Optimally Vague Contracts and the Law

• Authors: Giacomo Ponzetto.
• BSE Working Paper: 112108 | September 15
• Keywords: contracts , legal evolution , precedents , optimal contracts , contract enforcement
• JEL codes: D86, K12, K40
• contracts
• legal evolution
• precedents
• optimal contracts
• contract enforcement

Many real-world contracts contain vague clauses despite the enforcement risk they en- tail. 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