Contracts

• A contract is executed when each party has met all contractual obligations

• The execution of a contract is a delayed process (after some period of time)

• The longer the duration of a contract, the more uncertainty there is

Legal Approaches

Classical contract law

• Contract execution involves discreteness → clearly defined performance standards

  • All the obligations of the contract are specified in detail so that written obligations always trump informal obligations

• Presentiation → possible future events are embodied in the terms of the contract (ex: inflation)

  • Provision for future contigencies

    • Contigent claims contracting: contract includes provisions to deal with changes that affect one or both of the contracting parties. These allow a contracting party to claim some changes in rights or duties in contractual fulfillment

Problems

1. Discreteness: the contractual relationship is less discrete if the reason why the employee didn’t show up to work matters

2. There are limits to discreteness when delay in contractual fulfillment is at issue (force majeure: attempt to deal with disruptions to contract fulfillment beyond one’s control)

3. Presentiation: complete presentation is often costly or not feasible

   1. Impossible to anticipate all future contigencies (ex: COVID-19)

   2. Even if contigencies can be anticipated, it is not obvious what should be done about them until the contingency happens

   3. Who is right when a contingency arises is not self-evident and is complicated because each side want to advance its case aggressively

Neoclassical contract law

• Contractual parties and the courts accept the possibility of:

  • Third party mediation after a dispute has arisen

  • Allow mutual contractual adjustments by those parties ex post

Problem

1. Can encourage recidivism on the part of a contractual party at fault (ex: Mexican banks - bankruptcy, US bailed them out → tell themselves that they can bail us out anytime so continue irresponsible behaviour)

Relational contract law

• Dispute resolution mechanisms are set up ex ante (before the dispute arises)

• Establish an ongoing supervising entity to deal with contractual disputes - arbitration arrangements

Transactions Costs Economics

Ex post costs are always greater than ex ante costs!

Ex ante costs:

• Costs of lawyers to draft, negotiate, safeguard an agreement

Ex post costs:

• Losses of efficiency when contract performance is not aligned with the terms of the contract

• Costs to deal with the problem (lawyers)

• Costs of new structures to deal with disagreement - arbitration arrangement

• Ex post safeguards (bonding)

Problems:

1. Possibility of those very large ex post costs can be a deterrent to future potential profits

   1. Example Churchill Falls: NF wanted to sell electricity to US and use Quebec’s system but Quebec didn’t want so the contract was that NF should sell to Quebec and then Quebec would sell it to US (made a lot of profits). Later, NF didn’t want contracts for their new sites because of resentment

Assumptions About Human Behaviour

1. Bounded rationality: limits on the capacity to interpret information and foresee likely consequences of decisions

   1. Problem for designing contracts that allow contigent claims contracting

2. Opportunism (self-interest with guile): self-interest that is advanced using deception and misrepresentation

Guile in contracts

• Ex ante: adverse selection → bad risks tend to select themselves into insurance pools producing higher claims, higher premiums and a reduction in the amount of insurance bought

• Ex post: moral hazard → people take more risks after they have bought insurance

• As a result, guile means that people:

  • Overstate the cost to themselves of the issue in a contractual dispute

  • Understate the benefits to themselves of the situation at the time of the dispute

  • Avoid revealing information that might damage their case

Asset Specificity

• Asset specificity: the value of an asset is tied to a contract

Different types

Fundamental Transformation

• Fundamental transformation: one or both of the contractual parties has a strong incentive to continue the current contractual relationship

  • When asset specificity is present, it is less feasible to judge the quality of an ongoing contract by comparing its contents with offers from other potential contractors

Efficient Governance - Choosing the Right Contract

Example - Mutual Hostage Taking

• Mutual hostage taking: if one company disrupts the other’s supply, they can retaliate and each can damage the other

• If Imperial Oil behaved opportunistically with respect to Shell (coming up with pretexts to disrupt supplies to Shell’s gas stations), Shell could correspondingly do the same to Imperial Oil