Litigation and the Optimal Combination of Vague and Precise Clauses in Contracts

Abstract

In this paper we determine the optimal combination of precise and vague clauses written in contracts when the parties face writing and enforcement costs, the second ones in the form of litigation. We show that the parties may prefer to write vague instead of precise clauses not only because they are cheaper to write but also because they are cheaper to enforce. We extend Battigalli and Maggi (2002) to model the decision of a principal who chooses clauses to describe the actions that an agent has to perform. As both players observe nature imperfectly they may call for a court to determine whether the agent performed the right action. We show that the principal tends to sue the agent more frequently when a task is described with a precise instead of a vague clause. The reason is the following: with precise clauses, the frequency of litigation increases with the value of the task that is described because a smaller discrepancy in the beliefs of the players is enough to trigger a dispute, but with vague clauses, that frequency decreases with the value of the task because the probability that the agent performs the right action increases with the value of the task. The direct implication is that vague and not precise clauses (as it is predicted by Battigalli and Maggi) are used to describe the most important tasks of a contract.

Keywords: Optimal Combination of Clauses, Vague and Precise Clauses, Writing and Enforcement Costs, Litigation

JEL Classification: D86, K12, K41