INCOMPLETE CONTRACTS AND STRATEGIC AMBIGUITY

Why are observed contracts so often incomplete in the sense that they leave contracting parties' obligations vague or unspecified? Tradition al answers to this question invoke transaction costs or bounded ration ality. In contrast, we argue that such incompleteness is often an esse ntial feature of a well-designed contract. Specifically once some aspe cts of performance are unverifiable, it is often optimal to leave othe r verifiable aspects of performance unspecified. We explore the condit ions under which this occurs, and investigate the structure of optimal contracts when these conditions are satisfied.