inefficient, thus creating opportunities for efficiencyenhancing

adjustments.

 

Where law and economics and economic treatments of incomplete

contracting diverge is in the manner through which adjustments come about.

In economic contract theories, courts mechanically enforce contract terms, and

adjustments, if any, are accomplished through costless renegotiation. In law

and economics, the courts, rather than the transactors, evaluate opportunities

for adaptation and implement the necessary contractual modifications. In the

typical scenario, one of the parties will find performance at the contractually

specified price unprofitable and attempt to escape his contractual obligations,

leading the other party to bring suit to enforce the contract. If the contract is

incomplete and ex post bargaining is prohibitively costly, requiring

performance as specified in the agreement will be inefficient on at least some

occasions. By, instead, enforcing the contract in a way that corrects such

defects, courts will enhance efficiency, first, by increasing the efficiency of

performance ex post and, second, by reducing the need for transactors to

formulate detailed agreements, and hence the cost of contracting, in the first

place.

 

In general, the law and economics literature on contract advises courts to

complete incomplete contracts with terms the parties ‘would have bargained

for’ themselves had the costs of anticipating and incorporating provisions for

the event at hand been sufficiently low (see Chapters 4400 Implied Terms -

Interpretation; 4500 Unforeseen Contingencies - Risk Allocation; and 4600

Remedies). Since what the parties would have bargained for in the absence of

imperfections encountered during contract formation is a complete contract,

courts are essentially charged with discovering and implementing rules that

yield the efficient outcome given the information available to (that is, verifiable

by) the court (see Schwartz, 1992a, p. 281).

 

Overall, law and economics offers a richer characterization of background

legal rules and the role of courts in enforcing contracts from which economic

theories of contracting could benefit. At the same time, legal scholarship on

contracting can be faulted for not being more explicit about the purposes of

contracting and the ramifications of contract law for contracting behavior. As

Rubin (1996) observes, ‘When American legal scholars speak of “contracts”

they typically do not mean contracts at all, but rather judicial decisions ...

involving disputes about contracts. Contracts themselves, the transactions that

create them, and the business decision to comply with them, renegotiate them,

or breach them have rarely surfaced in the academic study of [contract]’ (as

quoted in Williamson, 1996).

 

5. Relational Contracting

 

Despite substantial differences in the roles they ascribe to courts, law and

economics and economic contract theory operate under the ‘legal centralist’

assumption that courts perform their assigned functions in ‘an informed,

sophisticated, and low-cost way’ (Williamson, 1983, p. 520). But whereas that

function in economic theories of contracting entails enforcing explicit

provisions, law and economics assigns courts the much more demanding

responsibility of discovering contracting parties’ ‘real’ intentions and

identifying opportunities for and implementing efficiency-enhancing

adjustments. As Oliver Williamson (1985b, p. 201) has remarked, ‘Judgement

based on detailed ex post knowledge of the particulars, including an

examination of the magnitude of the profitability consequences that accrue, will

often be the only way to ascertain whether an adjustment is warranted’

(compare Ayres and Gertner, 1989, pp. 116-117; Scott, 1990, pp. 600-601).

The prescription that courts fill gaps in incomplete contracts with what the

parties would have bargained for effectively presumes that courts possess such

knowledge and the expertise to perform the substantive calculations the

transactors would themselves have had to make to determine efficient

performance.

 

Law and economics’ confidence in the efficacy of court ordering and its

emphasis on substantive performance contain a paradox, however: if courts are

able to fill gaps accurately and costlessly, why would transactors ever incur the

time and expense of drafting definite performance obligations in the first place?

Instead, transactors could just indicate a vague intention to transact and let the

courts fill in the details thereafter. In a world in which contract formation is

costly and adjudication costless, a perfectly indefinite agreement, rather than

comprehensive Arrow-Debreu bargains, becomes the ideal contract (see

Charny, 1991, pp. 1840-1841). If transactors do specify definite performance

obligations, it must be to reduce the cost or inaccuracy of court ordering.

 

Explicit integration of adjudication costs into the analysis of contracting has

two immediate implications for contract design. First, where transactors design

contracts to avoid court ordering, the presumption that contract terms define

the substantive outcomes the transactors wish to see take place is no longer

justified. Transactors might reasonably prefer contract provisions that leave

gains from trade unrealized, or that relegate sufficiently worthwhile

adjustments to renegotiation or other forms of self help, over terms that specify

the efficient course of action but increase the costs or likelihood of litigation.

