Subjective ambiguity and moral hazard in a principal-agent model

It is suggested that individual behavior under ambiguity, or knightian uncertainty, may represent an alternative explanation for contractual incompleteness with respect to the traditional approach in terms of transactions costs. This paper aims at showing that the introduction of ambiguity in the economic analysis of contracts may be very fruitful. In particular, we analyze how ambiguity affects the optimal compensation scheme in a principal-agent framework, where the principal cannot observe the agent’s effort and, contrary to standard assumptions, is ambiguityaverse. Also, our model makes it possible to generalize the Mukerji (1998) approach to contractual incompleteness. In fact, it shows that incomplete contracts are costly and that, before reaching the conclusion that ambiguity leads to contractual incompleteness, their costs should be compared with those of complete contracts, other things being equal.