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

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.