A Model of Negotiation, Not Bargaining: Explaining Incomplete Contracts

Abstract

Bargaining models ask how a surplus is split between two parties in bilateral monopoly. Much of real-world negotiation involves complications to the original split which may or may not increase the welfare of both parties. The parties must decide which complications to propose, how closely to examine the other side's proposals, and when to accept them. Ex ante, this type of negotiation results in Pareto improvement, rather than reducing welfare. I model negotiation as a two-period auditing game, and find a variety of plausible equilibria. Precommitment or optimistic expectations can result in Pareto improvements. Perhaps most important, the model suggests a reason for contract incompleteness: contract-"reading" costs matter much more than contract-"writing" costs. Fine print that is very cheap to write can be very expensive to read carefully enough to detect the absence of booby trap clauses artfully written to benefit the writer.

JEL Classification: C7, D8