Framing contingencies in contracts

The paper develops a contracting model where the principal frames the contract when the agent is unaware of some contingencies, yet is aware that she may be unaware. We call the contract vague if the agent is still unaware of some contingencies after understanding the contract. We show that the optimal contract is vague if and only if the principal exploits the agent. Applying the model to an insurance problem, we show the insuree is free from exploitation if she slightly underestimates the unforeseen calamities. In a contracting problem, whenever the contractor is unaware of the force majeure event, she is always exploited by the employer. Then, we show that persuasive advertising of experience goods is exploitative. Lastly, a benevolent parent manipulates his kid’s belief to make her more optimistic, and therefore overcomes the kid’s self-control problem.

• Type: Journal
• Year: 2011
• Where: MSS
• Authors: Xiaojian Zhao
• Keywords: Contingencies, Force Majeure Event, Hardware, MSS 2011, Optimal Contract