Promises, trust, and contracts

Journal of Law, Economics, and Organization

Volumn 16, Issue 1, 2000, Pages 209-232

  Chen, Yongmin ^a  

^a UNIVERSITY OF COLORADO   (United States)

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EID: 0034421413     PISSN: 87566222     EISSN: None     Source Type: Journal    
DOI: 10.1093/jleo/16.1.209     Document Type: Article

References (44)

1. See, for instance, Dybvig and Spatt (1980), Shapiro (1983), Boot, Greenbaum, and Thakor (1993). Same as promises, reputations need not always be reliable. From time to time, people may run down their reputations, but that does not prevent the use of reputations to facilitate beneficial transactions [Gale and Rosenthal (1994)].
2. We shall in Section 2 discuss in more detail several possible motivations for the behavior assumption here.
3. Thus in our model an incomplete contract may be chosen, not because a complete contract is not available, but because the latter may not be optimal. Spier (1992) has also shown how incompleteness in contracts can arise endogenously, but it is due to signaling concerns: only bad types offer complete contingent contracts.
4. This is different from the residual right in incomplete contracts as is analyzed in Grossman and Hart (1986) and Hart and Moore (1990), where there are two sequential stages for investment and production and the residual right is associated with the ownership of assets. We also note that the notion of incomplete contract here captures a somewhat different aspect of contract incompleteness compared to the literature, where the incompleteness of contracts usually refers to a situation that the terms of contracts under some possible events are not specified. Here agreements can be made for all possible circumstances, and the incompleteness of contracts arises only if an agreement is not legally enforceable.
5. If only complete contracts are used under either arrangement, then it becomes irrelevant how residual rights are assigned under incomplete contracts.
6. In addition, real-world transactions may involve uncertainties that are not considered in our model, and the delivery can be nonconforming even if the seller has done the work in good faith. A price reduction allows the buyer to be properly compensated in such situations.
7. A related practice is the use of subjective performance measures in incentive contracts. In many firms, an employee's compensation depends not only on objective performance measures, but also on subjective assessments of performance [Baker, Gibbons, and Murphy 1994)]. Rewards for good performance in these situations can also be viewed as promises by an employer to its employees, and a certain level of trust that the promises will be kept is crucial for such incomplete contracts to be successful.
8. The nature of contract costs here differs from the verification (or monitoring) costs in Townsend (1979) and Dye (1986), where the outcomes can always be verified ex post and the costs occur only if there is verification. The cost of writing contingent contracts in Dye (1985) is more similar in nature to the contact costs here. Recently, Maskin and Tirole (1999) have noted that there can be a mechanism that turns an observable variable into verifiable when sufficiently high punishments can be imposed. Hart and Moore (1999), however, have instead argued that the usual "observable but not verifiable" assumption does lead to contractual incompleteness, provided that the panics cannot commit not to renegotiate.
9. Alternatively, we can say that the player with the residual right moves last, and therefore can renege on any promise (s)he made earlier.
10. l. 11. In reputation models, such as in Tirole (1996), it is customary to assume that there are three types of agents: those who are always honest, those who are opportunistic, and those who always cheat. The individuals in our model may be viewed in some sense as the continuous version of the three types.
11. To close a model like this, one would need to show that such behavior can be supported by some notion of equilibrium. Such an analysis is beyond the scope of this article.
12. The reason for this assumption can be justified by showing that this order of moves is most efficient ex ante, but we prefer to state this order of moves as an assumption rather than a result, since a formal proof involves details that are not essential for the purpose of this article. Basically with this assumption we have a screening model and avoid signaling considerations, since the party making contract offers will have no use of his private information.
13. Note that since the seller has no residual right under BP, the equilibrium does not depend on the seller's type.
14. l). 16. In other words, there is an important asymmetry between the buyer and the seller in the effects on social surplus when they break a promise: one involves only a transfer payment and the other involves a distortion in resource allocation.
15. This outcome is related to the "lemons problem" in models of adverse selection. See the seminal article on this issue by Akerlof (1970).
16. While the contracting parties in our model are private individuals, our analysis also applies to contracting between companies. In fact, one may be willing to place a higher level of trust on a company than on an individual, for reasons including that a company may value reputation more than an individual; honest dealing with other parties may be necessary if a company wishes to establish a culture of trust and cooperation within the organization; and usually an agent making decisions for the company will not receive all the monetary gains if he acts dishonestly on behalf of his company.
17. A limitation of our analysis is treating the (BP, SP) regime as exogenous. More generally, one could treat the regime as a contract provision and ask which regime will emerge in equilibrium (or prevail in the marketplace). This is an interesting issue that we hope will be addressed by future research.
18. Notice that, by empirical or laboratory studies, one may actually be able to estimate F(·), the population distribution of willingness to keep promises in a society.
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