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Discussion Paper Details

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Title: Contractual Incompleteness and the Nature of Market Interactions

Author(s): Martin Brown, Armin Falk and Ernst Fehr

Publication Date: March 2002

Keyword(s): contract enforcement, fairness preferences, incomplete contract, involuntary unemployment, market interaction and repeated transaction

Programme Area(s): Labour Economics

Abstract: We provide experimental evidence that contractual incompleteness, ie, the absence of third party enforcement of workers? effort or the quality of the good traded causes a fundamental change in the nature of market interactions. If contracts are complete the vast majority of trades are initiated by public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Moreover, the short side of the market attempts to appropriate the whole gains from trade, which causes much disagreement about contract terms. If contracts are incomplete the vast majority of trades are initiated by private offers. The contracting parties form long-term relations and the provision of low effort or bad quality is penalized by the termination of the relationship. The threat of terminating the relation turns out to be an extremely powerful discipline device. Markets with incomplete contracts resemble a collection of bilateral trading islands rather than a competitive market. The short side of the market shares the gains from trade with the long side of the market so that there is little disagreement about contract terms. Our results support theories of the labour market that are based on the idea that unemployment is a worker discipline device.

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Bibliographic Reference

Brown, M, Falk, A and Fehr, E. 2002. 'Contractual Incompleteness and the Nature of Market Interactions'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=3272