Complete contracts

What Are Complete Contracts?

Complete contracts are theoretical agreements in which all parties involved foresee and account for every possible contingency or future state of the world that could affect their arrangement. Within the field of contract theory, a complete contract is considered an ideal, representing a perfectly specified and exhaustive set of terms and conditions. These contracts detail the rights and obligations of each party for every conceivable circumstance, eliminating the need for future negotiation or dispute resolution.

In financial contexts, complete contracts aim to perfectly define the payoff for every possible future event, thereby allocating all risks and removing any ambiguity. This comprehensive nature minimizes potential conflicts and maximizes the efficiency of the agreement. The concept serves as a benchmark for analyzing real-world legal agreements, which are almost always incomplete.

History and Origin

The concept of complete contracts emerged as a fundamental building block in modern economic and legal theory, particularly within the framework of neoclassical economics. Its development is intertwined with the evolution of contract theory and the economic analysis of law. Early contract law, influenced by ancient Greek and Roman thought, focused on specific categories of transactions and required certain formalities for enforcement⁶. Over centuries, particularly during the Industrial Revolution and the rise of global trade, the need for more general principles governing agreements became apparent⁵.

While the formal study of contracts has roots in antiquity, the modern theoretical emphasis on complete contracts gained prominence with the rise of transaction costs economics. Influential work by economists like Ronald Coase and later Oliver Williamson, who popularized the term "transaction cost economics" in the late 1970s, highlighted how the costs of writing, monitoring, and enforcing contracts affect their design⁴. The notion of complete contracts serves as a theoretical counterpoint in this discourse, representing an ideal state where such costs, or the need for future adaptation, are entirely absent by design.

Key Takeaways

• Complete contracts are theoretical agreements that account for every possible future contingency.
• They fully specify the rights and obligations of all parties for every conceivable outcome.
• The concept serves as a theoretical benchmark in contract theory for evaluating real-world agreements.
• In theory, they eliminate ambiguity, future renegotiation, and potential disputes.

Interpreting the Complete Contract

In economic modeling, interpreting a complete contract means understanding that its terms explicitly cover every scenario. There is no room for implicit understandings, unforeseen events, or gaps in the agreement. For example, if a complete contract governs the sale of goods, it would specify what happens if the goods are delayed by natural disaster, if raw material prices surge, if government regulations change, or if a global pandemic impacts production. Every variable, no matter how remote, would have a pre-defined consequence and response embedded in the contract’s clauses. This exhaustive nature ensures perfect risk allocation and avoids issues related to asymmetric information, as all relevant information is presumed to be known and addressed at the outset.

Hypothetical Example

Consider a hypothetical complete contract between a space mining company, "AstroExtract," and a rare earth mineral refiner, "TerraProcess." The contract is for the supply of unobtanium, a critical component for advanced electronics.

1. Scope Defined: The contract specifies the exact quantity, quality, and delivery schedule of unobtanium for the next 50 years.
2. Price Mechanism: The price is set with an intricate formula that adjusts based on global demand indices, energy costs, and a pre-defined "extraterrestrial discovery bonus" if new, richer deposits are found by AstroExtract.
3. Contingency for Asteroid Impact: If AstroExtract's mining facility is damaged by an asteroid, the contract specifies the exact repair timeline, the percentage of cost absorbed by each party, and a tiered penalty for delays, varying by the severity of impact and market price of unobtanium at that moment.
4. Regulatory Changes: If a new international space law restricts certain mining practices, the contract pre-determines alternative extraction methods, their associated costs, and how the additional expenses are shared.
5. Technological Obsolescence: It even includes clauses for the discovery of a synthetic unobtanium substitute, outlining the terms for contract termination, intellectual property transfer, and a compensation package for the party whose investments are rendered obsolete.

In this scenario, every conceivable risk and future state, from market fluctuations to cosmic events and scientific breakthroughs, has been considered and explicitly addressed within the legal agreements.

