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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
Download Restriction: no

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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Web page: http://qed.econ.queensu.ca/
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  1. Bernheim, B Douglas & Whinston, Michael D, 1998. "Incomplete Contracts and Strategic Ambiguity," American Economic Review, American Economic Association, vol. 88(4), pages 902-32, September.
  2. Bentley W. MacLeod, 2003. "Optimal Contracting with Subjective Evaluation," American Economic Review, American Economic Association, vol. 93(1), pages 216-240, March.
  3. Subir Bose & Arup Daripa, 2008. "A Dynamic Mechanism and Surplus Extraction Under Ambiguity," Discussion Papers in Economics 08/24, Department of Economics, University of Leicester.
  4. Maskin, Eric & Tirole, Jean, 1999. "Unforeseen Contingencies and Incomplete Contracts," Review of Economic Studies, Wiley Blackwell, vol. 66(1), pages 83-114, January.
  5. Jean Tirole, 1999. "Incomplete Contracts: Where Do We Stand?," Econometrica, Econometric Society, vol. 67(4), pages 741-782, July.
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  7. Milne, Frank & Shefrin, H. M., 1987. "Information and securities: A note on pareto dominance and the second best," Journal of Economic Theory, Elsevier, vol. 43(2), pages 314-328, December.
  8. Simon Grant & Edi Karni, 2005. "Why Does It Matter That Beliefs And Valuations Be Correctly Represented?," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 46(3), pages 917-934, 08.
  9. Mark Westerfield & Tobias Adrian, 2007. "Disagreement and Learning in a Dynamic Contracting Model," 2007 Meeting Papers 270, Society for Economic Dynamics.
  10. 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.
  11. David S. Ahn, 2008. "Ambiguity Without a State Space," Review of Economic Studies, Oxford University Press, vol. 75(1), pages 3-28.
  12. Oliver Hart & John Moore, 1998. "Foundations of incomplete contracts," LSE Research Online Documents on Economics 19354, London School of Economics and Political Science, LSE Library.
  13. MacLeod, W Bentley & Malcomson, James M, 1989. "Implicit Contracts, Incentive Compatibility, and Involuntary Unemployment," Econometrica, Econometric Society, vol. 57(2), pages 447-80, March.
  14. Sujoy Mukerji & Jean-Marc Tallon, 2002. "Ambiguity Aversion and the Absence of Wage Indexation," Economics Series Working Papers 111, University of Oxford, Department of Economics.
  15. G. Carlier & L. Renou, 2005. "Debt contracts with ex-ante and ex-post asymmetric information: an example," Game Theory and Information 0502003, EconWPA.
  16. Pierpaolo Battigalli & Giovanni Maggi, 2002. "Rigidity, Discretion, and the Costs of Writing Contracts," American Economic Review, American Economic Association, vol. 92(4), pages 798-817, September.
  17. Mathias Dewatripont & Patrick Bolton, 2005. "Contract theory," ULB Institutional Repository 2013/9543, ULB -- Universite Libre de Bruxelles.
  18. 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.
  19. Guillaume Carlier & Ludovic Renou, 2005. "A costly state verification model with diversity of opinions," Economic Theory, Springer, vol. 25(2), pages 497-504, 02.
  20. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  21. Van den Steen, Eric, 2005. "On the Origin of Shared Beliefs (and Corporate Culture)," Working papers 27855, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  22. Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 871-915, August.
  23. Van den Steen, Eric, 2005. "Too Motivated?," Working papers 18180, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  24. Segal, Ilya, 1999. "Complexity and Renegotiation: A Foundation for Incomplete Contracts," Review of Economic Studies, Wiley Blackwell, vol. 66(1), pages 57-82, January.
  25. Jonathan Levin, 2003. "Relational Incentive Contracts," American Economic Review, American Economic Association, vol. 93(3), pages 835-857, June.
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