Incomplete Contracts, Power and Efficiency: A Theoretical Analysis

Abstract

This paper formalizes the idea that the allocation of tasks and adoption of technology in capitalist firms could be inefficient. Some previous studies have attempted this exercise, but the framework and results in this paper are different. The paper models contracts that are incomplete owing to the presence of unforeseen/indescribable contingencies, which opens up the possibility of renegotiation. Renegotiation can improve outcomes, but also leads to a hold-up problem. Given this, the equilibrium allocation is inefficient compared to other (non-hierarchical) alternatives. The extent of the inefficiency can be linked to the degree of incompleteness. This model captures insights from the literature on the microeconomic roots of inefficiency and the exercise of control and power. It also provides a concrete setting where indescribable contingencies do (and do not) matter—a much-debated issue. JEL Codes: D21, B1, B2