Differential awareness, ambiguity, and incomplete contracts: A model of contractual disputes

We focus on aspects of differential awareness that give rise to contractual disputes. Parties to a contract are boundedly rational as the state space available to them is coarser than the complete state space. Hence, they may disagree as to which state of the world has occurred, and therefore as to what actions are required by the contract. Such disagreement leads to disputes. We show that the agents may prefer simpler less ambiguous contracts when facing potential disputes.

► This paper shows how, under conditions of bounded rationality, semantic ambiguity may lead to incomplete contracting. ► Agents have access to state space with common formal description, but may disagree as to which state actually obtains. ► Representation of contract bargaining under ambiguity incorporates ‘war of attrition’ game and Gul and Pesendorfer expected uncertain utility preferences. ► Agents may prefer unambiguous contracts with incomplete risk sharing to ambiguous contracts that would yield full risk sharing in the absence of disputes.