The Efficiency of Incomplete Contracts: An Empirical Analysis of Air Force Engine Procurement

TLDR

Complete contracts reduce opportunism but require costly design; optimal incompleteness balances these forces and can be predicted from observable characteristics. The study investigates why parties intentionally leave contracts incomplete regarding future duties or contingencies. The authors test hypotheses with panel data on Air Force engine procurement pricing procedures. They find that actual contract completeness reflects parties’ effort to minimize economic costs of contractual exchange.

Abstract

This article examines the incentives of contractual parties to design agreements that are left intentionally incomplete with regard to future duties or contingencies. More complete contracts mitigate ex post opportunism and the associated distortions in unobservable investment, but at the cost of additional resources expended in ex ante design. The optimal degree of contractual incompleteness involves a tradeoff between these opposing forces, the magnitudes of which may be predicted based on observable characteristics of the transactors and of the exchange environment. The resulting hypotheses are tested using panel data on the pricing procedures using in Air Force engine procurement contracts. We conclude that the degree of contractual completeness chosen in practice reflects a desire by the parties to minimize the economic costs associated with contractual exchange.