Incomplete Contracts and Strategic Ambiguity

B. Douglas Bernheim and Michael Whinston

American Economic Review, 1998, vol. 88, issue 4, 902-32

Abstract: Why are observed contracts so often incomplete in the sense that they leave contracting parties' obligations vague or unspecified? Traditional answers to this question invoke transaction costs or bounded rationality. In contrast, the authors argue that such incompleteness is often an essential feature of a well-designed contract. Specifically, once some aspects of performance are unverifiable, it is often optimal to leave other verifiable aspects of performance unspecified. The authors explore the conditions under which this occurs, and investigate the structure of optimal contracts when these conditions are satisfied. Copyright 1998 by American Economic Association.

Date: 1998
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