In such circumstances, express terms may have only an indirect, and possibly

even a contradictory, relation to the parties’ substantive aims (for example,

Masten and Snyder, 1993, pp. 60-63).

 

Second, the existence of judicial imperfections opens the door to conduct

designed to contrive cancellation, evade performance, or otherwise force a

renegotiation of the existing terms. Unlike moral hazard, which is a passive

response to price signals within an existing agreement, such behavior aims to

exact a de jure modification of terms previously agreed to. Among the tactics

available to a party seeking a redistribution of the gains from trade are suing

for trivial deviations, ‘working to rule,’ and withholding relevant information

in hopes of inducing breach (see Muris, 1981; Williamson, 1983, p. 526;

Goldberg, 1985; Masten, 1988b). Contracts from this perspective do not so

much define the terms of trade as determine the process through which the

terms of trade are ultimately arrived at (Macaulay, 1985). As Victor Goldberg

(1976, p. 428) has described it, the emphasis shifts from devising ‘a detailed

specification of the terms of the agreement to a more general statement of the

process of adjusting the terms of the agreement over time-the establishment, in

effect, of a “constitution” governing the ongoing relationship’.

 

Inasmuch as both regard contract terms as starting points for future

negotiations, relational and incomplete contract theories bear a passing

resemblance. The difference, however, is that renegotiation in the relational

framework is costly and unilateral preservation of the contract’s original terms

(including price) is neither certain nor free. An essential element of contract

design, therefore, becomes structuring the relationship in a way that reduces the

incentive to engage in wasteful efforts to evade performance or force a

renegotiation (compare Williamson, 1983; Goldberg, 1985; Klein, 1992, 1995,

1996; Masten, 1988b). Contract terms will also be used to affect the extent of

court ordering. Indefinite contracts that use terms such as ‘best efforts’, ‘gross

inequity’, or ‘substantial performance’ to describe contractual obligations leave

the parameters of acceptable performance ultimately to the courts. By contrast,

contracts that specify precise performance obligations, define sanctions (such

as liquidated damages or termination), and allocate discretion to invoke those

sanctions unilaterally, shift the locus of decision making and adjustment, to the

extent courts defer to written terms, from the courts to the transactors.

 

Finally, a process orientation also highlights the interaction between judicial

enforcement policies and contract design. To the extent that deviations between

contract terms and transactors’ substantive intentions reflect efforts to

economize on adjudication costs, judicial efforts to complete ‘incomplete’

agreements may frustrate rather than foster the parties’ intentions. The ability

of contracting parties to achieve process objectives - to reduce court ordering

through the use of more precise language, for example - depends on the extent

to which courts are willing to defer to written terms.

 

6. Empirical Evidence on Contractual Choice

 

Several reviews of the empirical literature on contracting have been published,

the most recent of which are Shelanski and Klein, 1995; Crocker and Masten,

1996; Lyons, 1996, and Lafontaine and Slade, 1997, 1998. The following

identifies some of the most prominent findings and regularities and their

relation to the theories discussed above.

 

6.1 Contracting and Contract Duration

One of the most firmly established regularities in the empirical literature on

contracting is the association between relationship-specific investments (or

reliance) and the use and duration of contractual agreements. An early and

well-known example is Joskow’s (1987) econometric analysis of the duration

of nearly 300 coal contracts. Exploiting regional differences in the

characteristics of coal and transportation alternatives and variations in contract

quantity, Joskow’s study showed the duration of coal contracts to be

significantly correlated with measures of physical- and site-specificity and

dedicated assets. A more recent study of engineering subcontracting practices

in the United Kingdom by Lyons’ (1994) suggests that specificity affects not

only the duration of contracts but the decision to contract in the first place. The

engineering firms and subcontractors in Lyons’ sample were significantly more

likely to adopt formal contracts, over more flexible but less secure informal

agreements, where investments in relationship-specific physical and human

capital left the subcontractor vulnerable to ex post opportunism. Empirical

research has also identified a correlation between long-term contracting and

specificity in natural gas (Crocker and Masten, 1988); petroleum coke

(Goldberg and Erickson, 1987); and ocean shipping contracts (Pirrong, 1993),

among others.

