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Contracting under uncertainty: A principal–agent model with ambiguity averse parties

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  • Grant, Simon
  • Jude Kline, J.
  • Quiggin, John

Abstract

We introduce linguistic ambiguity into a principal–agent contracting framework. Contracts are drafted in a common language. Nevertheless, the principal and the agent may ultimately disagree about the terms of the contract that apply ex post. We presume that both parties are ambiguity averse and for tractability reasons that their preferences take a recursive constant absolute risk averse (RCARA) form. We consider various dispute resolution regimes and analyze how the optimal dispute resolution regime depends on the ambiguity attitudes of the parties. We also provide an axiomatization of the class of RCARA preferences.

Suggested Citation

  • Grant, Simon & Jude Kline, J. & Quiggin, John, 2018. "Contracting under uncertainty: A principal–agent model with ambiguity averse parties," Games and Economic Behavior, Elsevier, vol. 109(C), pages 582-597.
    • Handle: RePEc:eee:gamebe:v:109:y:2018:i:c:p:582-597
    DOI: 10.1016/j.geb.2018.02.008
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    References listed on IDEAS

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    1. Halpern, Joseph Y. & Kets, Willemien, 2015. "Ambiguous language and common priors," Games and Economic Behavior, Elsevier, vol. 90(C), pages 171-180.
    2. Grant, Simon & Kline, J. Jude & Quiggin, John, 2012. "Differential awareness, ambiguity, and incomplete contracts: A model of contractual disputes," Journal of Economic Behavior & Organization, Elsevier, vol. 82(2), pages 494-504.
    3. Oliver Board, 2008. "Object-Based Unawareness: Theory and Applications," Working Paper 378, Department of Economics, University of Pittsburgh, revised Mar 2009.
    4. Mohammed Abdellaoui & Aurelien Baillon & Laetitia Placido & Peter P. Wakker, 2011. "The Rich Domain of Uncertainty: Source Functions and Their Experimental Implementation," American Economic Review, American Economic Association, vol. 101(2), pages 695-723, April.
    5. Kim-Sau Chung & Oliver Board, 2007. "Object-Based Unawareness," Working Papers 2007-2, University of Minnesota, Department of Economics, revised 24 Aug 2007.
    6. Bentley W. MacLeod, 2003. "Optimal Contracting with Subjective Evaluation," American Economic Review, American Economic Association, vol. 93(1), pages 216-240, March.
    7. Hogarth, Robin M & Kunreuther, Howard, 1989. "Risk, Ambiguity, and Insurance," Journal of Risk and Uncertainty, Springer, vol. 2(1), pages 5-35, April.
    8. Quiggin, John & Chambers, Robert G., 1998. "A state-contingent production approach to principal-agent problems with an application to point-source pollution control," Journal of Public Economics, Elsevier, vol. 70(3), pages 441-472, December.
    9. Chew, Soo Hong & Sagi, Jacob S., 2008. "Small worlds: Modeling attitudes toward sources of uncertainty," Journal of Economic Theory, Elsevier, vol. 139(1), pages 1-24, March.
    10. Chambers,Robert G. & Quiggin,John, 2000. "Uncertainty, Production, Choice, and Agency," Cambridge Books, Cambridge University Press, number 9780521622448, November.
    11. Grant, Simon & Kline, J. Jude & Quiggin, John, 2014. "A matter of interpretation: Ambiguous contracts and liquidated damages," Games and Economic Behavior, Elsevier, vol. 85(C), pages 180-187.
    12. Chen Li, 2017. "Are the poor worse at dealing with ambiguity?," Journal of Risk and Uncertainty, Springer, vol. 54(3), pages 239-268, June.
    13. ,, 2013. "Scale-invariant uncertainty-averse preferences and source-dependent constant relative risk aversion," Theoretical Economics, Econometric Society, vol. 8(1), January.
    14. Daniel Ellsberg, 1961. "Risk, Ambiguity, and the Savage Axioms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 75(4), pages 643-669.
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    Cited by:

    1. Guichen Gao & Xinxin Han & Li Ning & Hing-Fung Ting & Yong Zhang, 2022. "Principal–agent problem under the linear contract," Journal of Combinatorial Optimization, Springer, vol. 44(4), pages 2286-2301, November.
    2. Grant Simon & Guerdjikova Ani & Quiggin John, 2021. "Ambiguity and Awareness: A Coherent Multiple Priors Model," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 21(2), pages 571-612, June.

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    More about this item

    Keywords

    Linguistic ambiguity; Principal–agent problem; State-contingent versus output contingent contracts;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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