Question

7. How can an incomplete contract prevent opportunism? Explain with an example.

This is the complete question. need an example of how an incomplete contract can prevent opportunism

Answer 1

The modern theory of the firm conceptualised by Williamson and Hart assumes contracts to be incomplete. Ownership structure and design rise as a response to the imperfections of contractual agreements. What makes complete contracts undesirable?

Contracting can be costly when trading partners engage in opportunistic behaviour to circumvent the purpose for which the contract was created and agreed upon. For instance, one party (who agreed upon the initial terms of the contract) may find loopholes in the terms stated in the contract that allow them to fulfill obligations without putting in the required effort and not in the manner intended when the contract was signed. This problem also arises when a court of law cannot verify whether contractual obligations are fulfilled or not - it cannot precisely say whether the requirements laid out in the contract are satisfied or not. Thus, when ambiguity in contracts arises, a contract that tries to be complete and efficient can end in costly opportunism.

An example to be considered is of General Motors and Fisher Body - the two parties signed a contract where GM agreed to buy closed metal automobile bodies exclusively from Fisher. The price agreed upon was equal to its variable costs plus a fixed markup of 17.6% to cover the fixed costs of production. In this case, Fisher exploited the clause in the contract, using labor intensive technology and upping transport costs so as to increase the variable costs stated in the contract. This opportunism is difficult to avoid - not every loophole can be foreseen, and often, transacting parties rely on contracts that are incomplete and offer weak incentives.

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