Endogenous Incomplete Contracts: A Bargaining Approach

Abstract

In this paper we argue that, by modelling the contracting process as a bargaining game, one can endogenize the choice between complete and incomplete contracts. This point is demonstrated within a stylized model in which agents can allocate an endowment stream either via a once-for-all bargain over the entire stream - a long-term contract - or through a series of bargaining rounds - a short-term contract. Within this structure, short-term contracts arise as equilibrium outcomes under very general conditions, because a short-term contract implies reduced bargaining costs for one of the agents. In essence, reduced 'transaction costs' produce a short-term contract. JEL classification: L14, C78