This paper offers an explanation of rationally incomplete contracts, where incompleteness refers to unforeseen contingencies. Agents enter a two-sided moral hazard relationship, in which a commitment to discard parts of the joint resources may be ex-ante efficient. This happens through costly legal dispute which arises when contract terms are missing for undesirable outcomes. We show that an optimal contract needs only to specify the obligation for the more litigious party to assure a certain output level – the threshold between foreseen and unforeseen contingencies – and a linear sharing rule for the foreseen contingencies. If litigation reveals some information about the effort levels of the agents, less costly dispute is typically needed and the allocation will improve.
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