Overcoming Contractual Incompleteness: the Role of Guiding Principles

Abstract: We develop a model where a buyer and seller contract over a service. The contract encourages the seller to invest and provides a reference point for the transaction. In normal times the contract works well. But with some probability an abnormal state occurs and the service must be modified. This puts the parties below their reference payoffs and may cause costly disagreement. We discuss why neither classical mechanisms nor lawyers’ standard approaches adequately deal with this issue. The adoption by the parties of guiding principles such as loyalty and equity as part of their contract can help.