Contracting with Opportunistic Partners: Theory and Application to Technology Development and Innovation

After a contract is signed, contracting partners may engage in opportunistic behavior aimed at circumventing the original intention of the agreement governing their business relationship, complying with the letter but not the spirit of the contract. We use an incomplete contracts approach to show that the anticipation and observability of such behavior are typically not enough to prevent it when parties can renegotiate contractual outcomes. This is because contractually specified incentives inevitably have conflicting effects: they simultaneously increase the likelihood of welfare-improving investments and welfare-reducing opportunistic behavior. The possibility of such opportunism thus limits the effectiveness of contractual incentives. We also discuss how our results relate to contracting practices observed in industries characterized by rapid innovation, such as information technology. This paper was accepted by Suraj Srinivasan, accounting.