Contractual incompleteness for external risks

In a model with internal and external risks together with incentive problems, this paper investigates the role of a risky environment on contractual incompleteness. We consider a typical employment contract with an extra control option. This option is contractable ex ante, exercisable ex post, and good for incentives. But, the employer may choose not to have it in a contract. We identify some interesting circumstances under which the option is not in the optimal contract. Our main findings are that (1) external risks determine contractual incompleteness, and (2) a complete contract can better handle incentives, while an incomplete contract can better handle external risks. Hence, our analysis of incomplete contracts is somewhat consistent with Williamson's (1985) idea of low-powered incentives inside the firm and high-powered incentives outside the firm.