Efficiently imprecise contracts: The role of conventionality

Actual contracts are often imprecise. This paper presents a principal–agent model that incorporates writing costs and contractual interpretation to analyze contractual impreciseness. The model allows us to examine how the complexity of a good, along with the conventionality of a good, affects the contractual impreciseness in an efficient equilibrium. It is shown that complexity alone does not determine the degree of contractual impreciseness. If two goods are equally conventional, a more complex good results in a more imprecise contract due to the writing costs. However, a less complex good can have a more imprecise contract if it is sufficiently more conventional, as conventionality allows the principal to write a contract without specifying the details. It is also shown that if a good is sufficiently unconventional relative to its complexity, the principal internalizes production. This paper provides a foundation for incomplete contracts and offers explanations for empirical findings in the literature.