 

Contracting appears less attractive as a way of protecting reliance or

relationship-specific investments, however, where the alternative to contracting

is integrated ownership and production. Empirical research on integration

decisions reveals a consistent preference for integration over contracting as the

specificity of investments increases (for overviews, see Joskow, 1988; Shelanski

and Klein, 1995; Crocker and Masten, 1996; and Chapter 0530 New

Institutional Economics). Contracting thus appears to be only an imperfect

response to the hazards posed by relationship-specific investments. Empirical

research suggests, moreover, that the costs and limitations of contracting grow

with the complexity and uncertainty of the transaction. In Lyons’ (1994) study

of engineering transactions, for example, firms were less likely to use formal

contracts for advanced technology projects than for relatively simple

procurements. Meanwhile, Goldberg and Erickson (1987) and Crocker and

Masten (1988) found that contract duration in petroleum coke and natural gas

contracts decreased in periods of increased uncertainty, contrary to what would

be expected if risk-sharing were the primary motive for contracting. Research

on the determinants of make-or-buy decisions suggests that uncertainty and

complexity diminish the attractiveness of contracting relative to integration as

well (for example, Masten, 1984; Anderson and Schmittlein, 1984).

 

Though clearly an important determinant, the protection of specific

investments is not the sole motive for contracting. Unsupported assertions to

the contrary notwithstanding, relationship-specific investments in franchising

appear to be modest and unimportant as a motive for franchise contracting (see

Lafontaine and Slade, 1997, 1998). Indeed, the viability of some contractual

arrangements, such as franchising and equipment leasing, may depend on

assets actually being redeployable at reasonably low cost (Klein, 1995; Masten

and Snyder, 1993). Case studies have also shown benefits of contracting to

accrue to the desire to control free-riding on the provision of information or

services (for example, Rubin, 1978; Masten and Snyder, 1993) and to avoid

unproductive search and sorting costs (Kenney and Klein 1983; Gallick, 1984).

 

6.2 Contract Design

(a) Incentive Provisions The empirical literature offers broad support for the

proposition that transactors choose contract terms to promote efficient

adaptation and mitigate transaction costs. In contemporaneous studies of

natural gas contracting, Masten and Crocker (1985) and Mulherin (1986) found

that take-or-pay percentages in natural gas contracts varied with the alternative

value of gas reserves, supporting an incentive interpretation over the alternative

view that take-or-pay provisions serve distributional or risk-sharing purposes

(for example, Hubbard and Weiner, 1986). Case studies describing the use of

minimum purchase requirements for coal (Carney, 1978) petroleum coke

(Goldberg and Erickson, 1987), and bauxite (Stuckey, 1983), among other

products, corroborate this finding (see Masten, 1988a, pp. 91-92, for a

discussion). In a related study, Crocker and Masten (1988) found that the

prospect of inefficient adaptation associated with distortions in the size of

take-or-pay provisions significantly reduced the willingness of parties to engage

in long-term contracting.

 

Incentive considerations also appear to be influential in determining sharing

arrangements. Lafontaine (1992), for example, found that royalty rates across

franchises tend to vary with the relative importance of franchisor and

franchisee effort. Observed correlations between uncertainty and royalty rates

(and the use of franchised versus company outlets) are inconsistent with the

standard assumption of franchisee risk aversion, however. (Reviews of the

empirical literature on franchise contracting can be found in Lafontaine and

Slade, 1997, 1998).

 

Risk sharing as a motive for contracting has fared poorly in other settings

as well. Allen and Lueck (1992), for instance, conclude that the incidence of

crop-share versus fixed-rent contracts between farmer-tenants and landowners

are unrelated to the riskiness of crops. Similarly, Leffler and Rucker (1991)

reject risk sharing as an explanation for why timber track owners and

harvesters sacrifice the incentive advantages of lump-sum relative to royalty

contracts in favor of the hypothesis that the use of royalty contracts on relatively

remote and heterogeneous timber tracks reflects the desire to avoid wasteful

pre-bid inspection under lump-sum contracts. Finally, Holmstrom and Milgrom

(1991) interpret Anderson’s (1985) and Anderson and Schmittlein’s (1984)

finding that importance of non-selling activities and difficulty measuring

performance of sales agents explain manufacturer reliance on low-powered

incentives as evidence that measurement costs in multitask settings are a

critical determinant of the intensity of incentives in contractual relations (see

also, Slade, 1996).

 

(b) Relational Contracts Whereas most of the empirical contracting literature

focuses on standard price and quantity provisions, research on relational

contracting has sought to account for the widespread use of contracts that leave

important terms like price and quantity indeterminate. Examples of such

provisions include price renegotiation and ‘market out’ provisions in natural

gas contracts (Crocker and Masten, 1991), ‘gross inequity’ provisions in

long-term coal contracts (Joskow, 1985), termination-at-will and best-efforts

clauses in franchise agreements (Hadfield, 1990), substantial performance

requirements in construction contracts (Goetz and Scott, 1981), and other ‘open

term’ agreements (for example, Gergen, 1992).

