An incomplete contract analysis of multinational enterprises and oil field unitization

Vijay Mohan

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This dissertation extends the property rights theory of the firm in two directions by examining, first, the value of information when contracts are incomplete, and secondly, the impact of incomplete contracts on situations characterized by non-excludability of assets and rivalry over the ownership of assets.;The first issue is addressed in the context of the choice between exports and foreign direct investment facing a firm commencing operations in a foreign country. Apart from considering similarities in cost structures and asset specificity of investments as location-specific factors, the view is presented that the ability to gain familiarity with an initially unfamiliar country is location-specific as well. A 'similarity effect' and a 'familiarity effect' are identified, and these effects can reinforce or oppose one another; in the latter case, the firm may choose different entry modes depending on the extent of its initial familiarity with the foreign market. From a more theoretical point of view, a somewhat surprising feature of the property rights theory emerges: information may lose value when contracts are incomplete.;The second issue is analyzed in the context of the oil industry. Specifically, two alternative organizational modes for extracting oil from a common pool are considered: competitive extraction and unitization. Competitive extraction results in significant rent dissipation, and unitization is generally viewed as a common property solution to this problem. Yet, a puzzle confronting the oil industry is that firms are often reluctant to voluntarily enter unitization agreements. The fact that unitization contracts are typically incomplete can serve to reconcile the puzzle. While the literature has stressed the role of ex ante bargaining problems in precipitating the failure of unitization agreements, the emphasis here is on demonstrating that the anticipation of ex post bargaining may impose inefficiencies on unitization that compete with the inefficiencies associated with competitive extraction due to the common pool problem. The outcome can be a lower surplus under unitization, which suggests that the general presumption in the literature that unitization is surplus enhancing relative to competitive extraction may not be always be valid.

Date: 2003-01-01
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