Contracting Costs and Residual Claims: The Separation of Ownership and Control

Abstract

IN the real world, as opposed to the standard economic model, complete, fully contingent, costlessly enforceable contracts do not exist.' Contracts are incomplete for two main reasons. First, uncertainty implies the existence of a large number of possible contingencies, and it may be extremely costly to know and specify in advance responses by the transacting parties to all of these possibilities. Second, contracts are incomplete because particular contractual performance, such as the level and form of energy an employee is to devote to a complex task, may be prohibitively costly to measure and hence to specify contractually. Therefore, contractual breach may often be difficult to prove to the satisfaction of a thirdparty enforcer such as a court. Given incomplete contracts, a general agency is likely to exist. While the standard statement of the problem assumes prohibitive costs of measuring agent inputs and therefore the necessity of contracting on the basis of assumed measurable output, it is merely one case of the broader class of phenomenon implied by incomplete contracts. A shirking problem exists even if performance is contractually related not to output measures but rather to imperfectly measured input supply. If one individual is hired by another to supply particular services and make particular decisions, it is unlikely that this service flow can be either specified ex ante or precisely measured ex post so that an incentive problem is not created. For example, the number of contingencies is so large and the