Date Published:

Abstract:

Why are contracts incomplete? Transaction costs and bounded rationality cannot be a total explanation since states of the world are often describable, foreseeable, and yet are not mentioned in a contract. Asymmetric information theories also have limitations. We offer an explanation based on “contracts as reference points”. Including a contingency of the form, “The buyer will require a good in event E”, has a benefit and a cost. The benefit is that if E occurs there is less to argue about; the cost is that the additional reference point provided by the outcome in E can hinder (re)negotiation in states outside E. We show that if parties agree about a reasonable division of surplus, an incomplete contract can be strictly superior to a contingent contract.