Investment Incentives under Contractual Unawareness

We study investment incentives when contracts do not cover all payoff-relevant contingencies. In a principal-agent model with moral hazard, the agent’s non-contractible investment changes both the distribution over contracted contingencies and the probability of an unforeseen contingency governed by legal default and ex post negotiation. First, we develop a framework separating awareness effects across parties and contractual branches: the agent’s awareness determines whether the unforeseen branch enters her investment incentives, whereas the principal’s awareness affects his perceived profitability and prediction of her investment. Second, we show contractual unawareness can reverse the hold-up comparison: the aligned contract gives the agent the full marginal surplus on foreseen contingencies, while her marginal return on the unforeseen branch is generated by default and negotiation, and either force can dominate. Third, heterogeneous ex post evaluations or transfer constraints can cause negotiation to fail, leaving the court-imposed default in place. Legal defaults thus shape ex ante investment and ex post efficiency, and we characterize the trade-off governing the optimal default.