Practical Applications

While true complete contracts are theoretical constructs, their underlying principles influence the design of complex financial markets and large-scale commercial agreements. In practice, efforts are made to make contracts as comprehensive as possible to reduce uncertainty.

One notable example is the widespread use of Master Agreements in the derivatives market, such as the ISDA Master Agreement. ³These agreements establish standardized terms for a wide range of derivative transactions between two parties, providing a framework that covers various events of default, termination events, and netting provisions. While not truly "complete" in the theoretical sense, they significantly streamline documentation and reduce counterparty risk by pre-defining how various scenarios are handled across multiple derivatives trades. Similarly, detailed contracts in large infrastructure projects, long-term supply agreements, and joint ventures aim to anticipate and address a multitude of potential issues to minimize future friction and ensure smooth enforcement. Companies often invest heavily in legal and financial expertise to draft contracts that are as exhaustive as practically possible, aiming to create clear incentives and mitigate future disputes.

Limitations and Criticisms

The concept of complete contracts, while foundational in theory, faces significant limitations and criticisms in the real world, primarily stemming from the inherent complexities of human interaction and future uncertainty.

1. Bounded Rationality: Parties to a contract have "bounded rationality," meaning their capacity to foresee and process every possible future contingency is limited. It is practically impossible to anticipate all potential events, let alone draft clauses for each one.
2. High Transaction Costs: Even if boundless rationality were possible, the costs associated with identifying, negotiating, and writing down every conceivable contingency would be prohibitive. This includes the cost of information gathering, legal drafting, and agreement.
3. Unforeseeability: Many events are simply unforeseeable when a contract is formed. Technological breakthroughs, major economic crises, or new regulatory landscapes cannot always be predicted with sufficient detail to be included in a contract.
4. Complexity and Interpretability: A contract attempting to be truly complete would be incredibly long and complex, making it difficult to understand, interpret, and enforce. The sheer volume of terms could introduce new ambiguities.
5. Behavioral Considerations: Traditional contract theory, which often assumes complete rationality, has been challenged by behavioral economics. This field suggests that human behavior is influenced by psychological factors, biases, and social norms, which are not easily captured by perfectly rational contractual terms. ²Individuals may not process information as exhaustively as a complete contract would require, or they may be subject to cognitive biases that lead to signing agreements without fully understanding all implications. ¹This can result in contracts that, while seemingly comprehensive, do not align with the actual incentives or understanding of the parties, potentially leading to unforeseen issues or a lack of enforcement in practice.

Complete Contracts vs. Incomplete Contracts

The distinction between complete contracts and incomplete contracts is fundamental in contract theory and economics.

The confusion often arises because real-world contracts aim for completeness as much as practically possible, blurring the lines. However, the theoretical distinction lies in the absolute exhaustiveness of a complete contract versus the unavoidable gaps in an incomplete one, driven by factors such as bounded rationality and the prohibitive transaction costs of foreseeing and codifying every possible future state.

FAQs

Why are complete contracts considered theoretical?

Complete contracts are theoretical because they assume that parties can perfectly foresee and account for every possible future event and its implications, which is impossible in the real world due to human cognitive limits (bounded rationality) and the unpredictable nature of future circumstances.

What are the main challenges in creating a complete contract?

The main challenges include the inability to predict all future contingencies, the prohibitively high transaction costs of drafting and negotiating such a comprehensive agreement, and the complexity that would make such a contract unmanageable to interpret and enforce.

How do complete contracts relate to risk?

In theory, complete contracts eliminate all unallocated risks by specifying how every possible outcome will affect the parties' rights and obligations. This means that all risks are explicitly assigned to one party or shared according to predefined rules.

Do complete contracts exist in financial markets?

No, true complete contracts do not exist in financial markets or anywhere else in practice. However, many complex legal agreements, such as those used in derivatives, aim to be as comprehensive as possible to cover a wide range of foreseen contingencies and minimize future disputes.