Economic analysis of contract choice, feelings of entitlement and contract enforcement in relationships governed by incomplete contracts

The first chapter of this thesis considers a contractual principal-agent relationship in an unstable environment. The players are uncertain whether repeated interaction is possible. I examine the role that the deliberate choice of an incomplete (non-verifiable and unenforceable) contract plays in signalling stability and trust. In this model, contractors may privately observe shocks that force them to end the relationship after the current period. Complete (verifiable) contracts, which are assumed to be feasible, ensure cooperation in compliance with the contract. With incomplete contracts, the players make themselves vulnerable to exploitation by their partners. But if cooperation occurs notwithstanding, the contractors update their beliefs about each other’s willingness to interact again. When the agent observes that her partner and herself are able to continue the relationship, she undertakes a non-contractible, mutually beneficial investment. The second chapter is based on the theory by Hart and Moore (QJE, 2008) that regards contracts as reference points for feelings of entitlement. Parties’ ex post performance depends on whether they receive what they feel entitled to, which is assumed to be the best possible outcome permitted by the contract. Consequentially, there exists a trade-off between contractual flexibility (agreement on a price interval) and rigidity (agreement on a single price). Hart and Moore do not analyse the role that third party contract enforcement plays for parties’ feelings of entitlement, shading on performance and contract choice. I demonstrate that Hart and Moore’s results rely on a number of assumptions that can be challenged when incorporating litigation into the model. They assume that trade is voluntary but renegotiation is prohibited. I argue that either trade is voluntary but renegotiation is possible or courts compel parties to trade according to the contract. In the former scenario, fixed price contracts may not act as reference points and the parties feel entitled to the best possible outcomes from renegotiation. In the latter scenario, contracts may act as reference points because of the option of contract enforcement. However, potential flexibility incorporated in the contract is lost. The third chapter provides an experimental examination of the effect of contract enforcement on contractors’ reference points for feelings of entitlement. Previous experiments by Fehr, Hart and Zehnder (AER 2011) analyse and support the theory by Hart and Moore (QJE, 2008) that contracts are reference points. Both theory and experiments ignore the role of contract enforcement for contractors’ feelings of entitlement. I replicate and confirm Fehr, Hart and Zehnder’s baseline experiment. I also run an additional treatment in which buyers can offer sellers more or less favourable prices than specified in the contract, whereas sellers can request enforcement of contracts as written. I find that contract enforcement matters, without being invoked, for sellers’ punishment behaviour through feelings of entitlement. Without explicit contract enforcement, flexible contracts (agreement on a price range instead of a single price) leave sellers feel entitled to the best possible price permitted by the contract. However, buyers rarely offer such a price which leads to disappointment and punishment. With the option of contract enforcement, sellers feel entitled to the price which the court would enforce, even if it is equally unfavourable than in the no court treatment. The presence of the court provides an outside validation for which prices are reasonable and thereby limits disappointment and punishment