Contract Incompleteness , Contractual Enforcement and Bureaucracies ∗

This paper explains frequently observed coexistence of deficient property rights and heavy bureaucracies. We suggest that there is a specific role for bureaucracies in environments with insure property rights. In such situations, bureaucracies substitute for enforceable contracts. We study irreversible investment in an asset over which property rights are unclear, and model the property rights allocation as a game between a ruler and investors. Since the ex ante ownership allocation is not enforceable, it is optimal for the ruler to increase his ownership share of the asset ex post. This adjustment is costly to the ruler; the heavier the bureaucratic machine the higher the cost. Bureaucracy improves investment incentives by reducing the wedge between the ruler’s ex ante and ex post equilibrium ownership shares. ∗I wish to thank Avinash Dixit for turning my attention to this topic, Ariel Rubinstein and Dilip Abreu for their encouragement and comments, Alessandro Lizzeri and Timothy van Zandt for valuable discussions and Faruk Gul for guidance and advice, without which this paper would have never come into existence. I am grateful to Patrick Bolton for his detailed reading and suggestion of a few interesting points, which introduce a more contractual outlook and connection to practical examples. I am indebted to Prita Subramanian, Carrie Thompson and Mike Schwarz for their corrections of an early draft and to my son for his stoicism in the neglect associated with the finishing stage of my Ph.D. Financial support from the Ford Foundation is gratefully acknowledged. The remaining errors are mine. Economics as a separate science is unrealistic, and misleading if taken as a guide in practice. It is one element – a very important element, it is true – in a wider study, the science of power. Bertrand Russell