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I have read about incomplete contracts in the context of vertical integration of firms, in which the two contracting parties are relatively "symmetric" (we cannot say that one is the agent and the other the principal. Both take hidden actions that influence the other party)

In principal agent theory, I have not read anything that explicitly talks about "contractual incompleteness" as a source of agency problems. Yet it seems intuitively that they are related.

How is contractual incompleteness related to the principal agent problem?

  • Are all principal agent problems the result of incomplete contracting?

  • is incomplete contracting merely one example of a source of principal agent problem?

  • How, in general, are they related?

EDIT: In particular, the term "admissible contract" or "feasible contract" is used in the context of principal-agent problems. Does "incompleteness" of contracts simply mean that "the set of admissible/feasible contracts is restricted in some important senses"?

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Not all principal-agent problems are the result of incomplete contracts, no. In fact, in most principal-agent problems, complete contracts are assumed.

An incomplete contract is one that cannot be contingent on every possible outcome that could occur after the contract is signed. You can't write a contract that gives out a different payment to each party under every possible circumstance, because you can't imagine every possible circumstance. For example, an American agricultural firm's profits might be affected in miniscule ways by weather in Peru. But a contract related to that firm might offer the same payouts regardless of Peru's weather.

A principal-agent problem arises when the incentives of the principal and of the agent are not aligned, and so the agent may not act as the principal desires. For example, putting in less effort than the principal would find optimal because the agent will be the primary benefactor of additional effort. A lot of the problem arises here because the principal cannot perfectly and costlessly observe what the agent does, and so must write a contract contingent on the outcome of the project, rather than contingent on the agent's actions, which cannot be observed.

You could, colloquially, say that the principal-agent problem is an example of incomplete contracts in the sense that you can't contract on the agent's actions. But that's not what economists mean by incomplete contracts. Incomplete contracts refers to the fact that your contract is not sensitive to every possible contingency, even though everyone will know what that contingency is after it happens, as opposed to principal-agent problems, which refer to the fact that you can't include unobservable actions of the agent in your contract, which are hidden to the principal.

As for how they're related, they're both examples of problems that can make it difficult to write a contract. There are certainly models that combine the two (for example this), but one doesn't subsume the other.

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  • $\begingroup$ Thanks! I have one question about this sentence: "Incomplete contracts refers to the fact that your contract is not sensitive to every possible contingency, even though everyone will know what that contingency is after it happens, as opposed to principal-agent problems, which refer to the fact that you can't include unobservable actions of the agent in your contract, which are hidden to the principal." What, roughly, are the differences in implications between those two? $\endgroup$ – user83014 May 2 at 8:27
  • $\begingroup$ cntd: One might think that whether the contract cannot be conditioned on X because the principal can't observe X, vs because it is "exogenously incontractible", is not relevant (since in either case, he doesn't know X ex ante). Is this just a difference in interpretation of the model, or are there hard differences in the resulting models, between those two assumptions? (observable but incontractible, vs unobservable and therefore incontractible). $\endgroup$ – user83014 May 2 at 8:27
  • $\begingroup$ @user83014 I think the last thing you said is the cleanest interpretation. Incomplete contracts deals with the incontractible despite being observable (if not currently observable, observable later), whereas principal-agent deals with incontractible because it's unobservable. $\endgroup$ – NickCHK May 2 at 20:27
  • $\begingroup$ I guess my question is, is that difference just a matter of interpretation that we put on the model, or do the two different assumptions have actual different modelling implications? $\endgroup$ – user83014 May 2 at 20:51
  • $\begingroup$ They're pretty different. One key source of that difference is that in principal-agent, the agent knows the unobservable variable and can select it, whereas in incomplete contracts, nobody knows or has (perfect) control over the exact contingency that will occur. $\endgroup$ – NickCHK May 3 at 0:36

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