Working Paper: CEPR ID: DP10700
Authors: Nicola Gennaioli; Giacomo A. M. Ponzetto
Abstract: 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.
Keywords: contracts; imperfect enforcement; legal evolution; precedents
JEL Codes: D86; K12; K40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| vague contracts (D86) | judicial discretion (K41) |
| judicial discretion (K41) | evolution of contract law (K12) |
| vague contracts (D86) | better enforcement outcomes (K40) |
| vague contracts (D86) | development of legal precedents (K41) |
| development of legal precedents (K41) | completeness and reliability of future contracts (G13) |
| vague contracts (D86) | spread from sophisticated to unsophisticated parties (Z13) |
| vague contracts (D86) | market size (L25) |
| vague contracts (D86) | judicial interpretation (K40) |
| judicial interpretation (K40) | adaptation over time (D15) |