Unforeseen Contingencies and Incomplete Contracts

The authors scrutinize the conceptual framework commonly used in the incomplete contract literature. This literature usually assumes that contractual incompleteness is due to the transaction costs of describing--or of even foreseeing--the possible states of nature in advance. They argue, however, that such transaction costs need not interfere with optimal contracting (i.e., transaction costs need not be relevant), provided that agents can probabilistically forecast their possible future payoffs (even if other aspects of the state of the nature cannot be forecast). In other words, all that is required for optimality is that agents be able to perform dynamic programming, an assumption always invoked by the incomplete contract literature. The foregoing optimality result holds very generally provided that parties can commit themselves not to renegotiate. Moreover, the authors point out that renegotiation may be hard to reconcile with a framework that otherwise presumes perfect rationality. However, even if renegotiation is allowed, the result still remains valid provided that parties are risk averse. Copyright 1999 by The Review of Economic Studies Limited.