[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

wants to mow it. You want him to take good care of your power mower. When
he sees a rock in the mower’s path, he should pick it up. But what incentive does he
have to take care of the mower? If you plan to charge him for repairs if the mower
does hit a rock, how can you tell whether the rock was hidden by the grass? If
he owned his own mower, he would have the appropriate incentives—an illustration
of why private property combined with the price system provides such an effective
solution to the incentive problem. But your neighbor’s son probably does not have
the money to buy his own power mower. Under these conditions, an incentive problem
is inevitable. Either you let him use your lawn mower and bear the risk of his mistreating
it. Or you lend him money to buy his own, in which case you bear the risk
of his not paying you back.
Many private companies must hire people to run machinery worth hundreds or
thousands of times more than a lawn mower. Every company would like its workers
to exert effort and care, to communicate clearly with one another and take
responsibility for their actions. Beyond a reliance on private property and prices,
the market economy has other partial solutions to these incentive problems, loosely
categorized as contract solutions and reputation solutions.
CONTRACT SOLUTIONS
When one party (firm) agrees to do something for another, it typically signs a contract,
which specifies the conditions of the transaction. For example, a firm will agree
to deliver a product of a particular quality at a certain time and place. There will normally
be “escape” clauses. If there is a strike, if the weather is bad, and so on, the delivery
may be postponed without penalty. These contingency clauses may also make the
payment depend on the circumstances and manner in which the service is performed.
Contracts attempt to deal with incentive problems by specifying what each of
the parties is to do in each situation. But no one can think of every contingency. And
even if such foresight was possible, writing down all the possibilities would be
prohibitively time-consuming.
There are times when complying with all the terms of the contract would be
extremely expensive for the supplier. He could make the promised delivery on time, but
only at a very great cost; a delay of just one day would save him a great deal. To provide
suppliers with the incentive to violate the terms only when doing so is really economically
worthwhile, most contracts allow delivery delays, but with a penalty. The penalty
gives the supplier the incentive to provide timely, but not overly costly, deliveries.
Sometimes the supplier may think it simply is not worth complying with the
contract. If she violates the agreement, she is said to be in breach of the contract.
When a contract has been breached, the parties usually wind up in court, and the legal
system stipulates what damages the party breaking the contract must pay to the
other side. Contracts, by specifying what parties are supposed to do in a variety of
circumstances, help resolve incentive problems. But no matter how complicated
the contract, ambiguities and disputes will always remain. Contracts are incomplete
and enforcement is costly, and thus they provide only a partial resolution of
the incentive problem.
338 ∂ CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKET