Promises, Trust, and Contracts

A transaction involving a buyer and a competitive seller is studied under the hypothesis that individuals may have a certain tendency to keep promises. The parties can choose a complete contract where costly arrangements are made so that it is verifiable whether the seller has delivered a certain quality. Alternatively, they can choose an incomplete contract where the quality agreed upon by the two parties is unverifiable, and one party is given the residual right to decide whether the quality is indeed delivered. Although complete contracts are always available, it may be optimal to use incomplete contracts, and social surplus can increase in contract costs. Social surplus is higher when the buyer has the residual right if under this arrangement incomplete contracts are optimal; and social surplus is higher when the seller has the residual right if only under this arrangement incomplete contracts are optimal