Incomplete contract theory and the optimum level of IIAs

Abstract

This chapter defines the 'optimum level of incomplete IIA' and shows how an incomplete IIA only reflects sub-optimality due to high transaction costs. After explaining incomplete contract theory, this chapter applies a marginal cost-benefit analysis to find the optimum level of incompleteness in an IIA. The optimum level can be achieved when the parties negotiate until the expected marginal benefit of adding the provisions equals the marginal transaction cost of agreeing on them. The benefit of inserting one additional provision (e.g., an investment protection article) is marginal, and the cost of inserting one additional provision is marginal. The parties will perceive themselves as doing better so long as the marginal benefit of the additional provision is greater than the marginal cost of the change. The parties will continue to make these small, or marginal, adjustments as long as the marginal benefit exceeds the marginal cost and will stop adding new terms when the marginal cost of the last change made equals the marginal benefit. This level maximizes the parties' economic gain from the IIA and reflects the optimum level of incompleteness in an IIA. An optimal level maximizes the benefit of the parties, given the high transaction costs that arise between states and within states. Lastly, the chapter shows how incomplete IIAs are sub-optimal.