Wednesday, November 26, 2008

Contracts as reference points: evidence

In a previous post, I mentioned Oliver Hart and John Moore's recent paper, "Contracts As Reference Points", in which the authors found a new building block for incomplete contracts by incorporating behavioral elements, such as reference points, shade and retaliation. Although their earlier and more influential work - Grossman and Hart (1986), Hart and Moore (1990) and Hart (1995) - has laid down the foundation of incomplete contract theory, some critical assumptions of their model were challenged, like events that are observable but not verifiable and ex post efficiency. Hart finds that "the early debate a bit sterile". In this new paper, they bring back ex post inefficiency, which is caused by behavioral problems. Relational specific investment, a crucial element that leads to ex post renegotiation in their earlier model is assumed away. The theory becomes somewhat more "rigorous and testable".

In the latest NBER working paper series, Ernst Fehr, Oliver Hart and Christian Zehnder provide their first empirical test of the new incomplete contract theory (see here or here). Here is the abstract:

In a recent paper, Hart and Moore (2008) introduce new behavioral assumptions that can explain long-term contracts and important aspects of the employment relation. However, so far there exists no direct evidence that supports these assumptions and, in particular, Hart and Moore's notion that contracts provide reference points. In this paper, we examine experimentally the behavioral forces stipulated in their theory. The evidence confirms the model's prediction that there is a tradeoff between rigidity and flexibility in a trading environment with incomplete contracts and ex ante uncertainty about the state of nature. Flexible contracts - which would dominate rigid contracts under standard assumptions - cause a significant amount of shading on ex post performance, while under rigid contracts, much less shading occurs. Thus, although rigid contracts rule out trading in some states of the world, parties frequently implement them. While our results are broadly consistent with established behavioral concepts, they cannot easily be explained by existing theories. The experiment appears to reveal a new behavioral force: ex ante competition legitimizes the terms of a contract, and aggrievement and shading occur mainly about outcomes within the contract.

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