How can an incomplete contract prevent opportunism? Explain with ...

[silviawilliams41]

How can an incomplete contract prevent opportunism? Explain with an example.

Question 2

Adverse selection and moral hazard are not problems associated with market transaction.
  Indicate whether the statement is true or false

[jointhecircus]

Answer to Question 1

A complete contract can create incentives for the parties involved to behave opportunistically. In such cases, it is in the interest of both parties to create a contract which is incomplete, but has adjustment clauses which can be used when unexpected events occur. Reaching agreement on what the contract will not specify can reduce incentives to behave opportunistically and increase the economic value it creates.

Consider the following example. You have agreed to supply me with fuel for my manufacturing plant, and that deliverability can pose a problem because my desired daily burn varies widely. I can avoid costly shutdowns and startups by arranging for you to supply all of my daily requirements between some maximum and minimum limits. Fulfilling your part of the deal requires that you make costly arrangements for storage and plan your own purchases from producers in advance. Because you have made some investments specific to this contract, we might agree that I must buy all of my fuel requirements from you. But what will you charge me for it? Fixing the price per unit in advance for the duration of the contract invites opportunism because the market offers alternatives. If market price rises above the contract price, you will want to evade your obligations and profit by selling my shipment elsewhere. If it falls below the contract price, I will want to purchase in the market and reject your shipment.

The risk of opportunism falls if the contract price changes with the fuel's market price. If it rises with market price your gain from breaching our agreement is less, and vice versa for me if market price falls. Contract prices for widely traded items often carry provisions called adjustment clauses or escalators that change their prices as market prices change. An adjustment clause must state when the price will change and by what formula the new price will be calculated. Energy commodities are often repriced monthly because more frequent changes would add to uncertainty and provide no clear benefits. The contract must also specify the data to be used in calculating the adjustment. For widely traded commodities, averages from industry newssheets are a common choice, as are figures derived from commodity exchange prices.

Answer to Question 2

False