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

<p>An <strong>incomplete contract</strong> is one that cannot be <strong>contingent</strong> on every possible <strong>outcome</strong> 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.</p>

<p>A <strong>principal-agent problem</strong> 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 <strong>contingent</strong> on the <strong>outcome</strong> of the project, rather than contingent on the agent's actions, which cannot be observed.</p>

<p>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.</p>

<p>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 <a href="https://www.jstor.org/stable/2555872?casa_token=ict_-tx5qv4AAAAA:TyRMvliNVZiCewqtSN8neiUuzyQ-j3_cz_cbEghZHL1nciqzzZ61LkRE8H51YxfxOamQpsDj5kvVFA_2KbfFy_3pYDa8E3rZa02KhFmiiX7I5Owrog-jXg&amp;seq=1#metadata_info_tab_contents" rel="nofollow noreferrer">this</a>), but one doesn't subsume the other.</p>

CC BY-SA 4.0
2019-05-02T08:27:44.803Z
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?
user8301
CC BY-SA 4.0
2019-05-02T08:27:54.513Z
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).
user8301
CC BY-SA 4.0
2019-05-02T20:27:53.797Z
@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.
NickCHK
CC BY-SA 4.0
2019-05-02T20:51:44.503Z
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?
user8301
CC BY-SA 4.0
2019-05-03T00:36:02.603Z
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.
NickCHK
CC BY-SA 4.0
2019-05-02T06:58:00.987Z
2019-05-02T07:03:07.950Z
2019-05-02T07:03:07.950Z
NickCHK
<p>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)</p>

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

<p>How is contractual incompleteness related to the principal agent problem?</p>

<ul>
<li><p>Are all principal agent problems the result of incomplete contracting?</p></li>
<li><p>is incomplete contracting merely one example of a source of principal agent problem?</p></li>
<li><p>How, in general, are they related?</p></li>
</ul>

<p><strong>EDIT:</strong> 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"?</p>

<principal-agent><contract-theory><contracts>
Relation between incomplete contracting and the principal agent problem?
user8301
# Relation between incomplete contracting and the principal agent problem?

(Asked by: username_0 on 2019-05-01)

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"?

**Tags:** principal-agent, contract-theory, contracts

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## 1 answers

### Answer by username_1 on 2019-05-02. Score: 2

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](https://www.jstor.org/stable/2555872?casa_token=ict_-tx5qv4AAAAA:TyRMvliNVZiCewqtSN8neiUuzyQ-j3_cz_cbEghZHL1nciqzzZ61LkRE8H51YxfxOamQpsDj5kvVFA_2KbfFy_3pYDa8E3rZa02KhFmiiX7I5Owrog-jXg&seq=1#metadata_info_tab_contents)), but one doesn't subsume the other.

> **Comments:**
> **username_0**: 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?  
> **username_0**: 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).  
> **username_1**: @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.  
> **username_0**: 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?  
> **username_1**: 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.  

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