DP3271 Unforeseen Contingencies

Author(s): Nabil I. Al-Najjar, Luca Anderlini, Leonardo Felli
Publication Date: March 2002
Keyword(s): fine variability, finite invariance, incomplete contracts, unforeseen contingencies
JEL(s): D81
Programme Areas: Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=3271

We develop a model of unforeseen contingencies. These are contingencies that are understood by economic agents — their consequences and probabilities are known — but are such that every description of such events necessarily leaves out relevant features that have a non-negligible impact on the parties’ expected utilities. Using a simple co-insurance problem as a backdrop, we introduce a model where states are described in terms of objective features, and the description of an event specifies a finite number of such features. In this setting, unforeseen contingencies are present in the co-insurance problem when the first-best risk-sharing contract varies with the states of nature in a complex way that makes it highly sensitive to the component features of the states. In this environment, although agents can compute expected pay-offs, they are unable to include in any ex-ante agreement a description of the relevant contingencies that captures (even approximately) the relevant complexity of the risky environment.