Feb 20

Imagine that you and I meet at a party, and I tell you about my research on behavioral economics. You see opportunities to use the principles to improve your business and think we could work together. You have two options: You can ask me to collaborate, with a handshake promise that if things work out, you’ll make it worth my while. Or you can prepare a contract that details my obligations and compensation, specifies who will own the resulting intellectual property, and so on.

For most of you, the decision is obvious. The second approach, the complete contract, is the way to go. But should it be?

The idea of making a deal with a handshake—what we generally call an incomplete contract—makes most of us uncomfortable. A handshake is fine between friends, but when it comes to vendors, partners, advisers, employees, or customers, we believe that incomplete contracts are a reckless way to do business.

Indeed, firms try to make contracts as airtight as possible—specifying outcomes and contingencies in advance, thus lowering the chances for misunderstanding and uncertainty. But complete contracts have their own flaws, and business’s increasing dependence on (I would say, fetish for) absurdly detailed contracts in every situation comes with its own downside.

All contracts deal with the direct aspects of the expected exchange and with unexpected consequences. Incomplete contracts lay out the general parameters of the exchange (the part that we shake hands over), while the unexpected consequences are covered by social norms governing what is appropriate and what is not. The social norms are what can motivate me to work with you, and what would establish goodwill in resolving problems that might arise.

As for complete contracts, they too specify the parameters of an exchange, but they don’t imply the same adherence to social norms. If something is left out, or if circumstances change, there’s no default to goodwill—it’s happy hunting season for all. When we use complete contracts as a basis for working together, we take away flexibility, reasonableness, and understanding and replace them with a narrow definition of expectations. That can be costly.

A CEO of a large internet company recently told me about one of the worst decisions of his career. He instituted a very specific performance-evaluation matrix that would determine 10% of his employees’ compensation. Before this, the firm, like most, had a general agreement with its employees—they had to work hard, behave well, and were measured on certain goals. In return they were rewarded with salary increases, bonuses, and benefits. This CEO believed he could eliminate the uncertainty of the incomplete contract and better define ideal performance.

The complete-contract approach backfired. Employees became obsessively focused on meeting the specific terms of their contracts, even when it came at the expense of colleagues and the company. Morale sank, as did overall performance.

Even lawyers see the risks of complete contracts. As part of my research, I asked the dean of Duke’s law school, David Levi, if I could take a look at the school’s honor code. Expecting a detailed contract written by lawyers for lawyers, I was shocked to find that the code went something like this: If a student does anything the faculty doesn’t approve of, the student won’t be allowed to take the bar exam. It was, in essence, a handshake agreement!

“Imagine that a student decides to deal drugs and raise chickens in his apartment,” Levi said. “Now suppose that our code of conduct bans many activities but doesn’t address pot or chickens. The student has honored the code. But does Duke really want that student to become a lawyer?”

Complete contracts are inevitably imperfect. So what’s better: a complete contract that mutates goodwill into legal trickery, or an incomplete contract that rests on the understanding we share of appropriate and inappropriate behavior?

This post first appeared on HBR