Monday, 16 March 2015

Short-term, long-term, and continuing contracts

The reference point approach to incomplete contracts as developed by Hart and Moore (2008) has in the last few years been applied to an increasing number of issues to do with contracts and related areas. According to this approach one role of a contract is to get parties "on the same page", so as to avoid future misunderstanding. Misunderstanding leads to "aggrievement" and "shading" (in the form of departures from consummate (or welfare-maximising) performance), and consequent deadweight losses. For examples of a couple of areas to which the reference point approach has been applied see Walker (2013) for a survey of the application of the reference point approach to the theory of the firm and Halonen-Akatwijuka and Hart (2013) which looks at why parties may intentionally write incomplete contracts.

Now Halonen-Akatwijuka and Hart have a new NBER working paper out on Short-term, Long-term, and Continuing Contracts, NBER Working Paper No. 21005, issued in March 2015. The basic idea being that there are 3 forms of contract that we can write: short-term (a one period contract) long-term  (a multi-period contract) and continuing (a contract that is normally rolled over each period). There is a growing literature on why parties write long-term contracts. A leading explanation is that such contracts are useful to support specific investments, and there is much empirical support for this. As to why parties write short-term contracts, that is, contracts that are shorter than the likely term of their relationship a commonly seen answer is that it is costly for the parties to anticipate the contingencies that will arise during the latter part of their relationship and to write down unambiguously how to deal with them. The disadvantage of the long-term contract is that costly renegotiation may be necessary if there are no gains from trade in some future period covered by the contract. A short-term contract is disadvantaged because a new contract needs to be negotiated for each future period in which there are gains from trade.

A continuing contract - that is, a contract which is neither long-term nor short-term but usually rolled over each period - can be better than both these other types of contract. Examples of such contracts would be rental contracts where the lease is typically renewed; month to month rental contracts with no lease; employment contracts where each party can (under some conditions) terminate the relationship, but where they usually do not – most of the time business continues "as usual". In a continuing contract there is no obligation to trade in a future period but if there are gains from trade the parties will bargain "in good faith" using the first period contract as a reference point. This has the advantage that it can reduce the cost of negotiating the next contract.

Unfortunately such contracts also have a down side in that good faith bargaining may preclude the use of outside options in the bargaining process and as a result parties will sometimes fail to trade when this is efficient. So no one contract type is superior in all situations.

  • Halonen-Akatwijuka, Maiji and Oliver D. Hart (2013). `More is Less: Why Parties May Deliberately Writes Incomplete Contracts', National Bureau of Economic Research, NBER Working Papers No. 19001, April.
  • Hart, Oliver D. and John Moore (2008). `Contracts as Reference Points', Quarterly Journal of Economics, 123(1) February: 1-48.
  • Walker, Paul (2013). `The `Reference Point' Approach to the Theory of the Firm: An Introduction', Journal of Economic Surveys, 27(4) September: 670-95.

No comments: