DP10700 Optimally Vague Contracts and the Law

Author(s): Nicola Gennaioli, Giacomo AM Ponzetto
Publication Date: July 2015
Keyword(s): contracts, imperfect enforcement, legal evolution, precedents
JEL(s): D86, K12, K40
Programme Areas: Public Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10700

Many real-world contracts contain vague clauses despite the enforcement risk they entail. To study the causes and consequences of this phenomenon, we build a principal-agent model in which contracts can include vague clauses whose enforcement may be distorted by opportunistic litigants and biased judges. We find three results. First, the optimal contract is vague, even if courts are very imperfect. Second, the use of vague clauses is a public good: it promotes the evolution of precedents, so future contracts become more complete, incentives higher powered, and surplus larger. Third, as precedents evolve, vague contracts spread from sophisticated to unsophisticated parties, expanding market size. Our model sheds light on the evolution and diffusion of business-format franchising and equity finance.