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The Elgar Companion to Law and Economics, Second Edition

Edited by Jürgen G. Backhaus

This thoroughly updated and revised edition of a popular and authoritative reference work introduces the reader to the major concepts and leading contributors in the field of law and economics. The Companion features accessible, informative and provocative entries on all the significant issues, and breaks new ground by bringing together widely dispersed yet theoretically congruent ideas.
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Chapter 10: Incomplete Contracts and Institutions

Antonio Nicita and Ugo Pagano


Antonio Nicita and Ugo Pagano Introduction The notion of incomplete contract has received increasing attention in law and economics literature as it permeates all economic problems that entail a legal solution. The incomplete contract framework is now applied to a wide range of research fields in law and economics, which cover, among other issues, the theory of the firm and economic organizations, the study of corporate governance and finance, the design of liberalization and privatization policies, the governance of intellectual property and international trade. In perfect competitive markets the relevant action to be made by economic agents is that of a Pareto-relevant economic exchange (Bowles, 2003): given initial endowments, the mere existence of potential gains from trade generates that trade automatically. Under that framework, there is no need for legal rules or institutions to facilitate economic exchange. As the Coase theorem reveals, this is the tautological1 outcome of perfect competitive markets: when transaction costs are negligible and property rights are well-defined, economic resources will automatically end up in the hands of those agents who value them the most, independently of any initial assignment of property rights on those resources. However, as long as transaction costs grow, potential Pareto-relevant exchanges could be inhibited, leading to an inefficient outcome. Since incompleteness raises relevant transaction costs, incomplete contracts are a potential source of market failure. In order to minimize transaction costs, an appropriate institutional environment has to be designed so as to enforce parties’ obligations against opportunism and renegotiation. The law...

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