Before signing such a contract, we run a cost-benefit analysis.
We compare the benefit from the other party’s expected behavior with the cost of the obligations we commit to in return.
Because contracts are free agreements, we sign the contract only if the benefits exceed the costs.
What if the other party behaves differently from our expectations?
Maybe because of a misunderstanding, maybe because of some external cause, maybe because
the other party voluntarily breaches the contract,
we face a behavior that is not what we expected when we signed the contract.
For example, the product we bought is not what we assumed it was, for example,
the tomatoes we bought were not organic.
If this happens, then it is likely that our Cost-Benefit evaluation was wrong.
There is a potential for a loss in profits (or utility).
In our example, we paid that high price because we assumed we were buying organic tomatoes.
However, the price was definitely too high for conventional tomatoes.
Here is where Law studies and Economics take different directions.
If you ask a lawyer about this problem.
He/she says that you can ask for compensation.
You suffered for an unfair loss in utility, and therefore, you are entitled of to compensation.
A Judge will assess the liabilities and the fair reparation.
The economist’s point of view is different.
The main idea is that lawsuits are risky and costly in time and resources.
It is better to stay away from them.
It is better to prevent the whole situation.
It is much preferable to design a contract in such a way, so that the other party has
not incentive to unexpected behavior.
The trick is making strategic concessions to make unexpected behavior unprofitable.
It may sound confusing now, but I hope it will be clear by the end of the module.
For now let’s focus on this study question: “How can we write a contract in such a way,
so that the other parties behave exactly as we expect them to do?”
Of course, being economists, we are interested in achieving our objective while minimizing the costs.
Let’s start our analysis describing “the perfect contract”, which is a contract that
makes us sure that our expectations are met.
We can be sure of this if several conditions are satisfied.
In particular, it must be possible and costless to write a contract that:
is perfectly clear and leaves no rooms for misunderstanding.
It considers all possible cases and actions, leaving no loopholes of any kind.
The actions of all parties are perfectly observable.
All parties know exactly if whether and how the others fulfill their obligations.
If somebody breaches the contract, all other parties detect the violation and can assess its extent perfectly.
Once violations are detected, the party can be forced to fulfill the obligations.
Otherwise, perfect compensation is obtained from a costless, immediate and perfect judgment.
If all these conditions are met, we have a “Complete” contract.
A complete contract is efficient according to the Coase Theorem in Lesson 1 and effective.
Unfortunately, perfect contracts are also almost impossible to achieve.
In real life, things are different: writing a clear contract requires costly expertise,
for example, the work of a good lawyer. It is practically impossible
to rule out all conceivable loopholes.
Perfect monitoring is very rare.
Lawsuits are costly. In real life complete contracts are almost impossible.
Therefore, we need to use incomplete contracts.
This means that we need to deal with a serious issue: opportunism.
Opportunism is defined as “the taking of opportunities as and when they arise,
regardless of planning or principle”.
In our setting, opportunities arise from incomplete contracts.
If the contract is incomplete, changes in the business environment (such as a new customer,
changes in prices, or even the action of the other parties) may create new opportunities for profits.
Then, the opportunists might maximize their own profits by behaving differently from others expectations.