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Contracting in Vague Environments

  • Marie-Louise Vierø

    ()

    (Department of Economics, Queen's University)

This paper shows that a new trade-off arises in the optimal contract when contracting takes place with vague information (objective ambiguity), reflecting that real-world contracting often takes place under imprecise information. The choice-theoretic framework captures a decision-maker`s attitude towards vagueness by his optimism. The new trade-off is between (a) incentive provision and (b) exploitation of heterogeneity that arises endogenously because of the vague environment. Consequently, the optimal contract may distort effort in order to relax incentive compatibility and fully exploit the endogenously created heterogeneity, even when the agent is risk neutral and there is no insurance need in the relationship.

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File URL: http://qed.econ.queensu.ca/working_papers/papers/qed_wp_1106.pdf
File Function: First version 2006
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Paper provided by Queen's University, Department of Economics in its series Working Papers with number 1106.

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Length: 38 pages
Date of creation: Dec 2006
Date of revision:
Publication status: Published in American Economic Journal: Microeconomics
Handle: RePEc:qed:wpaper:1106
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  1. Mukerji, S., 1997. "Ambiguity aversion and incompleteness of contractual form," Discussion Paper Series In Economics And Econometrics 9715, Economics Division, School of Social Sciences, University of Southampton.
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  14. Marie-Louise Vierø, 2006. "Exactly What Happens After the Anscombe-Aumann Race? Representing Preferences in Vague Environments," Working Papers 1094, Queen's University, Department of Economics.
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  19. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
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  24. Mark Westerfield & Tobias Adrian, 2007. "Disagreement and Learning in a Dynamic Contracting Model," 2007 Meeting Papers 270, Society for Economic Dynamics.
  25. Ilya Segal, 1999. "Complexity and Renegotiation: A Foundation for Incomplete Contracts," Review of Economic Studies, Oxford University Press, vol. 66(1), pages 57-82.
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