The Law and Economics of Incomplete Contracts

Individual actors want to make their promises enforceable in order to motivate mutually profitable investments. But parties cannot easily design contracts that maximize beneficial investments and also respond appropriately to changing conditions. Although economists have designed theoretical models that maximize joint welfare both ex ante and ex post, these mechanisms depend on a perfectly functioning and costless system of enforcement. In the real world, parties must expend substantial resources to enforce commitments legally, and, in many cases, courts lack information to assess the parties' actions. This review examines one of the main insights of the theory of incomplete contracts: that legal enforcement alone cannot ensure the full realization of jointly beneficial cooperative ventures. Legal enforcement, supported by the coercive power of the state, is only one mechanism for inducing cooperation, and in many relationships it typically has only a limited role to play. Complex contracts do lend themselves to effective formal enforcement. But parties often choose to write simple contracts that look to renegotiation once the future is known. Simple contracts require enforcement by informal mechanisms, such as reputation, repeated dealings, and norms of reciprocity in order to motivate both beneficial investment ex ante and adjustment ex post.