Contracting with Opportunistic Partners: An Incomplete Contracts Approach

Abstract

After a contract is signed, contracting partners may engage in opportunistic behavior that circumvents the original intention of the agreement governing their business relationship (i.e. complying with the letter but not the spirit of the contract). We use an incomplete contracts approach to show that the anticipation and observability of such behavior are typically not enough to prevent it when parties can renegotiate contractual outcomes. This is because contractually specified incentives inevitably have conflicting effects: they simultaneously increase the likelihood of welfare-improving investments and welfare-reducing opportunistic behavior. The possibility of opportunism thus limits the effectiveness of contractual incentives and may call for simpler (less complete) rather than more complete contractual solutions. We provide general conditions for the optimality of incomplete contracts, a simple characterization of the second-best contract, and some comparative statics. We also discuss implications for vertical integration and make versus buy decisions.