Ambiguity and contractual incompleteness

ABSTRACT

We introduce ambiguous states into an experimental investigation of a tradeoff between contractual rigidity and flexibility. Ambiguity magnifies both parties’ pessimism in an incomplete context. Ambiguity aversion is revealed in their choice. More complex interactions emerge in ambiguous environments.

KEYWORDS:

• Incomplete contract
• ambiguity aversion
• shade
• experiment

JEL CLASSIFICATION:

• D80
• C90
• J41

Disclosure statement

No potential conflict of interest was reported by the author(s).

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

¹ $c\left(q,\sigma \right)$ represents sellers’ cost depends on quality and state. Sellers’ cost of normal-quality product is $c\left(q^n,g\right)=20$ in the good state and $c\left(q^n,b\right)=80$ in the bad state. Sellers’ cost of low-quality product is $c\left(q^l,g\right)=25$ in the good state and $c\left(q^l,b\right)=85$ in the bad state.

² Prices must be no less than sellers’ cost and outside option. Prices at a competitive level in a good or bad state are considered to be 35 and 95, respectively.

³ In this paper we use nonparametric signed-rank tests on the average price, average profit of buyers, average profit of sellers, relative frequency of rigid contract, and relative frequency of normal quality. The p-value is one-sided.

⁴ The discontinuities between periods indicate that in those sessions, either there is no trade because buyers choose rigid contracts and the states are bad, or no buyer chooses rigid contracts.

⁵ In Fehr, Hart, and Zehnder (2011), the reference point hypothesis states that sellers should never shade in rigid contracts.

⁶ This is the weighted average number of sellers’ relative frequency of normal quality in ‘MF’ and ‘FR’.