 

Large-scale analyses of relational contract provisions have focused on

methods of price adjustment. Crocker and Masten (1991), for instance,

conclude from their study of price adjustment in natural gas contracts that

circumstances favoring the use of long-term, fixed-quantity agreements favor

the adoption of relatively indefinite price adjustment provisions over formulaic

adjustment mechanisms that, although less costly to implement, are more likely

to induce efforts to evade performance obligations in extreme situations. As

Goldberg and Erickson (1987) note, greater reliance on renegotiation

provisions in fixed versus variable quantity contracts is difficult to reconcile

with incentive alignment motives. Crocker and Reynolds’ (1993) study of jet

engine procurement contracts also found that price adjustment was likely to

become less definite as performance horizons lengthened and technological

uncertainty increased, while contractor litigiousness and the absence of

alternative engine suppliers favored more definite price terms. The available

evidence thus generally supports the notion that transactors’ choice of contract

terms reflects a tradeoff between the specification costs and rigidities associated

with specifying detailed performance obligations in uncertain or complex

transactions, on the one hand, and the greater flexibility but higher expected

cost of establishing the terms of trade ex post in less definite relational

contracts.

 

7. Implications and Directions

 

Economic research on contracting is important to both legal scholarship and

practice. Contracting is a - perhaps the most - fundamental institution of legal

as well as economic interaction (compare Williamson, 1996). At a practical

level, the study of contracting stands to inform lawyers and lawmakers about

the objectives of contracting parties and the sources of contractual failures. For

lawyers, such knowledge can provide insights with which to help clients design

more effective agreements. For legislatures and courts, understanding the

functions and limitations of contracting is crucial to the formulation of

appropriate legal rules and their application in individual cases. As noted

previously, whether and how courts intervene in contractual relations will

depend on the theory of contracting behavior to which they subscribe. Theories

that place confidence in the ability of parties to effect private orderings either

through ex ante specification of contingent performance or through low-cost,

ex post negotiation will favor a policy of passive judicial enforcement, whereas

theories that emphasize the behavioral and cognitive impediments to ex ante

alignment and ex post negotiation without similar regard for the cognitive

limitations of judges will tend to favor more active enforcement and

intervention by the courts.

 

As various commentators have noted, official contract law, as reflected in

the United States in Section 2 of the Uniform Commercial Code and

Restatement (2nd) of Contracts, has moved increasingly toward favoring more

active judicial enforcement. Where once courts were discouraged from using

extrinsic evidence in interpreting contractual obligations, modern contract law

endorses an active enforcement policy, encouraging courts to interpret

contractual agreements ‘in light of surrounding circumstances’. Despite this

widely-noted shift, however, the evidence is that courts have been far from

uniform in their approach to contract enforcement. In practice, courts as a

group neither universally seek to discover the parties’ true intentions from the

context of their agreement - as the Code and Restatement recommend - nor

consistently defer to written terms (Goetz and Scott, 1985, p. 307; Schwartz,

1992a). Such variations, moreover, cannot be explained entirely by

philosophical differences among courts; judicial enforcement policies appear

to vary systematically across disputes, courts tending to enforce franchise and

distributorship agreements more passively than contracts for intermediate goods

between manufacturers and suppliers (see Hadfield, 1990, pp. 978-990;

Schwartz, 1992a, pp. 271, 304-305; Farnsworth, 1990, p. 556). Further

research on variations in judicial enforcement policies and the dimensions

along which they vary is likely to shed additional light on the functions and

limitations of contracting.

 

Although there are indications that recent research on contractual choice

has already begun to influence how courts think about contracting and resolve

contract disputes (see, for instance, PSI Energy v. Exxon Coal, USA, 991 F.2d.

1265 (1993)), much more needs to be done before positive theories of

contracting can provide a solid basis for normative prescriptions. Such basic

questions as why transactors choose super-compensatory liquidated damages

have yet to receive a fully satisfactory explanation. More subtle but important

issues like the effects of contractual protections on the willingness of

transactors to make relationship-specific investments are just beginning to

receive scrutiny (for example, Saussier, 1998). Although theoretical tensions

are likely to persist between those who value axiomatic rigor and those willing

to invoke empirical regularities to develop testable predictions, on one issue at

least, the two approaches appear to be converging, namely, that further progress

on understanding contracting requires a better appreciation of the interactions

of contract design and contract enforcement and the process functions of

contracting (compare Tirole, 1994).

 


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