ABSTRACT
State-contingent contracts record agreements about rights and obligations of contracting parties at uncertain future scenarios: descriptions of possible future events are listed and the action to be taken by each party on the realization of each listed contingency is specified. Casual empiricism suggests that a real-world contract is very often incomplete in the sense that it may not include any instruction for some possible events. The actual actions to be taken in such events are thus left to ex post negotiation. The fact that real-world contracts are incomplete explains the working of many economic institutions (see surveys by Jean Tirole (1994), Oliver D. Hart (1995), and James M. Malcomson (1997)). Take for instance the institution of the business firm. What determines whether all stages of production will take place within a single firm or will be coordinated through markets? In a world of complete contingent contracts there is no benefit from integrating activities within a single firm as opposed to transacting via the market. However, contractual incompleteness can explain why integration might be desirable and more generally why the allocation of authority and of ownership rights matters. This insight developed by Ronald H. Coase (1937), Herbert A. Simon (1951), Benjamin Klein et al. (1978), Oliver E. Williamson (1985), and Sanford J. Grossman and Hart (1986), among others, underscores the importance of understanding what reasons explain why and in what circumstances contracts are left incomplete.
