Ambiguous Contracts

TL;DR

This paper investigates how ambiguity in contract design can benefit principals when agents are ambiguity-averse, revealing conditions under which ambiguity leads to better outcomes and when its advantages vanish.

Contribution

It characterizes the structure of optimal ambiguous contracts, identifies ambiguity-proof classes, and analyzes the impact of mixed actions on the benefits of ambiguity.

Findings

Ambiguous contracts can significantly benefit principals when agents are ambiguity-averse.

Optimal ambiguous contracts tend to be simple in structure.

The advantages of ambiguity disappear when agents can engage in mixed actions.

Abstract

We explore the deliberate infusion of ambiguity into the design of contracts. We show that when the agent is ambiguity-averse and hence chooses an action that maximizes their minimum utility, the principal can strictly gain from using an ambiguous contract, and this gain can be arbitrarily high. We characterize the structure of optimal ambiguous contracts, showing that ambiguity drives optimal contracts towards simplicity. We also provide a characterization of ambiguity-proof classes of contracts, where the principal cannot gain by infusing ambiguity. Finally, we show that when the agent can engage in mixed actions, the advantages of ambiguous contracts disappear.