Simplicity and Complexity in Contracts

Abstract:     
Standard economic models of contract imply that contracts should be highly "complex," by which we mean (1) rich in the expected number of payoff-relevant contingencies; (2) variable in the magnitude of payoffs contracted to flow between parties; and (3) severe in the cognitive load necessary to understand the contract. Yet most real-world contracts are simple along all three of these dimensions. We argue that many factors, often neglected in the literature, account for this discrepancy. The factors are categorized as asymmetric information, monitoring dynamics, evolutionary pressures, conventions, reliance on trust and reputation, enforcement costs, bounded rationality, and renegotiation. This positive analysis has normative implications for how lawyers draft contracts, and for how courts rely on the form of a contract (specifically, its degree of complexity) in order to interpret it.

JEL Classifications: K12

Working Paper Series