Economists define a complete contract as one that eliminates opportunities for shirking by stipulating each party’s responsibilities and rights for each and every contingency that could conceivably arise during a transaction (Economics of Strategy, Dranove D, Besanko D, Shanley M and Schaefer M, 7thedition, p105).
A complete contract therefore sets out courses of action during a transaction, providing rewards when objectives are met and penalties when they are not. The idea of a complete contract comes from the notion that the activities, actions and outcomes under a complete contract would mimic all the steps that a firm would undertake if it conducted that activity inhouse. With a complete contract you would be indifferent if you did the activity yourself (make) or you outsource the activity (buy).
The agreement must be enforceable such that an outside party, such as a judge or an arbitrator, must be able to observe which of the contingencies occurred and whether each party undertook their responsibilities. Finally, any specified damage must be capable of being met by the shirking party, otherwise what’s the point, right.
Suffice to say in a commercial context a complete contract does not exist. All relevant contingencies must be covered off, all actions agreed, rewards and penalties clear. Parties must agree on what makes for satisfactory performance and parties must be able to measure this.
So then most contracts must be incomplete – check out the Lululemon controversy.
There are a number of reasons why contracts are incomplete.
Problems with complexity – how is it possible to consider every contingency in every transaction, a concept otherwise known as bounded rationality.
There are also problems with specifying or measuring performance just like in the Lululemon case. Was the see through yoga pant due to lack of specificity of the sheer or a design issue? How many times have you seen the word ‘reasonable’ or ‘best endeavours’ in an agreement. See this Lululemon summary.
Then there is the old chestnut of asymmetry of information, where parties to an agreement do not share or do not have equal access to all contract relevant data or information. A caveat emptor for example or quality control for example; did the supplier of the Lululemon yoga pant follow specifications, was the sheer even specified?
A well-developed body of contract law such as in Australia or the USA makes it possible for transactions to occur smoothly when contracts are incomplete. Some agreements specify standard provisions, for example real estate transactions. Even within these transactions there are broadly defined terms which make matters contentious. Just what is reasonable notice? So we have to create guiding principles outside agreements to help what’s in the agreement.
Matters escalate to litigation which is a costly way of “completing” contracts, not to mention time delays, uncertainty and more often than not relationships which cannot be mended.
Relationships are developed by way of interactions in the market place. For example, when goods are produced or services delivered they are provided on the basis of some key performance measures – timing for example, sequencing, technical competencies, colour, condition, quality etc. Contracts tend to manage these relationships. Some contracts may even enable assignment of certain activities others may not.
Confidential or private information adds another layer of complexity. Patents go some way to help with protecting processes or intellectual property, but they also suffer from similar issues such as bounded rationality or what detail the patent actually intend to cover or protect. Employees for example may be trained or educated and this cannot be taken back, so they are managed through non-compete agreements. Again for reasons noted these agreements are also incomplete.
Economists describe these interactions as transaction costs.
Take transactions between parties which involve relationship specific assets, that is assets required specifically to complete a transaction. These assets could be technically trained staff in a specific area to manage client demands or geographically positioning a business, or assets acquired or developed either specifically for a client, for example specific plant to fulfil a special client order or you create an asset to serve a specific client, say the casting of a particular mould. In this setting you can see how disputes arise pre, during and post contract development.
A number of possible outcomes exist. One outcome could be that both parties attempt to negotiate safe guards into contracts. The upshot is parties enter into time consuming and costly contract negotiations and re-negotiations.
Parties could take up post contractual bargaining positions. For example either party may enter into plan B’s – a buyer may hedge against a contract hold up (deliberate or not) or a supplier may bargain with a standby provider. Both options create market inefficiencies.
Distrust may arise in so far as more and more safeguards are written into a contract or information is withheld impeding information sharing and raising the issue of asymmetry of information, creating further costs.
Finally, parties may reduce exposure or risk by under investing in facilities and relationship specific assets. For example, a supplier may not invest in maintenance of its plant, again reducing efficiencies which efficiency was the reason for using the supplier in the first instance.
The issue with market inefficiencies is that it reduces productivity which will in and of itself escalate conflicts.
There you have it, some reasons why disputes come about.