DP3272 Contractual Incompleteness and the Nature of Market Interactions

Author(s): Martin Brown , Armin Falk , Ernst Fehr

Publication Date: March 2002

Keyword(s): market interaction , contract enforcement , incomplete contract , involuntary unemployment , repeated transaction , fairness preferences

JEL(s): C70 , C90 , D20 , D40

Programme Areas: Labour Economics

Link to this Page: www.cepr.org/pubs/dps/DP3272.asp

We provide experimental evidence that contractual incompleteness, ie, the absence of third party enforcement of workers’ effort or the quality of the good traded causes a fundamental change in the nature of market interactions. If contracts are complete the vast majority of trades are initiated by public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Moreover, the short side of the market attempts to appropriate the whole gains from trade, which causes much disagreement about contract terms. If contracts are incomplete the vast majority of trades are initiated by private offers. The contracting parties form long-term relations and the provision of low effort or bad quality is penalized by the termination of the relationship. The threat of terminating the relation turns out to be an extremely powerful discipline device. Markets with incomplete contracts resemble a collection of bilateral trading islands rather than a competitive market. The short side of the market shares the gains from trade with the long side of the market so that there is little disagreement about contract terms. Our results support theories of the labour market that are based on the idea that unemployment is a worker discipline device.