Wednesday, 3 November 2010

Tram fiasco: an incomplete tale

It's a spectacular failure of contracting (the picture is an Edinburgh tram that did run on on Princes Street). But what's wrong? Is that because the Germans are 'delinquent'? Well, maybe, maybe not, but in any case a good contract should take into account the incentive to go delinquent, but this contract hasn't, apparently.

We economists are fully aware that most contracts are incomplete: we cannot possibly specify every future contingency on a contract, so there must be circumstances where the contract does not say what to be done and contracting parties disagree on it. But in standard models of incomplete contracts (such as the famous Grossman-Hart-Moore model, yes Moore is our Prof Moore) we don't see such a prolonged dispute or lawsuit as we see now, because if the players are rational and there is no asymmetric information, they renegotiate efficiently (and any delay or lawsuit is inefficient so they shouldn't occur!).

This means there must be an assumption(s) that does not hold in reality. Asymmetric information about the the other party's outside option, i.e. what happens to the opponent if they never reach an agreement, could explain an aspect of the dispute (my colleague Santi has a very nice paper about a related theme, though in the context of war, but I am inclined to think more about rationality and the very basic assumption in game theory (and contract theory) that all players fully understand and agree on the rule of the game (i.e. what exactly the contract means), not least because it may also give an insight into how we could have avoided such inefficiency by designing the initial contract in a cleverer (and perhaps less incomplete) way.

But then there are so many ways in which people can be irrational and disagree on the rule (contract) they should abide by. So we would need to think carefully and precisely about how they have been irrational and/or what's each party's understanding of the contract like.

Anyway, I think there's a good undergraduate dissertation to be written on this subject... I'm really curious what exactly the actual contract says, and how that can be interpreted and analysed both from legal and economic viewpoint.

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