Incomplete Contracts and the Courts - an Exploration

Abstract: The paper explores the role of the courts and of the law in the economic theory of incomplete contracts. In the last decades, economists have made significant progress in analyzing incomplete contracts and their implications for institutional choice. At the same time, substantial disagreement remains over whether and why contracts are, or can be, “incomplete”. The dominant paradigm has been to assume that the contractual exchange depends on the ex post realization of an important variable. While the parties can “observe” the realization, the courts cannot “verify” it and therefore cannot enforce a contract that conditions on it. Critics have challenged the observable-but-not-verifiable assumption. They point out that the contract can specify sophisticated implementation mechanisms that force the parties to disclose the true realization ex post. Hence, it is argued, there is no reason why a contract should remain incomplete. The paper relates the economic debate to the role of the courts in contractual disputes. At first blush, it is tempting to equate the courts to an implementation mechanism. This seems to coincide with a notion of courts as “gap fillers” in incomplete contracts. Yet litigation bears little similarity to the mechanisms contemplated in the economic literature. Courts have other, less reliable means of eliciting information and of “verifying” the realization of the relevant variable. Another major difference is that litigation is time consuming: Even if courts can – to some extent – verify the true realization, it is often too late to carry out the efficient trade that should have taken place. But because verification is uncertain, remedies other than specific performance often fail to align the parties’ incentives for efficient trade. The paper thus seeks to show how contractual incompleteness arises in spite of courts with some limited ability to verify the state of nature.