Unforeseen contingencies and incomplete contracts

We scrutinize the conceptual framework commonly used in the incomplete cont ract literature. This literature usually assumes that contractual incomplet eness is due to the transaction costs of describing-or of even foreseeing-t he possible states of nature in advance. We argue, however, that such trans action costs need not interfere with optimal contracting (i.e. transaction costs need not be relevant), provided that agents can probabilistically for ecast their possible future payoffs (even if other aspects of the state of the nature cannot be forecast). In other words, all that is required for op timality is that agents be able to perform dynamic programming, an assumpti on always invoked by the incomplete contract literature. The foregoing opti mality result holds very generally provided that parties can commit themsel ves not to renegotiate. Moreover, we point out that renegotiation may be ha rd to reconcile with a framework that otherwise presumes perfect rationalit y. However, even if renegotiation is allowed, the result still remains vali d provided that parties are risk averse.