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Satisficing Contracts

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes from Patrick Bolton of Columbia Business School.)

In my working paper Satisficing Contracts which I recently presented at the Law, Economics and Organizations Workshop here at Harvard Law School, my co-author Antoine Faure-Grimaud and I analyze a contracting model with two agents, each facing thinking costs, in which equilibrium incomplete contracts arise endogenously. The basic situation we model is an investment in a partnership or an ongoing new venture. The contract the agents write specifies in a more or less complete manner what action-plan they agree to undertake initially, and how the proceeds from the venture are to be shared. In any given state of nature both agents face costs in thinking through optimal decisions in that state. Therefore an optimal contract that maximizes gains from trade net of thinking costs is generally incomplete in the sense that it is not based on all the information potentially available to agents in all states of nature. By introducing positive thinking or deliberation costs into an otherwise standard contracting framework, it is thus possible to formulate a theory of endogenously incomplete contracts.

The main results from our analysis are as follows: First, incomplete contracts specifying control rights may emerge in equilibrium (when such contracts are not strictly dominated by a complete contract with the same equilibrium information acquisition). The rationale for control rights in our model?defined as rights to decide between different transactions in contingencies left out of the initial contract?is that the holder of these rights benefits by having the option to defer thinking about future decisions. Second, control rights tend to be allocated to the more cautious party. Indeed, the more cautious party is then more willing to close the deal quickly, even though it has not had the time to think through all contingencies, in the knowledge that thanks to its control rights it can impose its most favored decision in the unexplored contingencies. Third, the sharp distinction between a first contract negotiation phase followed by a phase of execution of the contract usually made in the contract theory literature is no longer justified in our setup. In particular, the contracting agents may choose to begin negotiations by writing a preliminary contract specifying the broad outlines of a deal and committing the agents to the deal. Fourth, when agents? objectives conflict more, equilibrium contracts are more complete. The main reason is that each agent may be concerned about the detrimental exercise of control by the other agent, so that abuse of power cannot be limited by just allocating control to the agent that is least likely to abuse power. In such situations the exercise of control may have to be circumscribed contractually by writing more complete contracts. Another reason is that when agents have conflicting goals they are less willing to truthfully share their thoughts, so that the net benefit of leaving transactions to be fine-tuned later is reduced.

Our analysis thus provides new foundations for incomplete contracts and the role of control rights. In particular, our framework allows for contractual innovation by the contracting agents independently of any changes in legal enforcement. In addition, changes in legal enforcement may have no effect on equilibrium contracts if enforcement constraints were not binding in the first place. The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on November 29, 1999 (boomark / email).