Williamson Meets Hart: Haggling Costs and Incomplete Contracts

This paper introduces a cost of contracting that originates from the possibility that a contracting partner may be able to …nd and exploit loopholes in contractual formulations. A potential buyer and seller want to trade a widget and prior to trade the seller can make an investment to create an improved version of the widget. We assume that buyer and seller cannot be sure that this improved widget can be described accurately. To be more precise we assume that with a certain probability the seller can exploit loopholes in the contract and make an e¤ort to create a new widget which also satis…es the requirements of the contract. The creating of this widget is ine¢ cient, but since it cannot be distinguished from the improved widget by a third party, it allows the seller to haggle for a larger share of the surplus. We show that whenever a contract provides incentives to foster investments to improve the widget, this contract also fosters investments to create a haggling widget. We characterize conditions under which the …rst-best can be attained and under which the incomplete contract is optimal.