Incomplete Contract and Verifiability

Abstract

While the theory of incomplete contracts has contributed greatly to our understanding many topics such as the nature and nancial structure of the firm, its rigorous foundation has been debated. Maskin and Tirole (1999) show that the usual "observable but not verifiable" assumption is not sufficient for the incomplete contract to be optimal, provided that parties can commit themselves not to renegotiate. We show that the assumption is not necessary, either. In sequential bargaining where parties can write a contract contingent on (ex post) verifiable variables, an equilibrium contract turns out to be a null contract (the ex post Nash bargaining solution). A key to our result is endogenous revealing of private information during contract negotiations. The possibility of renegotiations is irrelevant.