Framing contingencies in contracts

Abstract

This paper develops a contracting model in which the principal frames the contract when the agent is unaware of some contingencies, yet is aware that she may be unaware. We call the contract vague if the agent is still unaware of some contingencies after understanding the contract. We show that the optimal contract is vague if and only if the principal exploits the agent. Applying the model to an insurance problem, we show the insuree is free from exploitation if she slightly underestimates the unforeseen calamities. In a contracting problem, whenever the contractor is unaware of the force majeure event, she is exploited by the employer.